A long-time goal and initiative of tax reform, which came to fruition with the enactment of the Tax Cuts and Jobs Act (TCJA), has been serious corporate tax change. The Congressional and Presidential motivation to make America’s operating environment more comparable with the rest of the industrialized world is intended to enhance the competitive viability of operating within the borders of the United States.
The TCJA goes a long way in meeting these goals, providing permanent changes that benefit corporate taxpayers. The taxpayer-friendly provisions include a significant reduction to the corporate tax rate, favorable changes to corporate deductions and tax credits, and a switch to a territorial tax system for companies that earn income outside of the United States.
The TCJA replaces the prior-law graduated C corporation rate structure (that included four tax rates ranging from 15% to 35%) with a flat 21% rate (effective for tax years beginning after December 31, 2017) for all taxable income. In an interesting change, the new rate regime is not graduated, but rests solely with a single flat rate of 21% on all taxable income.
However, the statutory language of the legislation relating to the permanent decrease in the corporate tax rate does not include any discussion of how taxpayers with fiscal year-ends that straddle the effective date of the new provision (again, for years beginning after December 31, 2017) should handle the first-year tax calculations.
Though not directly related to the TCJA, the Internal Revenue Code contains a provision to address tax calculations made in such circumstances. Internal Revenue Code section 15, Effect of Changes, was incorporated into the Code to address just these circumstances.
About IRC Section 15
IRC Section 15 provides guidance on how to calculate an income tax liability for any taxpayer whose tax year spans the effective date of any tax rate change under Subtitle A, Chapter 1, Subchapter A.The following rule is from IRC Section 15:
(a) General rule If any rate of tax imposed by this chapter changes, and if the taxable year includes the effective date of the change (unless that date is the first day of the taxable year), then—
(1) tentative taxes shall be computed by applying the rate for the period before the effective date of the change, and the rate for the period on and after such date, to the taxable income for the entire taxable year; and
(2) the tax for such taxable year shall be the sum of that proportion of each tentative tax which the number of days in each period bears to the number of days in the entire taxable year.
Essentially, the provision intends that for corporate taxpayers that have a fiscal year straddling the effective date of the rate change (January 1, 2018), a blended tax rate will be applied to taxable income for the full fiscal year based on the tax rates in effect for the proportional number of days included in the fiscal year before and after the effective date of the rate change.
The result is that fiscal-year corporations will receive a benefit of the reduced corporate rates prior to their first fiscal years that begin after December 31, 2017. Accordingly, because implementing IRC Section 15 is mandatory, there is no benefit for transitioning a fiscal-year corporation into a calendar-year taxpayer – the benefits of the reduced tax rate will occur on January 1, 2018, regardless of a taxpayer’s year-end.
Illustration of the Mechanics of Applying IRC Section 15
If a corporation has an October 31 fiscal year-end and was previously subjected to the 35% tax rate, its statutory tax rate for the year ending October 31, 2018, will be computed as follows:
Number of days of fiscal year occurring in 2017 at 35% rate: 61 days (November 1, 2017 – December 31, 2017)
Number of days of fiscal year occurring in 2018 at 21% rate: 304 days (January 1, 2018 – October 31, 2018)
Proportion of days in 2017: 16.7% (61 ÷ 365)
Proportion of days in 2018: 83.3% (304 ÷ 365)
Blended rate for fiscal year ending June 30, 2018: 23.29% [(35% x 16.7%) + (21% x 83.3%)]
Please note that IRC section 15 applies only to statutory tax rate changes. It does NOT impact the effective date for the implementation or repeal of other provisions contained in the TCJA, which will be effective pursuant to the dates provided in the Act (generally for tax years beginning after December 31, 2017).
Optimizing Tax Benefits
Fiscal-year corporate taxpayers should assess whether there are any available opportunities to accelerate tax deductions into the fiscal year that straddles the effective date of the tax rate change. Because taxable income during this straddle year will be based partially on the higher prior-law statutory tax rates, tax deductions may be more valuable in the straddle year than when a corporation is ultimately, and fully, subject to the flat 21% rate for its full fiscal year.
Note that even for deductions for items that are generally temporary in nature, there will be a permanent element to tax savings as result of the blended rate.
Leveraging the Fiscal Year Rate
By way of illustration, assume that a corporation with an October 31 fiscal year-end normally purchases $500,000 of depreciable property during its fiscal year. An important provision of the TCJA allows for 100% bonus depreciation for fixed assets placed in service after September 27, 2017. Pursuant to the TCJA, this corporation will now be entitled to claim 100% bonus depreciation on its qualifying fixed assets placed in service from November 1, 2017 – October 31, 2018.
Based on the blended rate computed in the above example, this $500,000 deduction would be valued at $116,450 ($500,000 deduction x 23.29% blended rate) for the fiscal year ending October31, 2018. In the following fiscal year (the year ending September 30, 2019), the taxpayer will be subject to a flat 21% tax rate, and, accordingly, that same pre-tax deduction will be valued at only $105,000 ($500,000 deduction x 21% rate). Effectively, the result indicates that the tax savings is $11,450. This is a permanent savings if one can successfully implement the strategy.
Keep in mind that larger levels of machinery and equipment acquisitions, as well as fiscal years ending earlier in 2017, can significantly enhance the tax savings associated with this planning.
Capital asset budgeting is a critical element to exploring tax savings opportunities. To address your specific questions, please contact Bob Grossman or Don Johnston at 412-338-9300.
