November 28, 2017
Pending tax reform has been receiving a lot of press, particularly the significant tax rate reductions for C corporations – with the top rate dropping from 35% to a flat 20% rate. If passed, this change could prove to be an enormous benefit for C corporations with significant profits. This change may also cause certain S corporations or even some partnerships to consider a variety of tax restructuring options to introduce a C corporation into the business structure due to the highly favorable tax rate.
There is a unique accounting twist to this potential change that has received very little press. If a current C corporation has significant net operating losses or other tax attributes that are recorded as a “deferred tax asset” on its balance sheet in accordance with U.S. Generally Accepted Accounting Principles, these attributes are valued based on expected utilization at future tax rates.
For example, if a C corporation has a $1 mil. net operating loss that it expects to utilize to offset future income at a 35% tax rate, it would record a deferred tax asset of $350,000 ($1 mil. x 35%). If tax reform is passed with a rate reduction to 20%, that same deferred tax asset would need to be devalued to $200,000 ($1 mil. x 20%), causing a book "expense" of $150,000 simply for tax reform's lower tax rates. Even though the tax rate reduction will save the corporation tax dollars in the long run, the short-term implication of tax reform will cause a large number of C corporations to record large book tax “expense” items to adjust deferred tax assets. While this book expense is a non-cash item, it may prove to be a surprise to many owners, CFOs, and financial professionals.
The exact opposite thing may happen for C corporations with deferred tax liabilities. A typical deferred tax liability may stem for example from a fixed asset acquisition with favorable accelerated tax depreciation. In this case, the C corporation would revalue the deferred tax liabilities using lower tax rates, which would create a positive non-cash adjustment to book income.
Keep this financial accounting twist in mind as we all watch the political wranglings over the tax reform legislation.
This article is intended to serve as general guidance, and should not be construed as specific advice for your situation. Please consult your accounting advisor for any specifics for your situation.
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