BBA 4226 Unit VIII PowerPoint Presentation

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INSURANCE & RISK MANAGEMENT

JOURNAL OF FINANCIAL SERVICE PROFESSIONALS | JULY 2018

Risk Management for Business Owners: How to Deal with the Uncertainties of the Tax Cuts and Jobs Act of 2017 by Steve Parrish, JD, RICP, CLU, ChFC, RHU

Vol. 72, No. 4 | pp. 30-34

ABSTRACT

When sweeping new tax legislation arrives,

risk is not far on its heels. There is the risk

that the client ignores the law, missing out

on short-term opportunities. There is the

risk that the client, armed with incomplete

information, moves too quickly, paying at

leisure for mistakes made in haste. And

there are risks for the advisor.

With the Tax Cuts and Jobs Act of 2017

(PL 115–97), we’re seeing another risk—the

risk of continued uncertainty. Particularly in

the business tax sections, this law still has un-

clear terminology, creates unintended conse-

quences, and has purposely included sunset

provisions. This column discusses how an ad-

visor can help business owners manage the

risks of uncertainty the legislation creates.

Did anyone else go through this experience at the end of 2017? It’s mid-December, and I’m ready to take off the rest of the year. Then along comes the Tax Cuts and Jobs Act of 2017 (TCJA).1 I look at some of the provisions just so I’m up to date come the beginning of the year:

• 21 percent flat tax rate for C corporations. Check. • Double the estate and gift tax exemption. Got it;

no, wait a minute—it’s only through 2025? • A 20 percent deduction for “qualified business

income” for owners of pass-through businesses. Sounds fairly straightforward. But what’s this about “specified service businesses,” and all this “great- er-than” and “less-than” math in the law? Uh-oh.

I discovered this new tax law to be neither tax reform nor simplification. And worse, I knew my phone would be ringing sooner rather than later— with people on the other end asking me to explain the implications of this law. Indeed, before 2017 was over, I was asked about prepaying 2018 property taxes, advancing charitable donations, and delaying year-end bonuses. And worse yet, I was confronted with the risk-laden question, “Should I change my company’s tax status?”

The Risks of Uncertainty When sweeping new tax legislation arrives, risk is not far on its heels. There is the risk that the client ignores the law, missing out on short-term opportu-

INSURANCE & RISK MANAGEMENT

JOURNAL OF FINANCIAL SERVICE PROFESSIONALS | JULY 2018

nities. There is the risk that the client, armed with incomplete information, moves too quickly, paying at leisure for mistakes made in haste. And there are risks for the advisor: Act too quickly and your interpreta- tion could be flawed; wait too long, and your client blames you for missed tax savings. With the TCJA, we’re seeing another risk—the risk of continued uncertainty. At the time of this writing, we are still plagued with unclear provisions, unintended consequences, and knowingly sunsetting tax law. In February of this year the American Insti- tute of CPAs demanded answers to six questions on the flow-through tax law deduction, while in March the U.S. Chamber of Commerce sent the Treasury Department 15 pages of detailed requests for clari- fication on how the law affects multinational corpo- rations, mutual fund investors, and mom-and-pop pass-through entities. Yet here we are at midyear, still uncertain as to how to advise clients. Some have hoped this uncertainty will be cleared up with technical corrections legislation and targeted regulations from the Treasury Department. Others have posited that Congress will just reform the law. Barely a month had passed after the signing of the TCJA when a Wall Street Journal editorial demand- ed that Congress “repeal and replace” the act. Sound faintly familiar? This kind of speculation is usually dangerous. Traditionally, advisors have cautioned their clients to avoid focusing on proposed tax law changes. The best rule of thumb is to deal with what you have for law right now, not with what it might become. But this heuristic isn’t as true in our current tax en- vironment. First, the TJCA came into being through a single-party initiative, and it is largely subject to the tax reconciliation rules of the Senate. As we saw with both the Economic Growth and Tax Relief Reconciliation Act (EGTRRA) and the Patient Protection and Afford- able Care Act (PPACA), such large, partisan legislation is subject to challenge and revision when the political mood of the country changes. Second, the TCJA is re- plete with technical mistakes and unclear provisions. From a planning perspective, it would be a mistake to

ignore the fact that the law is subject to major reinter- pretation and revision. Finally, the law has a labyrinth of provisions that sunset, expire, or index. For example, the corporate tax rates are permanent, whereas the pass- through business deduction associated with IRC Section 199A is temporary. Because this lack of permanency is baked into the law, it must be factored into planning. Tax planning must now include the uncertainty factor. A piecemeal, haphazard approach to advising cli- ents on the uncertainties of TCJA is not wise. The cli- ent will not understand, and as advisors we could fail to follow up when things become clearer. We should recognize the risks associated with these uncertainties and build them into our planning. How? Below are some suggested steps to formalize the process of factor- ing the uncertainty factor into our planning process.

First: Learn the Law Humility is the new demonstration of expertise. When the TCJA was first passed, a number of supposed experts flat-out misinterpreted large swaths of the law. In contrast, those who initially stuck with the facts in- stead of slipping into speculation are not now having to eat their words. Consider the early pronouncements concerning new IRC Section 199A. This unusually complex provision was interpreted by some to provide all flow-through businesses with a 20 percent income tax deduction. Others declared that it applied only to nonservice businesses. In reality, of course, this provi- sion is far more nuanced and resistant to generalizations. Risk management entails assessment of the risk. In the case of this new law, the learning curve is steep. The law must first be understood before we can weigh the risk. Many of us started by reading what- ever was available and doing our best to make sense of what we read. We are now at the stage where for- malized training is available. Designation programs, continuing education (CE) providers, and tax pub- lishers are starting to release organized explanations and interpretations. There is time remaining in 2018 to learn the TCJA and understand the opportunities and risks for our business clients.

JOURNAL OF FINANCIAL SERVICE PROFESSIONALS | JULY 2018

INSURANCE & RISK MANAGEMENT

status, and employees are changing to Schedule C independent contractors. The risk, however, is that switching entities affects more than tax status. And it can disturb the business owner’s exit and estate planning strategies in numerous ways. To avoid the risk of unintended consequences, the entity analysis must go beyond just tax planning.

3. Tax planning principles have changed. Advisors must reset how they look at taxes when advising businesses and business owners. First, the emphasis has changed as to which taxes are most important. Whereas in the past, buy-sell planning for fami- ly-owned businesses often focused on federal estate and gift taxes, these taxes are now largely moot for all but the wealthiest families. Similarly, while state taxes were usually a minor consideration, they are now potentially a much more important piece of the puzzle. State taxes are potentially going to be ei- ther higher, more diverse, or costlier, and they vary widely among the jurisdictions.

Second, tax planning has new rules of thumb. Whereas income tax deductions and deferrals were traditionally the primary tax objectives for most business owners, planners should now focus on timing of tax recognition and the entity that is be- ing taxed. For instance, a tax at the business level will generally be much lower than at the personal level. This means a current tax at a low business tax bracket rate may, in certain situations, prove better than a deferred tax assessable at a higher personal tax rate. The decision is best handled by making a tax risk assessment using various scenarios.

Third: Build the Uncertainty Risk into Projections An old insurance planning adage states, “Tell me when you’re going to die, and I’ll tell you what to buy.” In the current estate tax planning environment, this adage can be modified to say, “Tell me when you’re going to die, and I’ll tell you which exemption to ap- ply.” The challenge is that in 2018 an owner’s estate and gift tax exemption is a healthy $11.18 million. But,

Second: Develop Themes Associated with the TCJA This new tax law is so vast in scope that it requires a view of the forest before stepping in among the trees. To return to IRC Section 199A, one can easily get lost in the byzantine provisions and completely miss the opportunities it affords. But by considering the tax law as a whole, certain themes can be gleaned. Keeping these themes in mind will help define and implement appropriate business planning. Further, understanding the themes is a way to acknowledge the risk of uncer- tainty while not allowing inaction to be the result. 1. Multinational taxes will affect closely held

business planning. From a purely financial per- spective, the TCJA is more focused on worldwide business taxation than on small business domestic taxation. In an effort to capture over a trillion dol- lars of U.S. companies’ income residing outside of our borders, the TCJA dramatically changes how multinational companies are taxed. In essence, the act offers a onetime repatriation tax at a low rate, and then moves to a territorial-based taxation system. While this new tax regime affects very few closely held businesses directly, it does affect commerce in general. And what affects commerce can affect business planning. Business owners are wise to stay attuned to how this complex new tax regime is implemented. Many of their customers and suppliers will be multinationals, and what these large companies experience will have a trick- le-down effect on closely held businesses.

2. Business entity planning is taking center stage in the short term. The new law has radically changed how the various business entities are taxed. C corporations now have a significantly lower top tax rate, and pass-through entities offer the poten- tial for a lower tax rate than that on one’s personal income. This means that in many situations, we are seeing advisors recommend that their clients change entities. Depending on the business owners’ situation, pass-throughs are converting to C corpo- rations; C corporations are electing S corporation

JOURNAL OF FINANCIAL SERVICE PROFESSIONALS | JULY 2018

INSURANCE & RISK MANAGEMENT

ness owners can take advantage of currently that, at worst, might result in some minor additional taxes if the future pans out different from expected. Let’s take an example. A compelling argument can be made that affluent business owners consider estate freeze techniques. Examples would include the use of grantor retained annuity trusts (GRATs), in- stallment sales of the business, and gifts of discounted interests in a family-owned businesses. All of these ap- proaches leverage the TCJA’s higher estate and gift tax exemption and yet offer little risk if tax laws change in unexpected ways. If, as the current law provides, the exemption returns in 2026 to pre-TCJA levels, the freeze helped move assets out on a tax-favored basis (a positive). If, however, the exemption remains at the current higher levels, the value of the removed assets continues to be frozen (a positive or neutral). The worst that can happen, and a scenario that is gener- ally thought to be unlikely, is that the exemption is “clawed back” to 2017 levels. Even in this situation, the estate freeze caused little if any tax harm.

Fifth: Wait Where Waiting Works While not all good things come to those who wait, some good things do. Specifically, caution is good advice when dealing with some of the business uncertainties of the TCJA. For example, choice of tax entity for a particular business is a decision that de- serves deliberation. I teach a class in business law that deals with business entities, and none of the content includes tax issues. Choice of business entity includes factors such as control, labor law, privacy, gover- nance, asset protection, cost of formation, and cost of ongoing operations. Even when the actual entity isn’t changing, as in the situation of a C corporation elect- ing S corporation status, there are substantive issues to be dealt with beyond taxation. For instance, S cor- poration limits on ownership and permitted classes of stock can inhibit other corporate strategies. A popular TCJA discussion topic is whether to bunch or separate business entities to leverage the provisions of IRC Section 199A. In some cases, the

in 2026 it returns to an inflation-adjusted $5 million. The business of business-planning can’t stop just be- cause we’re not sure which exemption will apply at the time of the owner’s death. For wealthier business own- ers, this issue is very real because the tax rate is a flat 40 percent. In this kind of planning environment, plan- ners are well advised to use more than one tax scenario in their tax projections. One approach is to run estate and gift tax projections using both the 2017 and 2018 exemptions. This would help the business owner bet- ter quantify the tax threat and its vagaries depending on the date of death. It would project a rough estimate of the tax exposure and help set a baseline for how to manage the uncertainty built into the TCJA. The uncertainty risk is comparatively easier to man- age with income taxes. Granted, the corporate tax rate is fixed at 21 percent, whereas the 20 percent flow-through tax deduction (IRC Section 199A) is scheduled to sunset in 2026. However, income taxes apply year to year. If the tax rules change, business owners can generally switch their choice of entity taxation without significant imped- iments. More challenging, however, is managing the best timing for recognition of income. One approach is to push income recognition into the present. This addresses the risk that tax rates for flow-through business entities are scheduled to be higher in the future. On the other hand, deferral of tax offers the time value of money. The further the tax is deferred into the future, the lower the present value cost; plus there is the political possibility that the low tax rates will continue past 2025. The advi- sor can best help the business owner assess this issue by running projections of both scenarios. There’s not a right or wrong answer, but an informed decision will likely yield better results than a guess.

Fourth: Move Now if It Makes Sense Uncertainty should not lead to apathy. The risk involved with the TCJA is primarily determining which approach is less costly on an after-tax basis. So, a bad decision is generally a matter of degree, not a de- termination of right or wrong, risk or no risk. There are a number of tax planning opportunities that busi-

JOURNAL OF FINANCIAL SERVICE PROFESSIONALS | JULY 2018

INSURANCE & RISK MANAGEMENT

can truly help business owners with their planning. Now that half a year has passed since the TCJA became law, I can see how off base I was with my initial read of the rules. But now I feel more attuned to the risks and benefits of this major legislation. Are you feeling comfortable about the advice you’re pro- viding your business clients? n

Steve Parrish, JD, RICP, CLU, ChFC, RHU, is an adjunct professor and interim director of the Compliance and Risk Management program at Drake University Law School. Parrish is also an adjunct professor at The American Col- lege. He can be reached at [email protected].

(1) Tax Cuts and Jobs Act of 2017, PL 115–97 (2017).

consolidation of operations will allow more of the de- duction to be used, while in others it may be necessary to separate service functions from sales. The opportu- nities from this kind of planning are many, but there remain questions to be determined by Treasury De- partment regulations or corrective legislation. Until these questions are resolved, some of these planning ideas could backfire. Witness how the so-called “grain glitch” in IRC Section 199A gave an unintended ben- efit to farm co-ops. Resolution of this mistake became part of the bipartisan budget bill passed by Congress in March of 2018. A too-quick transition to co-op sta- tus would have been a waste. The advisor who stays current on governmental activity is the advisor who

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