Parts of the 2017 tax act and recent rules from Treasury could end up kicking companies while they are down, as the coronavirus outbreak threatens to trigger a recession.
The White House and lawmakers are planning tax relief to combat some of the impact of Covid-19, the official name for the disease, which Trump hopes can include several months of a payroll tax cut. Major stock indices and oil prices have tanked, as people have stayed home and steered clear of travel and companies have faced supply chain disruptions and lowered or withdrawn their earnings estimates.
One of the tax law’s changes can lead to higher tax bills for debt-reliant companies as they earn less and borrow more. Another eliminated companies’ ability to get what are effectively quick tax refunds in hard times by “carrying back” their losses to earlier, more prosperous years. The law also put a ceiling on the amount of income companies can offset with losses later on.
“All these things are impacting companies at vulnerable times,” said Vipul Amin, a managing director at the private equity giant Carlyle Group Inc.
The law placed a cap on the amount of debt interest payments a company can use as tax write-offs each year, for companies with annual gross receipts of more than $25 million, subject to inflation adjustments. But lawmakers made that cap a percentage of company earnings, so as their earnings go down, their tax benefits associated with borrowing shrink. Taking on more debt to fund operations where income or equity fall short could only exacerbate the problem.
“Obviously, in general, the limit will kick in more as the economy descends,” said David Kamin, a New York University School of Law professor and former special assistant for economic policy to former President Barack Obama.
“Overall, it is better for the tax code to be more responsive in the event of a recession,” he said.
The overhaul also restricted the use of “excess business losses” as tax offsets by owners of pass-through businesses such as partnerships and limited liability companies, Kamin noted.
That change, to tax code Section 461(l), could “be having an even larger effect if the economy dropped into recession,” he said.
‘A Real Sleeper’
The law additionally barred companies from carrying back net operating losses to use them as tax breaks in prior years, something companies could do previously if they had a highly profitable year or two followed by a year deep in the red. It also capped at 80% the amount of income companies can write off using losses.
“A real sleeper is the elimination of the carryback,” said Robert Willens, a New York-based tax consultant, adding that it could hurt airlines if they accrue losses in this period, as demand for flights decreases.
In the aftermath of crises such as the Great Recession, Congress allowed certain businesses to carry back losses for as many as five years.
Still, the 2017 law allowed companies to carry losses they can’t use as tax breaks in one year forward to future years indefinitely—rather than for 20 years, as under prior law—which could offset the negative effects of the loss limits, said Kyle Pomerleau, a resident fellow at the American Enterprise Institute.
That’s not much help for companies in need of cash immediately, he said, adding that it’s possible lawmakers will allow companies to carry back losses to earlier years, as a form of temporary relief if things take a turn for the worse.
The National Taxpayers Union Foundation has already called for a temporary rollback of the cap on income offset by losses, arguing that the payroll tax cut floated by the administration won’t solve the problem of individuals’ declining demand for businesses’ goods and services.
“Cutting an individual’s payroll tax liability doesn’t change the decision-making framework in this context because the constraints they face are not primarily financial, they are social,” Nicole Kaeding, the group’s economist and vice president of policy promotion, wrote in a Tuesday post. “Regardless of ability or desire to go see a movie or enjoy time at a bowling alley, Americans are being told to stay home, avoid crowds, and not to travel.”
More Loss Limits
On top of the 2017 tax law provisions, Treasury issued Section 382(h) proposed rules in September that could squeeze companies emerging from bankruptcy or tough times.
The rules govern an annual limit that kicks in when a company buys a struggling business or a startup to keep the buyer from using the target company’s losses to shield too much of its much bigger profits from tax. The annual cap is equal to a tiny percentage of the target company’s market value. But in the first five years after the deal, it can be expanded—even doubled or quadrupled—by what’s known as “built-in gains,” which are essentially deductions the acquired company didn’t take.
The proposed rules would eliminate a method of calculating those “built-in gains” that is often used to maximize them, prompting private sector backlash. The National Bankruptcy Conference—a group of bankruptcy lawyers, judges, and academics—is among those criticizing the rules. The group contends that, mixed in with the tax law’s changes to interest and loss deductions, the rules could worsen the symptoms of a recession.
Todd Maynes, a partner at Kirkland & Ellis LLP, who signed a letter from the organization to the IRS, described the proposals as “the cherry on top” of Congress’s limits on interest deductions and tax-offsetting losses.
The American Investment Council is also among the groups calling for a rollback of this part of the proposed rules.
On top of other changes in the law, the council wrote, “the proposed changes will have significant adverse effects on loss companies—particularly emerging growth and troubled companies—that hampers their ability to grow or recover.”