Tax Reform and the Impact on U.S. Government Contractors - PowerPoint Presentation

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Tax Reform and the Impact on U.S. Government Contractors

Patrick J. Bearjar, CPA, CGMAChristopher D. Weir, CPA/ABVMay 3, 2018Alumni hallUniversity of pittsburgh

Overview of U.S. Tax Cuts & Jobs Act

The $1.4 trillion new tax law is most drastic change since 1986.The bill changes everything – how individuals, businesses, estates, nonprofit organizations, etc. are taxed, including tax rates, tax deductions, credits, and more. Tax reform will have broad implications for government contractors.

Impact on business “after tax” cash flowImpact on entity choice decisions –

legal ramifications

More robust economy as a whole

Impact on M&A activity –

higher valuations

of government contracting entities

Impact on employee

“after tax” compensation

2018 BDO Tax Outlook Survey

Following the bill signing, more than three quarters (78 percent) of survey participants have an optimistic outlook, expecting the tax overhaul will have a positive effect on their businesses’ net income. The impact of tax reform is different for every business due to different legal structures, capital structures, geography, business objectives, etc.

Federal tax reform will be followed by state tax reform

Proactive planning is needed!

Impact on Government Contractors

Corporations and Pass-through EntitiesTop Tax Reform “Takeaways”

Takeaway #1 – Lower Corporate Tax Rates

Beginning in 2018, the corporate tax rate was permanently reduced from 35 percent to 21 percent. Comparison of Tax Brackets Calculation of Tax Savings

Takeaway #2 – Tax Break for Owners of Pass-Through Entities (S Corps, Partnerships, LLCs)

The new law provides owners of pass-through businesses—which include individuals, estates, and trusts—with a deduction of up to 20 percent of their domestic qualified business income, whether it is attributable to income earned through an S corporation, partnership, sole proprietorship, or disregarded entity. Without the new deduction, taxpayers would pay 2018 taxes

on their share of qualified earnings at rates up to 37 percent. With the new 20 percent deduction, the tax rate

on such income could be as low as 29.6 percent. Certain service industries may be excluded from the 20% deduction:

Health

, law, accounting, actuarial sciences,

consulting

, athletics, financial

services, any

trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners, or

Which involves the performance of services that consist of investing and investment management trading, or dealing in securities, partnership interests, or commodities

Note that architecture and engineering are not specified service trades or businesses, and so can be qualified trades or businesses for Code Sec. 199A purposes if they otherwise qualify.

Takeaway #3 – Choice of entity should be revisited

Taxpayers should consider evaluating the choice of entity used to operate their businesses. The 21 percent reduced corporate tax rate may increase the popularity of C corporations. Factors such as the new 20 percent deduction for pass-through income, expected use of after-tax cash earnings, and potential exit values will significantly complicate

these analyses. The potential after-tax cash

benefits ultimately realized by owners could make choice-of-entity determinations one

of the most important decisions taxpayers will now make.

Takeaway #4 – AMT & DPAD are eliminated

Corporate Alternative Minimum Tax (AMT) was repealed for tax years beginning in 2018. Section 199 Domestic Production Activities Deduction (DPAD) is repealed (provided up to 9% deduction for qualified activities)

Takeaway #5 – R&D Tax Credit

The R&D credit remains a viable option for many types of government contractors who engaged in R&D type activities The R&D credit results in a dollar for dollar reduction in tax due.If a company is devoting resources towards developing new products, processes, or software—successfully or unsuccessfully—it is eligible for R&D tax credits.AMT – with AMT’s repeal, taxpayers who would have been subject to AMT and who therefore generally would not have been able to use R&D credits to offset their federal income tax liability will be able to do so.Discussion Point for Start-Up CompaniesStartup companies may be able to use the R&D credit to offsetpayroll taxes if certain criteria are met.

Takeaway #6 – Changes to Net Operating Loss Carryovers

Previously, businesses were able to offset current taxable income by claiming net operating losses (NOLs), generally eligible for a two-year carryback and 20-year carryforward. Now NOLs for tax years ending after 2017 cannot be carried back, but can be indefinitely carried forward. In addition, NOLs for tax years beginning in 2018 will be subject to an 80 percent limitation.

Takeaway #7 – Impact on Accounting Methods

Government contractors can take advantage of favorable accounting methods that can be applied for tax purposes.For example, Companies may report financial results using an accrual basis, but taxable income is reported using a cash basis – results in significant savings for growing companies!We recommend tax accounting methods be reviewed annually to maximize available tax benefits.

Takeaway #8 – Favorable Depreciation Methods

Capital expenditures are now able to be deducted for tax purposes much faster than before. (Great news for manufacturing entities!) Section 179 Deduction is enhanced Bonus Depreciation is enhanced

Takeaway #9 – Small Business Tax Relief

Beginning in 2018, the average annual gross receipts threshold for businesses to use the cash method increases from $5 million to $25 million. Additionally, small businesses who meet the $25 million gross receipts threshold are not required to account for inventories and are exempt from the uniform capitalization rules. The $25 million is indexed for inflation for tax years beginning after 2018.

Takeaway #10 – “Fine Print” changes could have significant impact on companies

Disallowed deductions for transportation fringe benefits provided to employeesFurther deduction limitations on certain meal and entertainment expensesAs the IRS releases guidance, employers need to update their payroll and expense reporting systems.

Takeaway #11 – Interest Expense Limitations

Interest is already an unallowable cost for government contractors – tax reform could further negatively impact contractors with high leverageTax reform limits the tax deduction for interest expense to 30% of adjusted taxable incomeThis provision is an attempt to level the playing field between businesses that capitalize through equity and those that borrow. An example:

Economic Considerations

Overall impact of tax reform on the economy as a whole as well as private company valuation

Broad economic p

erformance since tax reform was enactedWhat has changed?As of early February 2018, the broader market indices are up > 20% since late 2016.Inflationary pressure cause rise in pricesRising interest rates

Many corporations have announced new or enhanced bonus or fringe benefit programs for employees.Corporations have announced new capital expenditures that will absorb some of the benefit of the tax savings.

Impact on Valuation of Contractors

The M&A environment for government contracting firms remains strong. With a reduction in the federal/state tax rate from 38% to about 25%, there will be a substantial increase in after-tax cash flow.Other things being equal, value should rise for privately owned C corporations as a result of the lowering of corporate tax rates. Other things being equal, EBITDA multiples will rise to reflect the higher values resulting from higher after-tax cash flows.Use of “rule of thumb” multiples when valuing contractors may not be appropriate, as the historically accepted multiples are based on transactions that occurred prior to the tax reform being in place Buyers and sellers should beware!

Specific Considerations for Government Contractors

Additional Thoughts & Unique Considerations

Best Practices for Government Contracting companies

Consider whether any tax reform motivated transactions (i.e. additional bonuses and incentives, other fringes, etc.) have been accounted for properly as either allowable or unallowable per FAR Part 31Tax reform motivated transactions (i.e. additional capital expenditures, added compensation or costs, etc.) have been properly reflected in provisional and forward pricing rates.Review whether the type of entity (C Corp, LLC, etc.) remains the BEST option?Higher after-tax profits will reflect stronger financial results – companies can revisit their existing financing packages and look for better interest rates, or increased borrowing capacity to support future growth.Update policies and procedures re: expense reporting for meals and entertainment type expenses.

Walk the fine line between sound tax planning and prudent use of cash resources –

Planning is the Key!

Questions & Answers

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