By Warren A. Kirshenbaum
April 25, 2017
The tax filing deadline for 2016 has passed, and with it any opportunity to minimize tax obligations for 2016, but now is the time when businesses and their principals should begin to consider – and to plan for – their 2017 tax liabilities.
We encourage our clients to include tax credits as one of the tools of their financial planning arsenal. Taxpayers are already aware of the more well-known hedges – such as incurring capital expenditures on equipment or machinery in the current year, deferring asset sales or other profitable transaction closings into 2018 (unless a 1031 like-kind exchange can be achieved) – but these are deferral strategies. Tax credits which directly reduce the tax obligation are deftly utilized by the largest corporations and financial institutions, but for less known and understood by the greater population – even though they could also be of great benefit to many individual taxpayers.
Tax Reform is a topic which Washington has been actively discussing this year, as the climate for a reform of our tax code has become more probable with a Republican administration and a Republican-controlled Congress. The Trump administration has suggested a major tax reform package will be one of its earliest initiatives – the cornerstone of which will include tax cuts.
For background: as our tax system is a progressive one, 60% of all taxes are paid by the top 10% of earners and 25% of all taxes are paid by the top 2%. Most US companies are flow-through entities; those being partnerships, S-Corporations, and limited liability companies. Flow-through entities are not directly taxed; rather all income flows through to the owners who pay taxes as individuals. Large corporations not structured for flow-through have employed numerous strategies, such as tax inversion, hoarding cash overseas, and tax credits to significantly reduce their tax rates. We’ve all read stories of corporations like GE and Apple paying little – if anything – in income taxes.
The proposed tax cut most talked about lately is the corporate tax rate, which at its current 35% level is among the highest (if not the highest) in the world. The new administration has stated they will cut that rate to 15% and take away the seven tax brackets for personal taxes (including flow-through income) and replace them with three brackets – the highest of which will be around 31% rather than the current 39.6%.
For the tax cuts to stimulate the economy there would need to be corresponding sending cuts or elimination of other deductions. It is my belief the tax reform package that moves through Congress likely will be “revenue-neutral) (i.e. it does not add to the federal deficit). As revenue-neutral, the plan can be passed through the Senate with only 51-vote majority needed to make the tax code changes permanent. If the tax changes produced results that were not revenue-neutral, then the tax code changes will expire after nine years, as did the Bush tax cuts.
The Trump Administration seems to be suggesting the tax code changes need to be permanent to substantially boost business investment. Therefore, in a tax reform package that contains major cuts to the tax rates, for those tax changes to be revenue-neutral there need to be several programs and deductions facing the chopping block. Moreover, the President and his advisors have also proposed a $1 trillion infrastructure spending plan, as well as significant increases in defense spending – all of which will need to be balanced against the tax cuts and the failed passage of health care reform (which had included tax savings). The President, when he was on the campaign trail, suggested that the infrastructure plan would comprise a public-private partnership, and he and his advisors have stated that there would be a tax credit for investors in infrastructure spending. In fact, the suggestion seems to be that the $1 trillion infrastructure spending package can be financed with private investment of $167 billion and an 82% tax cut. (1) Interestingly, Congressional Democrats (who have been in favor of an infrastructure spending plan for years) support the president’s plan and even agree with his $1 trillion cost estimate – which looks to be a rare opportunity for bipartisan agreement. In fact, it was the Conservative Republicans that stymied Democratic infrastructure spending plans in years past, creating this unholy alliance on infrastructure spending between the Democrats and Congressional Republicans.
The Democrats’ objection to the Trump plan is that they would rather see federal investment instead of a tax credit because they cannot envision how a tax credit would pay for the spending. Nevertheless, there is enough common ground that my sense is that the final plan will have both a federal spending component and a tax credit component. Large private equity firms, such as BlackRock and Blackstone – who are already invested in oil, gas, power production and power infrastructure, as well as other infrastructure projects – are raising large pools of money to invest more deeply into infrastructure projects. This is a clear Wall Street indication that directly supports the administration’s theories of a revenue-neutral tax plan and infrastructure tax credits. Furthermore, for those who have been concerned that the future of tax credits may be uncertain, note that it is the Republican administration that is favoring a tax credit strategy for the infrastructure spending, while it is the Congressional Democrats who are hedging on tax credits. To me this is a good sign that in a Republican-controlled Congress tax credits as a general strategy will continue to play a role in our economy and be a part of, and not a casualty of tax reform.
So, naturally the overriding question is how will tax cuts and increased infrastructure and defense spending be acommodated in a revenue-neutral tax plan. Congressional tax “authorities” have mentioned a few possibilities: dropping the 1031 like-kind exchange rules, eliminating the federal deduction for payment of state taxes, lowering payroll taxes, or eliminating the deduction for mortgage interest payments.
To mitigate this uncertainty, it is as important now as it has ever been for taxpayers to act on their own to minimize their tax obligations rather than to expect that their government will do so. With good planning, one can take control over his or her tax obligations overfed years to come. What this paper is suggesting is that the addition of a tax credit strategy will amount to more certainty in the planning for tax obligations – and that is a good thing!
Tax Credits as a Strategy:
Simply stated, a tax credit is a dollar-for-dollar offset against taxes that are due to either the state or federal government. (2) Taxpayers can utilize their tax credits to satisfy their own tax obligations or transfer (3) their tax credits to other taxpayers. Certain taxpayers, such as those holding newly acquired and rehabilitated real estate or newly formed single asset entities, may not have generated sufficient income to be able to utilize their tax credits. For such taxpayers, “selling” their tax credits is a better alternative than anticipating the future usability of those credits at a discount – such a translation invariably results in substantial tax savings.
How do tax credits work, and how can they be effectively used by taxpayers? Using a tax credit strategy advanced planning, and should be funded with resources that otherwise would be used to pay taxes. It is important ot realize that – although you are making an investment in a transaction that generates tax credits – the “return” is the tax credits themselves and not the capital invested. With that in mind, the following is an explanation of how a typical tax credit translation would work:
The tax credits that we will largely reference here are Investment Tax Credits (“ITC”), which are allowable in Section 38 of the internal Revenue Code (“IRC”). There are several different ITCs, such as low-income housing tax credit (4), the historic rehabilitation tax credit (5), and the renewable energy tax credit (6). As noted earlier, we speculate that there might also be an infrastructure investment tax credit, which we believe will be structured in a similar fashion to existing federal tax credits. For that reason, our explanation of a federal tax credit transaction will use a historic rehabilitation project as an example that can be applied across the various ITCs.
Assume that a developer has acquired an old mill complex in Northern New England for a cost of $5 million. The complex was once a textile factory, and provided housing for the loom operators and factory workers – which was the genesis of the town in which it is located. The mill buildings are eligible for listing on the National Register of Historic Places, and so the proposed rehabilitation of the buildings, which will convert the mill complex into a mix of residential apartments, stores, restaurants, and small offices will qualify the project for the historic rehavilitation tax credit (“HTC”). The rehabilitation budget for the project is $36 million, of which $30 million are deemed to be “qualified rehabilitation expenses” or QREs, and are thus eligible for the 20% federal HTC. The HTCs that the project expects to be awarded are $6 million (20% of the $30 million QREs). The developer is also separately able to secure other state tax credits and local incentives totaling $5 million, so his capital stack will be comprised as follows: