Tax Law Changes

Tax Law Changes

By Brad Thomason

 

Well, tax reform is now a thing.  I see ahead of myself a rather lengthy homework assignment in which I read a lot and listen to a lot of folks who specialize in taxation and know more about this stuff than I do.  I expect the changes to impact my personal taxes, the taxation of my business, and of course have implications for our clients.  Some of them will see major changes.

So while there’s a lot about the new tax law that we haven’t digested yet, what I can tell you is that the major benefits will accrue to the same folks that are always the recipients of tax planning opportunities: those who have something left after they pay their monthly bills.

Tax planning is a wide field with many twists and turns.  But the thread running through the vast majority of the strategies is that they are less useful to the earn-and-spend crowd than they are the earn-and-save crowd.  The ubiquitous example of this in the lives of most individuals is the IRA and the various work-place analogues like 401(k) accounts.  But investors who operate beyond simple stock and bond portfolios (e.g. real estate and private equity), as well as business owners, have even more levers that they can pull.

A key theme in tax planning is rate arbitrage.  Essentially, even though you don’t get out of paying taxes altogether, you pay them at a lesser rate than someone else might.  The reduction in corporate rates is likely to spark a new round of moves for those looking to reduce the rate on business earnings.  But it will only have value for those who need to spend less than what they earn.

The prime complaint about corporate taxation for individual tax payers has always been the notion of double taxation.  If you earned it at the corporate level you paid tax once, and then when you issued a dividend, you paid a second time (i.e. the recipient, which was usually the business owner, paid again on the personal return).  Or, you paid it out to the owners as salary; which eliminated the corporate tax liability, but made it ordinary income at the 1040 level.  Neither result landed you anywhere better-off than other tax payers, and in fact maybe caused you to pay more.  In other words, no large-scale opportunities for rate arbitrage.

What’s on the table now is the opportunity to take advantage of the lower corporate rate, leave the money in the corporation, and avoid that tax bite at the individual level.  There may even be an opportunity for a further savings at the state income tax level, depending on where you live and where the corporation is formed (which generally speaking doesn’t have to be the same place).

Essentially, a company that made $100 in the past might have only been left with $60 or $65 to reinvest after taxes, and earnings on those reinvested amounts would have been taxed in the 35% to 40% range.  Now, assuming no state taxes, the same level of earnings would leave $79 available to use, with future earnings on those reinvested amounts only being subject to a 21% tax.  You get more to reinvest, and the downstream tax load is also reduced.  It shouldn’t be hard to see how this is of benefit.  Best of all, the benefits compound from one year to the next, so the value of the strategy increases the longer you let everything ride.

Eventually you may want to take the money out of the company, and bring the whole matter to a close.  But you still get a deferral benefit in all of the years until that takes place, and depending on how the liquidation is handled, it may qualify for capital gains treatment, instead of the higher ordinary income treatment.

Owners of small businesses will have options in terms of growing their core business, or making private equity investments in other businesses.  Real estate investors will have opportunities to further reduce any tax burden not already offset by depreciation deductions and loan interest deductions.  Some basic applications of the new rate structure are already obvious, and no doubt with time more nuanced once will become evident as well.

But to finish where I started: these tax benefits are only available to those who don’t need to spend everything they earn.  A lot of people are not in that club.  Most who aren’t will complain that the tax reform didn’t really do much for them.  But a few will see the opportunity and start looking for ways to get themselves in position to join the club.  Then the real fun begins.  Because when you invest enough time studying the possibilities, you come to understand that of all the things a person could do with a dollar, spending it is about the least interesting one available.  Wealth building begins for many when they arrive at that point.

For wealth builders, I think we’re all going to find that there’s a lot in the new tax bill to like.