Rate cuts and incentive shifts in the new federal Tax Cuts and Jobs Act will keep Kentucky tax lawyers and accountants busy for years helping clients make the most of lower levies and an altered inducement landscape. The reforms will result in business structure changes for many – but not yet. Internal Revenue Service staff must write the implementing rules first, and that will take months.
“I think at this point they (business owners) have a lot of questions. Everybody’s happy that the rates have dropped,” said Rachael High Chamberlain, an attorney who handles state and local tax work for Frost Brown Todd in its Lexington office. “But there are so many other factors that come into play for a company deciding what their overall tax burden is; they might have one provision in the tax bill that is absolutely amazing for them, and then you flip over to a different aspect of their tax compliance and there’s something else in the bill that’s really bad.
“So it really depends on the company and their particular structure,” Chamberlain said, reflecting the current common wisdom of Kentucky’s accounting and law sectors.
With a push from President Donald Trump but no hearings, open debate or public input, Congress passed a massive tax overhaul in December designed to further stimulate an economy that has been slowly gaining steam for seven years.
“It’s still early on and … there’s a lot of concern about what’s actually in the bill because it’s the biggest change since 1986 in the tax law,” said Noah J. Stern, an attorney who handles tax work in Cincinnati for Dinsmore, which has offices in 22 cities, including Covington, Frankfort, Louisville and Lexington. “There hasn’t been time for the IRS to publish guidance on the legislation.”
Accountants and attorneys said they have not identified any provisions that might create unique impacts on Kentucky businesses compared to those in other states. But they also emphasized – over and over again – that there are striking differences between the federal and state tax codes.
Kentucky lawyers and accountants say the federal Tax Cuts and Jobs Act is expected to impact virtually every taxpayer, but there are still many unanswered questions about the rate-cutting legislation. Some taxpayers and businesses will fare far better than others when they calculate their taxes for 2018. And, yes, some people and companies may wind up paying more this year than they did in 2017.
A little more than a month after the president signed the Tax Cuts and Jobs Act on Dec. 22, the sentiment at the national level and in the offices of Kentucky accountants and tax attorneys seems to be something like “What’s not to like about a tax cut?”
Early advice, though, is to hold off awhile on spending what you think you’ll save in taxes this year.
Clients curious but need not rush
Since the federal code changes apply to taxes not due until next year, there has been no tsunami of clients needing their returns completed in the next 15 minutes. But plenty of people have questions: Kentucky accountants and lawyers’ office phones rang and email inboxes filled faster than is typical for an icy January, they said.
“There’s definitely a lot of interest in this legislation, and right now people are digesting it and trying to figure out … what they want to do about it,” said Mark A. Loyd, a partner in the Louisville law office of Bingham Greenebaum Doll. “It will create a demand for CPAs and tax attorneys with regard to thinking about their business structure and whether it needs to change and then (in some cases) changing that business structure. It is tough to estimate how many companies might be revising their status for tax purposes,” said Loyd, who chairs the firm’s Tax and Employee Benefits Department.
The concept of “changing that business structure” is critically important because the new code treats a “C corporation,” the organizational structure typically chosen by the largest companies, differently from smaller businesses that are classified as “S corporations,” partnerships, LLCs or sole proprietorships.
One of the most widely discussed provisions of the new legislation cuts corporate tax rates from a maximum of 35 percent to a flat rate of 21 percent.
Smaller businesses will be allowed to take a 20 percent deduction on what’s classified as “qualified business income,” which is often “pass-through” income to the owner or owners, who would pay taxes on that income as individuals.
For individual taxpayers, the maximum rate under the new legislation is 37 percent for someone who makes more than $500,000. The key here is how “qualified business income” is defined. Accountants and attorneys made it clear that the business income equation can be extremely complicated.
But it’s doubtful many businesses will swap one structure for another – from “C corporation” to “S corporation,” or vice versa – until they have some clear indication about which option would deliver the biggest tax savings.
Largest corporations fare best
Although they stress that it’s way too early to say much with absolute certainty about the 400-plus-page tax bill, attorneys and accountants seemed to agree that C corporations – organized under Chapter C of the Internal Revenue code – will reap the greatest benefits.
