CFOs have dozens of issues to worry about, not the least of which is being able to project future earnings with confidence. Conducting this task is not simple since a key model input — taxes — is anyone’s guess right now in terms of rules, rates, and recissions. While it would be nice to avoid the garbage in, garbage out disaster of flawed assumptions, it is a veritable Rubik’s Cube to correctly forecast which political priorities will prevail in November.
Grappling with the uncertainty of federal and state tax policy is even more problematic for midsize private firms with limited resources, S Corporations, those vulnerable to the non-renewal of business-friendly terms of the Tax Cuts and Jobs Act, and companies operating in multiple states with complex tax rules.
The Challenge of Tax Uncertainty
Absent a renewal of the Tax Cuts and Jobs Act, certain businesses may experience volatile earnings and cash flow when current provisions for research and development (R&D) and machinery and equipment expire.
CFOs of companies that heavily invest in intellectual capital need to know whether lawmakers will reinstate the ability for a business to deduct R&D costs right away, or maintain the requirement to deduct these expenses over a longer period as a “pay for” a lower 21% corporate tax rate. CFOs that purchase machinery and equipment will push to keep accelerated deduction rules before they are completely phased out by the end of 2026.
“Anything that distracts [CFOs] from their mission to grow the company is a problem.”
Jack McCullough
President, CFO Leadership Council
Private companies set up as S Corporations, or other kinds of pass-throughs, could face higher taxes should the qualified business income deduction provision of the Tax Cuts and Jobs Act disappear. According to Todd Horsager, a CPA and CFO at Compass Strategic Investments, a failure to renew this part of the legislation will do away with the mechanism intended to level the playing field between pass-throughs and C Corporations.
To make permanent the 20% deduction for qualified small businesses, Montana Senator Steve Daines proposed the Main Street Tax Certainty Act of 2023. His initiative has the support of more than one hundred business organizations that signed a May 18, 2023 letter in favor of this twenty percent deduction. Horsager describes the situation as complex, adding, “Without an extension, numerous pass-through owners will switch or consider converting to C Corporation status, possibly causing a bigger decline in business tax revenue to the federal government than the decline associated with equalizing corporate tax rates.”
Tax Complexity Risk
Forthcoming state elections could make it harder for CFOs of companies operating in multiple tax jurisdictions if newly installed legislators seek to add to already complicated rules. According to Patrick Rowland, a former forensic accountant who now provides tax advice to small and midsize company entrepreneurs, the maze of tax rules in the fifty states directly impacts all facets of a company’s activities, from raising capital to operating locally and much more. He references a Connecticut-based client who stayed put instead of relocating due to the higher tax-inclusive costs of building a new facility in Texas or Mexico. Rowland links bad tax policy to these kinds of unintended consequences that result in strategic decisions being preempted by tax considerations.
CFOs understand that taxes are a corporate cost, along with the expense of gathering data, calculating amounts owed, and then preparing statutory filings. The greater the differences in tax rules from state to state (or country to country), the greater the expense, and the harder it is for CFOs to strategically plan around tax considerations.
The taxing of marshmallows highlights the trickiness of figuring out how to incorporate taxes as a model input to forecast sales, earnings, and free cash flow. “In one state, it’s taxed as a candy item,” Rowland said, “but in another state, it’s taxed as a food ingredient.” Below the state level, there are taxes levied by towns, school districts, and counties, each one being determined by the winners of local elections. In Denver, Colorado, Rowland says, “There is one corner that has four different taxes, depending on which corner someone transacts.”
Tax Policy Nudging
As stated by the Tax Foundation, optimal tax policy should raise revenue to pay for government-provided services. It should neither “favor or punish specific industries, activities, and products.” Neutrality does not always prevail. Some tax rules fall harder on companies by virtue of their size or industry or they disproportionately create winners and losers.
According to Dan Steele, a CPA and partner with the DPAD Group, one example of a winning tax policy for small to medium-sized companies is the Domestic International Sales Corporation. Established in 1971 by the U.S. Congress, the DISC is an income-deferred mechanism, designed to place U.S. manufacturers that export on the same footing as U.S. companies that locate operations offshore. As reported by the Small Business Administration earlier this year, there are at least 1.3 million exporting small businesses.
Steele advocates for tax policy fairness and transparency. He is concerned that higher global effective tax rates could impede earnings growth, make companies less competitive worldwide, and result in businesses having to raise consumer prices or reduce headcount or both. “These problems are particularly acute for mid-size companies with fewer resources," Steele said.
CFOs Worry About Hidden Taxes
Unknowns such as hidden taxes worry CFOs, especially when they come with a hefty price tag. If a CFO cannot identify, let alone measure, something, it is hard for them to implement strategic plans. Hidden taxes in the form of volatile economic conditions, inflation, and regulatory costs keep CFOs up at night.
Abiding by mandates, and reporting the results, is another type of hidden tax. With rare exceptions, regulations expand with every new political administration. Jack McCullough, president of the CFO Leadership Council, describes CFOs as anxious about environmental compliance, something that can be cost-prohibitive for smaller companies. He adds, “Anything that distracts them from their mission to grow the company is a problem.”
Sherri Hockfield, senior director with Eventus Advisory Group, tells her mid-sized private company clients to put aside an estimated percent of revenue for tax compliance and Sarbanes-Oxley Act or SOX testing. Determining the right percentage to put aside depends on the specific regulations that apply. A geographically diverse company must comply with different mandates relating to tax, operations, labor, and reporting. Going public adds another layer of regulatory compliance costs.
“CFOs are most concerned of not capturing the potential aftershock [of regulation changes]. It is important for them to add their voices during SEC comment periods when new regulations are proposed.”
Rachel Cappell
Director, Eventus Advisory Group
Rachel Cappell, CPA, and head of the governance area with Eventus Advisory Group, thinks more regulations are on their way. She predicts an increasing focus on Environmental, Social, and Governance (ESG) regulation in the United States, like the European regulatory model. She says it is not just regulators who want to know about a company’s ESG activities. Shareholders and other stakeholders such as prospective clients and business partners are similarly interested. Cappell acknowledges that regulations have unintended and inevitable consequences, adding, “CFOs are most concerned of not capturing the potential aftershock. It is important for them to add their voices during SEC comment periods when new regulations are proposed.”
As Benjamin Franklin quipped in 1789, “Nothing is certain except death and taxes.” The CFO equivalent is, “Nothing is certain except change and taxes.” Given the importance of taxes in mapping out strategic plans, smart CFOs will continue seeking input about tax policy, current and expected, from in-house and external experts.
This is the second article in a two-part series about how domestic and foreign tax rules influence strategic decisions made by CFOs. You can find part one here.