Changing Tax Consequences
Whether you are an investor or a service provider, the Tax Cuts and Jobs Act (the “TCJA”) has changed the tax consequences for entities that compete in the transportation equipment lease finance marketplace. Investment stands on the marginal revenues and cost (including tax) it generates. The great news: TCJA reduces the after-tax cost of capital in our capital-intensive transportation sector.
The foundation of the TCJA was a reduction in the C-Corp tax rate from 35% to 21%. But such a one-sided decrease caused the competitive business playing field to severely tilt. For Equipment Leasing firms and service providers organized as Partnerships, Trusts, S Corporations, or Sole Proprietorships who are considered Pass-Through Entities (“PTEs”) TCJA created new complications with marginal benefit and an adverse tilt of the playing field.
You may recall prior to the subject TCJA and before considering capital gains tax, PTEs were subject to a 39.6% rate or an additional 4.6% over the 35% C-Corp rate. Therefore on $100 of income, the highest bracket PTE was subject to an additional $4.60 or a premium of 14% over the $35 a C-Corp would pay on identically derived income. Under the new TCJA, PTEs are subject to a reduced 37% rate or 16% over the new 21% rate for C-Corps.
Now on $100 of income, PTEs would pay an additional $16 or a premium which is 76% over the $21 a C-Corp will pay on identically derived income. PTEs would have lost the significant advantage over their C-Corp competitors if no additional relief was provided.
Section 199A
In the TCJA, Congress created a deduction for Qualified Business Income (“QBI”) of PTEs enacted under Section 199A and it is among the TCJA’s most complex components. On its surface, Section 199A allows owners of PTEs a deduction of 20% against income from their business. The intent was to reduce the effective top rate for PTEs from 39.6% under the old law to 29.6% under the new law (a new 37% top rate * a 20% deduction = 29.6%). With the 20% QBI deduction, PTEs might lessen their competitive disadvantage over C corporations ignoring capital gains.
But controversy and grey areas remain. The new Section 199A QBI deduction is not fully available to all PTEs. It is subject to both W2 and investment caps. Yet PTEs compete head to head in the leasing marketplace with C-Corps who are not subject to such limitations. PTEs now find themselves at a competitive disadvantage against their C-Corp counterparts who manage investment decisions to maximize after-tax cash to the corporation, not the individual investor. Individuals who have built successful businesses and created jobs as PTEs are faced with competing against this lower C-Corp tax rate without full access to the Section 199A deduction.
Aftermath
The TCJA has created competitive disadvantages. Air and rail investment alternatives have economic consequences and the tradeoffs between C-Corp and PTE equipment investment require clarification. Investors and service providers need clarity in order to make informed decisions regarding cash flow, entity structuring, and investment planning alternatives.
The significant wealth of private equity is invested through PTEs and into transportation equipment. These PTE investors must compete for capital. ‘Grey’ areas in the TCJA are subject to interpretation. There is a need to develop a solid understanding of decision alternatives that give rise to planning opportunities while understanding how to integrate that knowledge into the larger picture of after-tax investment decision making.
This is a call to action. If you are interested in the developing consequences of the TCJA on transportation equipment investment, please contact us. RESIDCO is leading an effort to gain regulatory clarifications, technical corrections and devising optimal entity structures to enhance the impact of the TCJA for transportation equipment investment.