“The larger corporations that are formed as C corporations are the ones that are really getting the windfall in the tax package, and that was really the design of it – the theory being that (lower taxes) makes the U.S. competitive with other countries and hopefully will bring opportunity, stimulate growth, create jobs,” said Mike Shepherd, director of tax services and one of the owners of Dean Dorton, an accounting and business consulting firm based in Lexington.
“On the small businesses, we’re going to see a lot of restructuring. … You’ll see some businesses that may want to change their structure and take advantage of the lower corporate rates or they may want to change how their pay works,” Shepherd said.
“I think we (Dean Dorton) will see more work in the summer when we can sit down with nearly every client to see if something needs to be adjusted on how they manage their business with these new laws.”
Accountant Kevin Fuqua, tax services team leader for MCM CPAs and Advisors in Louisville, provided an example of how one of his clients, a Kentucky C corporation, will benefit under the new law when 2018 taxes are filed. This manufacturer, which he did not identify, had sales of about $60 million last year.
Fuqua ran the company’s numbers through a model of the new tax code.
“On taxable income of about $12 million, they saved a couple million dollars” in tax payments, he said. “The beauty of this is, and what’s getting lost is: What are they going to do with the money? Many of these companies are saying either ‘We’re building (expanding),’ or ‘Our biggest issues are (finding and retaining) employees, so we’re going to be doing something for them.’”
Walmart, Home Depot, FedEx, Walt Disney and Honeywell are among major corporations that have announced bonuses or pay hikes for their employees because of the tax savings those companies expect.
“I think most people will have some benefit, but they’re not going to get a benefit like they will with a C corporation,” Fuqua said.
“For example, I did my (personal) taxes, and it was about a $2,000 savings,” he said. “It was nice; it’s better than paying $2,000. It’s not a windfall like for a C corporation, so I don’t want people to get overly excited and expect a big refund. I think some folks are going to be astonished by the fact that they’re not going to get as much as they think.”
Passing the federal tax reform law late last year was a positive step, Fuqua said, but the specific impact won’t be known until the Internal Revenue Service issues implementing instructions.
“But we have no (revised) regulations; we have no interpretations (of the new law),” he said.
However, MCM’s tax services team will work up what it expects the new code’s rules are likely to say and come up with strategies in hopes that their interpretation dovetails with that of the IRS.
Think about business structure
Fuqua and Shepherd plan to provide their clients with nuts-and-bolts data on how the new legislation may affect them.
“One thing I’ve done and we’ve done as a firm is taken 2016 tax returns and gone through and calculated them as if they were in the 2018 tax law to show them the difference in the law versus what kind of benefits or, in some cases, what kind of taxes they may owe differently,” Fuqua said.
“People want to do planning as quickly as possible, make adjustments for the new law with their specific situation,” said Dean Dorton’s Shepherd. “When we do their ’17 taxes we’re going to run an analysis and plug it into the ’18 rules and give them an idea – absent changes to their situation – of what their taxes would look like under the new rules. One size doesn’t fit all. I expect we’ll have some happy campers and some less happy campers.”
Most people, Shepherd said, will find little change in how they’re taxed under the new legislation.
Lexington attorney Chamberlain and Fuqua both said their firms have scheduled “road shows” on the new code in Lexington, Louisville, Indianapolis and Cincinnati in the near future.
While the tax rate is lower for C corporations, Fuqua pointed out that plenty of people cringe at the “double taxation” that occurs when a company pays its corporate taxes and then distributes dividends to shareholders, who must then pay taxes on those dividends.
“If you’re a bigger company I think you’re going to say something to the effect that it’s about time the U.S. lowered the corporate income tax rates to a level commensurate with the rest of the world,” said Loyd, the law partner in Louisville. “This is the most significant overhaul of the Internal Revenue code in the last 30 years, so it’s not just something you can sit down and digest in an afternoon.
“This is going to take some time to appreciate it and understand it, and my take on it is you need to be very methodical about taking advantage of it rather than rushing to take advantage of it,” Loyd said.
“This year I would tell them (my clients) to rethink how their business is structured for tax purposes. They might not want to change it, but they should at least consider whether changing it would be advantageous to them or not, particularly if they haven’t looked at it for a number of years.”
