Switching Gears: Positioning Your Business to Take Advantage of Tax Reform in Your Financial Reporting
It could be the best of times – or the worst of times – depending on how you incorporate certain elements of the Tax Cuts and Jobs Act (TCJA) into your financial reporting. With proper planning and forecasting, businesses across the manufacturing and logistics industries may reap substantial benefits under the new tax law.
However, it all depends on your unique business situation and how you choose to apply some of the different incentives to achieve your financial reporting objectives. Your vigilance and planning could help you take advantage of some of the corporate-positive changes while mitigating any potential negative effects.
What are some of the choices business owners and C-suite managers will need to consider for financial reporting purposes, and what are some of the potential pitfalls for which businesses need to prepare?
Business Owners: Should You Incorporate?
For privately owned pass-through entities, taxation generally happens at the individual level, meaning the business income is taxed at the individual tax rate (currently at 37 percent in the highest bracket). The reduced corporate tax rate (lowered from 35 percent to 21 percent) has some pass-through entity owners wondering if they should restructure as C corporations to take advantage of the lower rate.
Being a C corporation might look attractive at first, but owners need to consider all the ramifications before making the switch.
Restructuring to a C corporation will result in increased financial reporting obligations. For example, C corporations are required to apply the Financial Accounting Standards Board (FASB) Accounting Standards Codification 740, Income Taxes.
Under this standard, C corporations must calculate and recognize deferred taxes at the company level. This is essentially an additional compliance requirement for financial reporting purposes, and does not impact how the business is actually taxed.
There are other trade-offs, too. Pass-through entities should analyze their situation under both classifications before committing to a change. Going through an analysis process with your CPA can help you reach an objective decision that addresses your specific situation and motivations.
Financial Reporting Challenges for C Corporations
C corporations are required to recognize the changes in the tax laws and tax rates on their deferred tax assets and liabilities retroactively in the period in which the new law is enacted.
In this case, since the law went into effect on December 22, 2017, if your company yearend is December 31, the new tax law needs to be reflected in the fourth quarter 2017 financial statements.
Changes in the allowable deductions and other taxable credits will also create temporary differences between tax and book amounts, differences that will need to be accounted for in the financial statements. FASB issued guidance in recent months in the wake of tax reform to help companies make the necessary disclosures over the coming year.
Reassessment of Valuation Allowances
Since elements of the TCJA could affect a business’ cumulative income or loss, valuation allowances will likely need to be reassessed. Items that can affect your valuation allowance include but are not limited to:
- Net operating losses, which can no longer be carried back after 2017 but can now be carried forward indefinitely, and which are limited to 80 percent of taxable income for those generated in 2018 and forward, in most cases;
- Deferred tax assets that can act as a source of taxable income (e.g., taxable income in prior carryback years and the reversal of any existing temporary taxable differences);
- Your tax-planning strategies and future taxable income projections; and
- Changes to the Subpart F regime in the U.S. tax code, regarding deemed repatriations from foreign subsidiaries for 2017 and future tax years.
Multinational corporations in particular may need to reassess their valuation allowances because of the deemed mandatory repatriation of foreign earnings as of the end of 2017.
The one-time toll charge could create cumulative income not previously considered under certain scenarios. The good news, however, is that all available evidence is taken into consideration in a valuation allowance assessment. Therefore, this one-time increase in income will not be the only factor in your final assessment.
International Corporations and Deemed Repatriation of Foreign Earnings
For companies with international operations, the most significant item that will affect your 2017 financial statements is the repatriation tax on undistributed earnings and profits of U.S.-owned foreign corporations. Previously, foreign corporations would typically defer income taxes until the earnings were repatriated. The new tax law allows for a one-time transition tax on the deemed repatriation of earnings that were previously deferred.
Effects on Financial Statements
The new tax law will result in many complex calculations for financial statements. For publicly traded companies, the Securities and Exchange Commission will permit companies to use “reasonable estimates” and “provisional amounts” for some tax line items when preparing financial statements. Private companies are also allowed to follow these rules. Companies should include specific financial statement disclosures to provide information about the material financial reporting impact of the new tax law and any estimated amounts used.