By Steven W. Reed, Howard I. Gross and Sam Pollom
Last June, the House Republican Tax Reform Task Force put forth their blueprint for tax reform, entitled “A Better Way — Our Vision for a Confident America.” Now with a Republican president and majorities in both houses of Congress, tax reform seems more imminent than it has been since 1986. While the blueprint puts forth changes to both individual and corporate taxes, we will focus on the corporate changes being discussed.
The Republican blueprint believes that the current corporate tax structure encourages businesses to move money overseas. At 35 percent, the United States has one of the highest tax rates in the developed world, with only two of 173 countries having a higher rate. They point to the fact that in 1960, 17 of the 20 largest global companies were in the United States. In 2015, only six of the top 20 were in the U.S. They further discuss the $2 trillion in capital that American companies hold overseas due to the impending tax bill if they bring the money back to the United States.
So how would the corporate tax structure change under the blueprint? The new tax system would move toward taxation based on a destination-based cash-flow tax. This system would be administered in a similar fashion as the current income tax, with each business required to file and pay tax on an annual basis.
As the name implies, there are two parts under the proposal. The first, destination-based, means the taxing jurisdiction is based on the location of the consumption rather than the location of production. This is a move to a territorial tax system, through border adjustments, that is more prevalent around the world. Under the proposal, amounts received by a business from selling products in the United States would be subject to tax. Amounts received from sales of products exported from the U.S. would not be subject to tax. Amounts paid for products from within the U.S. could be deducted by the company, however, amounts paid for products imported into the U.S. would be subject to tax through denying a deduction for their cost. For a business conducting operations exclusively in the U.S., an accounting system that records the receipts to the company and payments made by the company would be sufficient to calculate the income tax. For a business that is importing material and exporting finished goods, a more sophisticated accounting will be required to calculate taxes.
The cash-flow portion of the proposal would allow businesses the benefit of full and immediate expensing of the cost of investments. This immediate cost recovery will apply to both investments in tangible property (equipment and buildings) and intangible assets (goodwill). Gone will be the days of needing to determine if an expenditure should be capitalized or what depreciable life should be assigned. Land would become the only expenditure subject to capitalization. With tax imposed on cash received less cash paid, the accrual method of accounting and issues associated with its application would be eliminated.
With the move to a cash-flow tax, interest expense would only be deductible to the extent of interest income. The blueprint indicates that the immediate expensing of business investment is more beneficial and more neutral than the deduction of interest expense associated with debt financing. Allowing both the immediate write off and the interest expense would be an additional tax subsidy for debt financing.
Another hallmark of the blueprint is that corporate and individual income tax rates would be reduced. For sole proprietors or pass-through entities, the blueprint would apply a 25 percent tax rate on the active business income of sole proprietors, partnerships and S Corporations. However, under this approach, sole proprietorships and pass-through businesses will pay, or be treated as having paid, reasonable compensation to the owner-operator. This reasonable compensation would be deducted by the business and subject to the individual tax rates.
For C Corporations, which are currently subject to graduated rates that quickly become 35 percent, the blueprint will lower the corporate tax rate to a flat rate of 20 percent. While not eliminating the double taxation that occurs on the dividends of C Corporations, it will be reduced through the reduction in the tax on dividends and capital gains of individual shareholders. While not discussed here, the blueprint would tax dividends and capital gains at half the regular individual rate of the shareholder.
There is still much negotiating and deal making left to do to get these changes into law, but it seems that complete tax reform is a topic high on the priority list of many. As we get closer to the changes, accountants and attorneys alike must be aware of the potential changes and the issues and opportunities that they may give to our clients.•
Steven W. Reed, CPA/ABV/CFF, Howard I. Gross, CPA/ABV/CFF, CFP, and Sam M. Pollom, JD, CPA are with BGBC Partners LLP – Litigation, Forensic and Business Valuation. Contact BGBC at 317-633-4700 or visit www.bgbc.com. The opinions expressed are those of the authors.