Deduction cap’s bite begins at $170K
Another element of the tax package that has received plenty of attention is the $10,000 cap on the federal deduction for state and local taxes, which has been widely discussed in high-tax states such as New York and California.
But several of those paid to know the tax laws pointed out that capping that deduction could prove costly to some Kentucky taxpayers who have never spent a night in Beverly Hills.
Chris Gilbert, an attorney and tax partner in the Louisville office of PricewaterhouseCoopers, said some of his clients learned about the $10,000 cap and paid 2018 property taxes in advance late last year so that the deduction wouldn’t be subject to the cap.
“Even in Kentucky, which isn’t a particularly high tax state – we’re in the middle to the bottom in overall tax burdens – there will be quite a few people in Kentucky who will be affected by this as well,” said Chamberlain.
She and other attorneys and accountants said state and local taxes on average cost many Kentucky residents 9 or 10 percent of their income, with the biggest chunk going to the state, which has a 6 percent rate for people who earn $75,000 or more. With the state rate alone, a taxpayer would hit that maximum deduction of $10,000 with an income that’s just under $170,000.
Shepherd said high-income taxpayers would be hit hardest by the $10,000 cap.
The people who either do tax work or analyze tax policy also stressed that there are substantial differences between the new U.S. code and the rules and regulations that are in effect in Kentucky, which hasn’t taken steps to make the state tax code conform to the new federal code.
“Right now,” Chamberlain said, “the state is using a version of the federal tax code that’s a couple of years old. You could wind up in a situation – and some of our clients recognize this, and some of them don’t – where you’re doing one set of calculations for your federal income tax and they could be drastically different when you get down to the state side.”
Gilbert echoed comments by Chamberlain and several others interviewed for this story.
“One interesting thing is that a lot of the provisions won’t even be effective in Kentucky,” he said, “because Kentucky law adopts the Internal Revenue (Service) code as of December 31, 2015, so since the tax reform law is not part of the (earlier code) … a lot of the changes won’t even be relevant until the state changes” its tax code.
Kentucky tax update advised
Attorneys and accountants said one of the most striking differences between the federal and state codes is how some purchases of new equipment are handled and how the state “decouples” – Chamberlain’s verb – from the new U.S. legislation.
The Trump tax package allows businesses to deduct the entire cost of the equipment – up to $1 million – this year. Fuqua said that purchase could be treated much differently under Kentucky tax laws, where the equipment, which he described as a “five-year asset,” would be depreciated over five years with a 20 percent deduction in the first year.
An analyst with the non-profit Tax Foundation in Washington, D.C., said she believes it’s time for Kentucky to revise and update its tax system even if it doesn’t duplicate every provision of the new federal code.
“It took the federal government some 30-odd years since the last major tax overhaul, and I think it’s time for Kentucky to take up that responsibility now too,” said Morgan Scarboro, an analyst for the Center for State Tax Policy in the Tax Foundation, an 80-year-old nonprofit that focuses on tax reform throughout the country.
Without factoring in the impact of the new tax package, Kentucky ranks 33rd in the country in the foundation’s Business Tax Climate Index, which analyzes the impact of corporate, individual, sales, property and unemployment insurance taxes on businesses.
“Kentucky has a fairly uncompetitive tax code compared to a lot of its neighbors … so that’s one reason in itself to look at reform,” said Scarboro, whose organization supports broad bases of taxation with low tax rates.
A spokesman for the Cabinet for Economic Development, which set records for business development in Kentucky last year, was optimistic that the tax cuts would spur further business growth this year.
“While it’s too soon to know what specific effects individual tax code changes at the federal or state levels will have, tax cuts tend to create the opportunity for business investment,” Jack Mazurak, communications director for the department, said in an email.
Mazurak cited tax reform, right-to-work legislation, improvements in the business climate, a focus on workforce development for the near- and long-term and the national economy as key factors that would fuel economic growth in the state.
He said he has not heard about any effort to adopt all or part of the new federal tax code.
Greg Paeth is a correspondent for The Lane Report. He can be reached at [email protected]