Sweeping changes
Was the 2017 Tax Act needed? Will it help with capital expenditures and bank lending? And what about the S versus C Corp decision? Here’s what area experts have to say.
From the pages of In Business magazine.
Congress passed the 2017 Tax Act in December, fulfilling a campaign pledge from President Donald Trump and making sweeping changes to a tax code that hadn’t been overhauled since 1986.
Regardless of which president gets the credit, the ratification marked the end to a year that saw the Dow Jones Industrial Average soar 25% despite geopolitical tensions and Mother Nature’s fury, leading experts to project a strong 2018, as well, although few predicted the same upward trajectory.
As if on cue, a first quarter stock market correction hinted at volatility that could continue for a while, especially in a global market that seems to respond to every nuance and presidential tweet.
Still, companies nationwide announced increased wages and/or benefits for employees. Locally, CUNA Mutual Group made its largest contribution ever, $20 million, to its charitable arm, CUNA Mutual Group Foundation; American Family Insurance credited tax reform for its ability to give 11,000 workers a one-time bonus of $1,000; Wisconsin’s utility companies expect to save millions, if not hundreds of millions, over time; and other companies made headlines for increasing their own minimum wage.
With this backdrop, we asked several area experts to share their professional insight.
IB: Was the 2017 Tax Act (tax act) needed, in your opinion?
Mike Steinl, CPA and partner, Wegner CPAs: I’ve been doing this 29 years and this is the biggest year I can remember where people are caring more about planning for next year than they are the current tax year (2017). In my opinion, before the law passed the economy was showing some weaknesses and if the tax act can help correct that, yes, tax reform will be very worthwhile. There just may be a little less confidence than there was before.
Gary Schaefer, executive vice president/Madison market president, Associated Bank: I think the tax act has given additional legs to the economic growth already in the market. I don’t think anyone is expecting robust growth in 2018, but it may stay on par with 2017, which I categorized as good, but not excellent.
E. David Locke, chairman and CEO at McFarland State Bank: Generally speaking, I think this bill was long overdue. It’s been more than three decades since the last tax reform and the U.S. and businesses in the U.S need to remain competitive. We’re in a global marketplace now, and if you’re not competitive in terms of tax treatment, you’re at a disadvantage.
IB: What’s the general mood of your business clients?
Schaefer: A lot of our clients have enjoyed a pretty good run since the Great Recession. I’m seeing discussions and plans for future expansion more so now than we’ve probably seen in the last 18 months.
Steinl: This is a major tax law change and a lot of people are still trying to figure out how it will affect them. Honestly, I don’t envy the IRS right now. They’ll have a lot of regs and codes to write just to address what the government has put in place.
I lead our manufacturing supply chain group, and last year a lot of our clients had big backlogs so they knew there would be work for them through the end of the year. Over the past six months or so, that backlog isn’t there, so I’d characterize many clients as having a good start in 2018 versus 2017, but they’re unsure how long it will last.
Jimmy Kauffman, president/CEO, Bank of Sun Prairie: I am seeing a lot of optimism out there even as businesses are trying to figure out what tax reform means to them. There are certainly plans to grow and invest in their franchises. I think the mood is even better compared to where we were a year ago. Rates are ticking up and there’s unquestionably more conversation about growth in the marketplace.
Locke: In terms of small businesses (less than $40 million in sales), I think a general tone of optimism exists. Borrowing activity is still fairly strong and it’s been buoyed by the tax act in early December. C Corps are getting a pretty significant tax cut but the jury is still out relative to how the tax bill will ultimately treat S Corps, which tend to be the smaller businesses.
IB: Was tax reform the spark needed to ignite capital spending?
Kauffman: I think people are charging ahead cautiously. Nobody wants to relive the [2008-09 financial] crisis. We’ve learned and we’re all smarter now, which positions us well. We’ve seen clients moving forward with hires they may not have otherwise made as quickly. We did, too. We might have made those hires anyway, but why wait?
Schaefer: Many of our business clients had decent liquidity on their balance sheets that they’re using up now to fund their own expansions, whether that means a plant expansion or purchasing new equipment. As that cash and liquidity gets depleted, we’ll probably see some additional loan demand, as well.
But some of the companies we’re working with are holding back because they want to make sure they’ll be able to find the right employees and enough employees before they expand — whether they’re planning to purchase new equipment or technology, add to their plant, or even acquire another company.
Hiring, especially for manufacturers, remains an issue. If they want to buy new equipment, they’ll need people to run that equipment. At the same time, new purchases can also create more efficient operations that could help their employment situation. One positive, in my opinion, is the work our technical colleges are doing. We’re seeing kids coming out of those programs and immediately helping.
Steinl: Certain rules have been added regarding expensing equipment. In the past, you could only expense new equipment, but the new law in certain instances applies to used equipment, as well. Last year, for example, there was a lot of used equipment on the market that nobody wanted because everyone was buying new. The new tax law allows you to get a tax break right away whether you buy new or used equipment to help your business.
Companies valued at over $25 million, however, might be limited to how much interest expense they can deduct, which could put a dent into some plans.
In the past, a business owner could purchase a new piece of equipment, go to a bank, and potentially finance it 100%. They’d be able to write off the cost of the equipment in the first year, but they’d also get a deduction for all the interest they paid on the loan they used to purchase it.
Now, going forward, essentially they’ll look at your income, add back your interest, and then take 30% of that, which would be the most interest you could take. So a company that is at breakeven or not making much profit might not be able to deduct all their interest or use their interest to create a loss.
