Market Commentary

A Run Down on Tax Reform

Christmas-Tax

It’s official! The massive revision to the US’s tax code is nearing completion. All that’s left is for President Trump to sign the final version, which is expected to happen in the next week or two. Although Congress “bills” this (pun intended!) as a great accomplishment, it still leaves individuals and companies scrambling to figure out what it means and how we’ll be impacted as there are numerous changes to the tax code. Although not economists or tax/accounting professionals, we take a stab at the key points that affect individuals and corporations, and provide a comprehensive list of updates in the appendix for your perusal.

The nearly 1,100-page bill (if you’re having trouble sleeping, check it out here) was filed late Friday, December 15th and passed in the Senate (51 to 48) and House (227 to 203) the ensuing Wednesday, almost along pure partisan lines. For what it’s worth – as far as our due diligence is concerned – this is the first tax bill ever passed along party-line votes and goes beyond just taxes by repealing the Affordable Care Act individual mandate, moving to a “chained” inflation estimate for tax bracket threshold adjustment, drilling in the Alaskan Arctic National Wildlife Refuge, among others. Additionally, it’s worth noting that these “reforms” increase our government’s balance sheet by almost 2X the stimulus from the Obama administration that took place at the top of the financial crisis.

From a high-level, the bill is a bit like when Buddy eats spaghetti for breakfast in the movie “Elf”: looks messy but I like a lot of those ingredients. Although the bill has a “fiscal cliff” – meaning a big percentage of these changes expire – for individuals in seven years, it is arguably the most substantial corporate tax overhaul in over 30 years. Overall, it has tax rate cuts for a good portion of individuals and families, but it significantly reduces the number of deductions available for a significant portion of taxpayers. Additionally, it cuts tax burdens for corporations and alters how the government taxes international companies (including bringing back cash held overseas).

The main question is how does this affect you? The quick answer is: it’s complicated and varies case-by-case. But according to the Joint Committee on Taxation in Congress, middle income households (annual income of $20K-$100K) should save $61B through these measures as soon as 2019. However, those cuts are set to expire by 2027, which will then generate a net tax increase for those households. Conversely, according to the JCT, the wealthiest (over $500K a year) will see the same savings in 2019 but an additional $12B in savings by 2027.

From a company and portfolio perspective, it will clearly have a positive impact to Catamount’s favorite theme: earnings! According to Bank of America which surveyed over 300 domestic companies, 65% said they would use the “savings” to pay down debt, which should lower interest payments and raise earnings per share – further enhancing the EPS growth we’ve been accustomed to since the Great Recession. Of note, corporate debt issuance in the US has risen every year except one since the financial crisis, and it is on pace for a record year in 2017, so a deleveraging of the corporate balance sheet as a whole is positive long-term for the economy. Additionally, when the Bush Administration implemented a “repatriation holiday” in 2004, which allowed for companies to cheaply bring back cash abroad, approximately 80% was used for buying back their shares. “Buybacks” theoretically result in shares rising and show confidence to investors.

We at Catamount believe lower tax bills will result in a combination of the two (debt paydown and share repurchases) and could also be a boon for dividends and M&A. All of which benefit shareholders and the stock market, keeping us tepidly bullish on our outlook for equities.
Happy and safe holidays!
– Catamount Wealth Management


DISCLAIMER: Catamount Wealth Management does not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.


APPENDIX

More detail on some of the key items of the bill:

Rate Cuts, Deductions, Credits, Exemptions

  • 21% Corporate Tax Rate Starting on January 1, 2018 (“permanent”)
    • That’s a 14 percentage point corporate tax cut, which starts right away in 2018
  • Top Individual Rate Drops from 39.6% to 37%
    • Income thresholds increase from about $418K to $500K for individuals
      • From about $470K to $600K for married couples
    • This expires after seven years on January 1, 2025
  • Corporate Alternative Minimum Tax (AMT) Is Eliminated
    • We view this as positive news for companies who applied the research & development tax credit, like technology companies
  • Individual AMT Was Retained
    • However, the exemption was increased from $54,300 ($84,500 for a married couple) to $70,300 ($109,400 for a married couple)
  • State & Local Taxes (SaLT) and Property Tax
    • You can now deduct $10K for property taxes or SaLT (you can’t deduct $10K for each)
    • This goes back to normal in 2025
  • Corporate SaLT
    • There was no change here, which means corporations can keep deducting state and local taxes
    • SaLT in the wound for individuals (bad joke)
  • Individual Deductions & Exemptions
    • The standard deduction is up nearly 2-fold from $6,500 ($13,000 for couples) to $12,000 ($24,000 for couples)
    • Therefore, more will qualify and can no longer itemize
      • We see this as a disincentive to own a home
    • Personal exemptions are eliminated
      • It was $4,150 per taxpayer and dependent
    • The Pease Limitation on itemized deductions is eliminated
      • As mentioned above, you could deduct property tax, state income tax and sales taxes but now it’s all capped at $10K
    • This should go back to normal 2025
  • Child Tax Credit (CTC)
    • CTC has been increased from $1,000 to $2,000 with a $500 credit for dependents
      • Up to $1,400 is refundable
    • This begins to phase-out at $200K ($400K for couples)
  • Mortgage Interest & Home Equity Loans (HEL)
    • EXISTING principal home mortgages are grandfathered (continue at current cap of up to $1M)
      • This is the same with “second home” mortgages
    • However, all NEW mortgages (effective date TBD) can deduct $750K
    • Existing HEL are NOT grandfathered and new HEL will no longer be deductible
  • Estate Tax
    • The current rate is 40% on estates over $5.6M
    • This will now go to 40% on estates over $11.2M
  • 529 for K-12
    • The 529 plans can now be used for K-12 combined with the traditional college tuitions
    • This will apply to $10K per year per child
    • This could offset some of the SaLT impact
  • “Pass Throughs” (S Corps, LLC, etc)
    • Pass through businesses get a deduction of 20%
    • Coupled with the lower top individual rate, this equates to an effective rate of 29.6%
      • However, most service businesses are eliminated (specifically, health, law, accounting, consulting, financial services, investment management, brokerage services, lobbyists, etc)
    • Pass throughs will continue to be able to deduct SaLT
    • The 20% deduction begins to phase out at $315K of income for couples
  • Medical Expenses
    • The deduction for medical expenses goes from 7.5% of your adjusted gross income (AGI) in 2017 and 2018 and then 10% thereafter
  • Charitable
    • This goes from a 50% AGI limitation to 60%
  • Others
    • Tax preparation, moving expenses, investment advisor fees and alimony are all repealed

