In a recent article, we discussed the possibilities of tax reform and how to utilize tax planning measures in an uncertain tax environment. McGuire Sponsel would like to take a moment to revisit this topic. To date, the Border Adjustment Tax has been tabled and comprehensive tax reform is looking less likely. That said, there are still certain levels of the government that are pushing for tax reform before year-end.
Permanent tax reform will be difficult without changing the reconciliation rules. Under the current rules, a 60 vote majority will be required if reform is not revenue neutral. Without the Border Adjustment Tax, the odds of a large scale reform being revenue neutral is low, even with aggressive growth projections.
However, temporary tax cuts can be made with a simple majority, as long as the cuts are within the budget window of 10 years. This increases the likelihood of temporary tax cuts over a shorter window. A good question arises from this point, “If there is a temporary tax cut, should businesses hold deductions or use them as soon as possible?” The short answer is that most business deductions should still be maximized on a year by year basis. This does not make sense until we go through the math.
For purposes of this discussion, let’s assume that for a four year period, there is a 5 percent tax reduction, which would reduce the tax rate from 40 percent to 35 percent. If a taxpayer has a $1,000,000 deduction, they can take the deductions now, or hold them for five years until tax rates go up. How does this affect the taxpayer?
Just in terms of simple cash flow, it is an easy calculation. Under the reduced rates, this deduction is worth $350,000 at the 35 percent rate, and $400,000 at the 40 percent rate. However, in order to take the 40 percent rate, the taxpayer would have to hold the deduction. Therefore, it is important to take into consideration the time value of money. Assuming a conservative discount rate of 4 percent, the value of the $400,000 in 5-years drops to $335,282 (lower than the $350,000 at the temporary reduced rates). If any inflationary pressures hit these numbers, it becomes that much more imperative to maximize deductions in the short term.
Businesses also need to consider business risk. Many times we have seen businesses hold on to deductions for use in a future year and unforeseen changes in the business environment prevent the company from using them. Many time this could be due to a posted loss or reduced income. If the business had maximized the deductions in the high tax year, the company would now have the cash available.
While there are exceptions to every rule, it is rarely a good idea to sit on deductions if a business is in the upper tiers of tax rates. This confirms the belief that businesses should not put off cost segregation and other tax planning opportunities, even if there is a rate drop in 2017 or 2018. Through cost segregation, tax burdens can be minimized and allow for the opportunity to reinvest available money.
Cost segregation reclassifies assets to maximize personal property and optimize depreciation deductions – resulting in substantial cash flow. Can your client benefit form a cost segregation study? If you have any questions about tax reform and how it relates to cost segregation or would like to discuss a specific client situation, please contact McGuire Sponsel.