Schaefer: I think we’ll start to see some impact later in the year, but one of the drivers that might cause that to happen earlier will be the rising interest rate environment. With the feds planning on more increases this year, companies may decide that this is the best time to lock in their three- or five-year financing to take advantage of the lower rates, especially if they were on the fence before.
IB: What about business lending?
Schaefer: Right now, banks are in a great position to meet demand. We have liquidity and deposits have grown. For the most part, banks have clean loan portfolios, no big credit issues, and a solid capital structure, so the capacity is there to meet loan demand and remain competitive.
Kauffman: We had almost 14% loan growth last year, which is outstanding. We’ve been able to grow our bank by 27% over the last three years.
Dane County is seeing rapid growth in commercial real estate and multi-family housing, so you have to get into the right projects with the right developers, but there’s just so much demand out there.
At the same time, there are still a lot of deeply rooted regulatory costs that have made things harder for small banks. We’re just a $383-million bank and we have two full-time compliance officers here. For a bank with just $50 million in assets, it’s hard to employ a full-time compliance officer. Even if regulation reform is rolled out, it’s not like you can’t rewind things overnight.
Locke: We’re lending like crazy here — over $40 million in growth last year on the loan side. In banking terms, we are significantly loaned out. What that means is that typically, Wisconsin banks loan out 75 to 80 cents of every deposit dollar. In the last few years that ratio has gone up to about 90 cents on the dollar, which is a significant increase. You don’t have to drive around the area to see all the building activity out there. There’s a lot of lending going on.
(Continued)
To be or not to be an S Corp or a C Corp?
That is the question.
Recent tax law changes have many businesses asking their CPAs if they should remain an S Corp or switch to C Corp. Of course there is no black-and-white answer.
An S Corp passes most income or loss onto its shareholders who are responsible for reporting them on their individual tax returns (hence the term pass-through business).
In contrast, a C Corp files a federal form (1120) and pays tax due. Dividends or distributions to shareholders require shareholders to pay tax at their individual income tax rates, essentially leading to a double tax.
McFarland State Bank is an S Corp, and Chairman and CEO E. David Locke says the bank is currently weighing all the options.
“We have the ability and the right to switch [to a C Corp] if we choose. There is no ambiguity in C Corp rates being 21%, but the devil is always in the details, and we’ll have to see if Treasury will write the tax rules as they were intended.”
He looks forward to that day, arguing that businesses won’t make investments until they have clarity on the new rules of the game.
Kory Stoehr, CPA and tax partner at BDO’s Madison office, helps sort things through. “Prior to the Tax Act, one of the biggest issues with being a C Corp was the double tax,” he explains. A C Corp pays its own tax at a top rate of 35% and if dividends are paid out to shareholders, a second layer of tax gets paid by the individual shareholder at a federal rate of 23.8%.
A profitable S Corp, on the other hand, would get taxed at an individual federal rate — perhaps as much as 43.4% — but wouldn’t have a double layer of tax.
The new tax rules change that, Stoehr explains.
The C-Corp rate dropped from 35% to 21%, and the maximum individual rate went from 39.6% to 37%. “For some businesses, there is now a potential 16% difference between a C Corp’s rate and the S Corp shareholder’s rate,” he says.
In other words, on $100,000 a C Corp pays $16,000 less in tax every year. C Corps also are allowed to take deductions for state and local taxes, whereas the individual taxpayer has a limit of $10,000.
“This is where it can get complicated,” he warns.
With the new reform, S Corp or pass-through income may be eligible for a 20% reduction for qualified business income.
“Effectively that reduces the maximum rate of 37% down to an effective tax rate of about 29.6%, bringing the rate differential closer, but still higher than the C-Corp rate of 21%.”
However, C Corp dividends and passive shareholders of an S Corp also may be subject to the 3.8% net investment tax, which still exists, Stoehr cautions.
With S Corps, income or losses affect the basis in the event the company is sold.
“Say you pay $1,000 for C-Corp stock and $1,000 for S-Corp stock and you hold each for 10 years and in each of those years the stock generates $1,000 worth of income. As a C Corp, your basis in that stock is what you paid for it, so after 10 years, the basis is still $1,000. If you sell it for $10,000, your net gain is $9,000.
“On the other hand, if you’re an S Corp and paid $1,000 for the stock and it generates $1,000 in income over each of 10 years, that income increases your basis. So now your basis is $11,000 when you decide to sell and you’d potentially have a net loss.”
There simply is no one-size-fits-all answer when deciding between a C Corp or an S Corp, Stoehr insists. “It’s all facts-and-circumstances driven.”
A multi-generational family owned business, for example, with plans to pass stock from generation to generation may want to consider a C-Corp status.
“Although unlike an S Corp, the shareholders of a C Corp do not get a build-up of basis with annual taxable income generated at the C Corp,” he explains. “The heirs designated to receive the shares of stock, upon death, will receive a step-up in the basis equal to the fair-market-value of the stock at the date of death.”
On the other hand, if the plan is to sell the business in the future — depending on the type of sale asset versus stock — an S-Corp status could prove more beneficial.
“It’s all very complex and a multitude of variables (i.e. dividend policy, exit strategy, etc.) could ultimately impact your answer,” Stoehr states.
Only you and your tax advisor can make that determination.
“Until you model it out and get a true understanding, I wouldn’t advise anyone to make a decision simply based on the corporate tax rate,” he adds.
Meanwhile, Locke is weighing the rules carefully.
“In my opinion, we’re better off under a tax reform bill than we were without one, but if you think this is tax simplification, nothing gets simpler when it comes to the government.”
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