Territoriality & Deemed Repatriation

  • In 2018, the US will follow suit of most other countries by moving to a “territorial” system
    • This is likely a positive for multinationals
  • Deemed Repatriation
    • 5% on the cash and 8% on the permanently re-invested earnings going back to 1986
      • It’s currently at 35% and 15.5%, respectively
    • Companies have eight years to pay the tax

Net-Interest & NOLs

  • Net-Interest
    • For the first four years, companies can deduct net-interest up to 30% of EBITDA
      • This level turns into 30% of EBIT (no depreciation & amortization added back) in 2022
    • The global leverage ratio was not included
  • NOLs
    • Net Operating Loss (NOL) was limited to 80% of taxable income
    • The carry back provision was repealed (exceptions for farmers and some insurers)

Other

  • 100% Expensing
    • Bonus depreciation will be increased from 50% to 100% for qualified property placed in service after September 27, 2017 for a little over five years to the end of 2022
    • A phase-down then begins in 2023 in 20 percentage point declines (2023: 80%, 2024: 60%, etc)
  • Carried Interest
    • This moves from a one-year carry to a three-year carry
  • Entitlement Reform (Chained CPI)
    • Indexing of income tax brackets and thresholds is permanently changed
    • Previously it was linked to the Consumer Price Index for urban consumers (CPI-U)
  • Section 199 Repeal
    • The domestic production deduction (Section 199) is permanently repealed starting January 1, 2018
  • Base Erosion Anti-abuse Tax (BEAT)
    • This applies to companies that significantly reduce their US tax liability by making cross-border payments to affiliates
    • The 10% tax is increased to 12.5% for 2026
    • This is viewed as a win for “clean energy” as a higher rate would potentially discourage some companies from using wind and solar tax credits to cut their tax bills (more below)
  • “Minimum” IP Tax
    • It appears to be 10.5%, which is below the “Irish Threshold” test of 12.5%
  • Energy
    • The producer tax credit (PTC) stays in place along with the electric car credit
    • IDCs and all conventional energy tax credits are also unchanged
    • Utilities received a carve-out from the net-interest language (trade-off is that they do not get the 100% expensing)
      • Note: that is only on their regulated businesses – non-regulated businesses are subject to the net-interest haircut provisions
    • Puerto Rico
      • Puerto Rico did NOT get its requested carve out from the BEAT and other items
    • University Endowment Tax
      • University endowments will see a 1.4% excise tax
    • Bonds
      • Private Activity Bonds are not eliminated, though advance refunding bonds lose their interest exclusion on any bond issues after December 31, 2017
      • The bill repeals the authority to issue tax credit bonds and direct pay bonds after December 31, 2017
    • First In, First Out (FIFO)
      • A controversial provision that would force investors to see their securities on a FIFO basis was not included
    • Dividends & Capital Gains
      • Nothing in the bill
      • The 3.8% investment income surtax remains
      • Additionally, the 0.9% Medicare surtax on the wealthy remains
      • So the max rate on dividends and capital gains will remain 23.8%
    • ACA Individual Mandate
      • The tax (or “penalty”) was removed on the ObamaCare Individual Mandate on January 1, 2019
      • The CBO predicts this will cause premiums to rise 10% and will cause 13M people to lose coverage over the coming decade
    • Pay as you Go (PAYGO)
      • PAYGO has been in law for 30 years
      • This is a budget rule requiring that new legislation affecting revenues and spending on entitlement programs, does not increase projected budget deficits
      • It will now 100% be triggered when the bill passes into law
        • However, the overwhelming consensus is that Democrats will agree to waive this trigger by helping the Senate get the required 60 votes