What Tax Reform Could Mean for the Middle Market
The Senate and House of Representatives are working on reconciling their versions of tax reform in an effort to get a final bill to the President before Christmas. This means that the first comprehensive tax reform since 1986 is on the verge of being a reality.
So, we thought you’re probably wondering what each chamber’s proposal could mean for middle market businesses. Here are a few of the most important aspects of both bills that you need to consider.
A very important and easily overlooked aspect of this legislation is how each bill addresses S-corporations (or pass-throughs). The House bill cuts the top S-corporation rate to 25 percent, which would be a huge break from the current rate that’s based on personal income tax levels. On the other hand, the Senate bill leaves the top S-corporation rate at 38.5 percent but increases deductions from 17.4 to 23 percent.
Whatever comes out of the reconciliation between the two bills, this is a surprisingly significant issue given that about 50 percent of middle market businesses are structured as pass-throughs.
Both bills currently allow for the immediate expensing of 100 percent of the costs of capital investment in equipment. In the short- to mid-term, this would cause a large increase in investment due to the potent combination of businesses paying less in taxes with an effective decrease in the cost of investing.
The reason this isn’t in the “great” section of this article is because this tax cut expires after five years due to budget deficit concerns.
Perhaps the most striking aspect of both bills is the significant cut in the top federal corporate tax rate from 35 percent to 20 percent. According to the Congressional Budget Office, the U.S. has the highest corporate tax rate out of the top 20 economies in the world. When state and local taxes are added, the top statutory rate that companies can currently be required to pay is 39.1 percent.
That doesn’t mean that most companies pay a 39 or even 35 percent rate. In fact, the average income tax paid by C-corporations is about 27 percent because of the multitude of incentive-based tax deductions.
However, the fact that companies usually don’t have to pay the current statutory rate doesn’t discount the fact that the highest possible rate under this reform would be 7 percent lower than the average rate paid now.
The Not So Great
Alternative Minimum Tax
In an effort to keep the projected increase in the deficit below $1.5 trillion, the Senate kept the alternative minimum tax (AMT). This move helped them to get the slim 51-49 majority they needed to pass the bill. However, the House bill completely repeals the AMT. This divergence is definitely going to be a sticking point as the two houses go through reconciliation.
Some, including the President, have suggested the possibility of increasing the corporate rate to 22 percent to offset the cost of repealing the AMT.
While macroeconomic trends are always difficult to predict and always come with a partisan veil, a tax cut of this magnitude is going to increase the federal deficit. At the same time, the Fed is likely to continue its slow increase in interest rates, which will have the effect of increasing the cost of our debt. To solve this problem, we are likely to see a future debate in Washington about either a reduction in federal spending or the elimination of some of these tax breaks.
The Bird Rule
The entire reason that this bill has made it to reconciliation is because the Senate used what are often called “legislative maneuvers” to only require a simple majority to pass a bill. Usually, a bill that addresses the budget requires 60 votes to pass the Senate, and that would have never been possible.
However, the “Bird Rule” allows the Senate to pass a bill affecting the budget with only 51 votes, as long as it doesn’t impact the deficit for longer than 10 years.
This means that during the reconciliation process the Senate is likely to win out on many of the differences between the two bills because of the stricter guidelines it needs to follow to pass the reconciled version of the bill. So, most of the big changes are going to be temporary, and need re-approval after 10 years.
Optimism and Growth
Optimism would be the word to describe the business community’s outlook toward tax reform over the last year. We believe that if this legislation passes then that optimism will be justified and will continue.
Along with that optimism will be, according to the US Chamber of Commerce, huge reinvestments into businesses with the capital they keep rather than pay in taxes. And when capital is reinfused into businesses across the spectrum we are likely to see growth. The exact extent of reinvestment and growth is to be determined and is greatly debated, but there is little doubt that the middle market will benefit.
The optimism that we’ve been seeing over the last year has coincided with a “wait and see” attitude across the M&A landscape. After banner years in 2015 and 2016, 2017 has seen a huge slump as businesses held on to their capital and waited to see if tax legislation would go through. With the passage of tax reform the waiting will be over, and, we believe, M&A activity will increase significantly.
If you’re looking to take advantage of the beneficial aspects of the tax reform that seems to be on the horizon then you’re in the right place. The Symmetrical team has decades of combined experience helping companies complete M&A transactions and we can certainly help you grow in the coming years. Contact us here.
This blog provides business, financial, and tax information to clients and friends of our firm. This general information should not be acted upon without first determining its application to your specific situation. For further details on any article, please contact us.