There is a long list of reforms that the Trump administration intends to tackle and one of the items on the list is tax reform. Although there are multiple proposals by various players and significant variations among the proposals, the three primary goals of reform appear to be a reduction in income tax rates for both corporations and individuals, simplification, and some adjustment of the international tax regime. As is the case with all things political, the outcome is difficult to predict with any certainty and perhaps all or none of these objectives will be achieved. This discussion will focus on the implications of proposed changes in income tax rates for business and tax planning.
Clients base their decisions on a multitude of factors. In most cases, taxes (whether they be income, estate, employment or other) will generally have some weight in that decision. When we are in an environment where a fundamental aspect of how a particular tax operates may change, in this case a likely but not certain material reduction in income tax rates, the impact of taxes on the decision becomes even more difficult to assess. Notwithstanding this uncertainty, as practitioners engaged in assisting our clients in planning for the future, we must address this issue of the implications of changes in rates now because waiting for clarity is typically not an option.
Set forth below are some points to consider as you weigh the impact of tax reform and a reduction in income tax rates in your decision making process. As with all generalizations, the discussion below is intended to highlight only some of the factors to consider, the optimum outcome will be governed by your particular facts and circumstances.
The number one rule in an era of tax reform is to pay attention. Being informed about the details of reform is vital to positioning yourself for the future. Some of the items to be aware of are: (a) which taxes are changing and how much, (b) what are the effective dates, and (c) what are the transitional or phase-in rules that will cushion any change. Second, in some of these proposals, the benefit of a reduction in the income tax rate is offset by the elimination of a deduction or other tax relief. These changes will likely impact every phase of planning from business ventures, retirement planning, personal investments and to your estate plan. Any of the proposals under consideration if adopted will fundamentally alter the tax environment. The best way to navigate this new environment is to stay informed about the changes.
One Tax is Better than Two
As noted above, if there is a common denominator in most proposals for tax reform, it is lower maximum rates at both the corporate and the individual level. The double taxation of earnings of a C corporation (once as income to the C corporation and second as a dividend when distributed to the shareholders) will almost always be greater than income that is only taxed once. Thus, the use of limited liability companies, S corporations and other pass-through entities would still retain an income tax advantage over C corporations. The tax treatment of pass-through may become even advantageous if proposals to tax “business” income at a more favorable rate are adopted.
Change in Form
If an activity is carried out as an entity that is a “pass-through” entity and not subject to income tax (partnership, S corporation, etc.), it is typically possible to convert these entities into an entity that is subject to tax without triggering any income tax liability. The converse is not true. For C corporations and even some S corporations, the change in form to a pass-through entity subject to a single level of tax is almost always a taxable event. Thus, in the near term, continued use of pass-through entities would be a preferred option. If the change in rates or other changes make C corporations more tax efficient, changing from a pass-through entity to a separate taxable entity is not overly complex or burdensome.
Given that rates are expected to decrease, you would typically prefer to defer gain to a later date. Although both installment sales and like-kind exchanges generate their own complexities, these can be valuable tools in controlling the recognition of income. Similarly, if one is considering exercising stock options, or otherwise accelerating recognition of income, a more prudent step may be to defer as long as possible. You do need to be careful to avoid bunching of income in future years and, of course, recognize income when required, e.g. required minimum distributions from retirement accounts, but right now deferral would appear a prudent course to consider.
Another typical recommendation in a changing rate environment when rates are expected to decrease is to accelerate deductions. Clearly a deduction is more valuable in a higher income tax rate environment than a lower rate environment. Further, as noted above, many of the proposals eliminate or limit the utility of many common deductions in exchange for lower rates. Although all of the factors would call for the acceleration of deductions, the challenge is that this strategy may be less easy to implement than other options. First, there are the limitations on the right of a taxpayer to accelerate deductions. Second, there is the necessary expenditure of funds or transfer of assets required to claim the deduction which may create its own burden. Finally, if no change occurs, one could end up in a less tax advantageous position in later years.
In summary, when confronted with a changing tax environment, the primary task is to stay informed and to expect a few twists and turns. Although we cannot put our lives or businesses on hold until clarity is achieved, the prospect of tax reform must be a part of the calculation in any decision going forward where taxes are a factor in the decision making process.