How to Spend Tax Savings Under the TCJA

As its name suggests, the Tax Cuts and Jobs Act (TCJA) will reduce taxes for many businesses.

DS+B Team October 16, 2018

In turn, these tax cuts could increase operating cash flows and provide numerous growth opportunities. Here’s a look at reasons these cash flows are likely to increase under the TCJA, various alternatives for spending business tax savings and tools for evaluating those alternatives.

Pro-Business Changes

Some TCJA provisions will hurt businesses. For example, the law:

  • Limits business interest deductions,
  • Changes deductions for business entertainment and employee fringe benefits,
  • Repeals the domestic production activities deduction (DPAD) under Section 199,
  • Eliminates like-kind exchanges for swaps of personal property under Sec. 1031, and
  • Limits deductions for net operating losses (NOLs).

But most of the changes are favorable to businesses, including:

  • Reducing corporate income tax rates to a flat 21%,
  • Adding a qualified business income (QBI) deduction for qualifying sole proprietorships, limited liability companies, S corporations and partnerships,
  • Eliminating the corporate alternative minimum tax (AMT),
  • Expanding first-year bonus depreciation and Sec. 179 deductions, and
  • Liberalizing reporting alternatives for qualifying small businesses.

The tax law doesn’t do much to simplify the tax code. So, quantifying how much a specific company will save under the TCJA isn’t easy. Companies should consult with a tax advisor as soon as possible to get an idea of how the changes will affect them and to suggest strategies to maximize the potential benefits of the law. Most of the changes will go into effect for the 2018 tax year, but some are available only temporarily.

Spending Options

After a business identifies its potential savings, management will have to target an amount to allocate toward investment alternatives, including:

A company’s management team may have many competing investment ideas — but there’s only so much tax savings to go around. The owner (or board of directors) must decide which alternatives are worth pursuing. Some ideas may need to be tabled for future years.

Decision-Making Tools

Experienced valuation experts don’t rely on gut instinct to evaluate investment alternatives. They crunch the numbers to decide which alternatives will add the most to the bottom line using analytical tools, such as:

Accounting payback period
This is perhaps the most common — and basic — way to evaluate investment alternatives. For example, a piece of equipment that costs $100,000 and generates an additional gross margin of $25,000 per year has an accounting payback period of four years ($100,000 divided by $25,000).

When using this metric, management typically has established a benchmark for the time an investment has to pay back the initial investment. For example, management may not consider investments that take longer than five years to pay back. The downsides are that the accounting payback period ignores the time value of money, and it can be hard to calculate when cash flows vary over time.

Net present value
NPV measures how much value a capital investment adds to the business. To estimate NPV, valuation experts forecast how much cash inflows and outflows a project will generate over time. They then discount each period’s expected net cash flows to its current market value, using the company’s cost of capital or a rate commensurate with the project’s risk. In general, projects that generate an NPV greater than zero are worth pursuing.

Internal rate of return
IRR is another metric that accounts for the time value of money. A valuation expert uses it to estimate a single rate of return that summarizes the investment opportunity. Most companies have a predetermined hurdle rate that an investment must exceed to justify pursuing it. Often, the hurdle rate equals the company’s overall cost of capital — but not always.

When projecting amounts to use with these tools, it’s important to understand how the TCJA could affect expected earnings and returns. For example, when evaluating an equipment purchase, management needs to factor in the expanded depreciation deductions available under the TCJA. Bonus depreciation and Sec. 179 deductions could provide additional tax savings in the year the acquired asset is placed in service.

Likewise, certain provisions of the TCJA could affect a company’s cost of capital over the long run. The TCJA limits interest expense deductions for larger companies to 30% of adjusted taxable income. This could increase the cost of debt — because less interest expense would be tax deductible. (However, companies with average annual gross receipts of $25 million or less for the three previous tax years are exempt from this limitation.)

In addition, the TCJA could lead to other changes to a company’s cost of capital. For example, if a company decides to use its tax savings to pay off debt or repurchase stock, it could affect the capital structure over the long run. Companies that transition to more equity financing could potentially increase the overall cost of capital (because the pre-tax cost of debt is generally less expensive than the pre-tax cost of equity). Those that transition to more debt financing would likely reduce their cost of capital.

Tough Decisions Ahead

After crunching the numbers, management may consider qualitative issues before selecting which investment alternatives to pursue.

For example, an owner may arbitrarily decide to pay herself a bonus, rather than grow the business. Or a risk-averse owner might decide to pay off debt to safeguard against possible economic downturns. Or a company struggling with finding qualified employees might decide to allocate money toward recruiting and training, even though it potentially offers a lower return than other growth strategies.

A valuation expert can help companies understand the effects of the TCJA and evaluate the quantitative and qualitative considerations of each investment alternative.