Yes — the Tax Law Could Be Causing Corporations to Pay Bonuses. But It May Be a Tax Game That Won’t Last (with David Kamin)
[Note: This post is co-authored with co-blogger David Kamin, professor of law at New York University School of Law. Follow him on Medium here. On Twitter: @DavidCKamin.]
Lots of companies are announcing bonuses and attributing their payouts to the new tax law. USA Today lists two dozen S&P 500 firms that have announced cash bonuses already. Some have suggested that these bonuses are a publicity stunt from companies that want to drum up support for a corporate tax cut — a tax cut that in all likelihood will benefit shareholders much more than wage-earners. Others have said that these bonuses are the result of a tightening labor market and would have happened regardless of the tax cut.
It’s possible that a significant share of what’s going on reflects repackaging of bonuses that would have been paid anyway. But it’s also possible that the bonuses are directly attributable to the new tax law — though for a different reason than President Trump and his boosters have claimed. Specifically, corporations may be gaming the effective date of the corporate rate change and pulling forward employee compensation — compensation that would have been paid later anyway — in order to achieve significant tax savings. If so, a substantial share of these payments could reflect a one-time gambit that is unlikely to leave workers any better off in the long run, even as it comes at cost to the Treasury.
Moreover, bonus payments aren’t the only way that corporations can game the new law’s effective date provision. We can expect to see similar behavior when it comes to corporate spending of all sorts. By accelerating investments by a matter of days, weeks, or months, corporations can cut their tax bills without actually increasing long-term capital expenditures.
These arbitrage opportunities are available because of the way that the new law’s effective date, rate changes, and expensing provisions interact with longstanding rules regarding tax accounting.
For corporations whose tax years end on December 31, the application of the new corporate income tax rate is straightforward: the old rate (which maxed out at 35%) applies to tax year 2017, and the new rate (21%) applies to tax year 2018. For corporations whose tax years don’t match the calendar year, a blended rate applies to the year that straddles December 31. The rate is equal to 35% times the number of days that fall in calendar year 2017, plus 21% times the number of days that fall in calendar year 2018, divided by 365. According to IRS data, approximately 30% of corporations with positive income have tax years that straddle the calendar year.
As an aside, some readers who aren’t tax lawyers or accountants might wonder why so many corporations have tax years that don’t match the calendar year. One answer is that corporations are required to keep their fiscal years the same for tax and financial reporting purposes, and can choose when they wish that year to begin. Companies might choose an annual accounting period other than the calendar year for a variety of reasons. Wal-Mart Stores, Inc., whose current fiscal year began on February 1, 2017, presumably wants to account for post-holiday returns and refunds in the same year as the corresponding sale. American Greetings Corp. runs its fiscal year from March 1 to the end of February, presumably so that its year captures Valentine’s Day sales and returns. (Not coincidentally, one of the leading cases on tax accounting involves Hallmark’s Valentine’s Day merchandise.)
Corporations with average annual gross receipts above $25 million must adopt the accrual method of accounting for federal income tax purposes. That means that they account for liabilities in the year in which “all the events have occurred that establish the fact of the liability, the amount of the liability can be determined with reasonable accuracy, and economic performance has occurred with respect to the liability. “ 26 C.F.R. § 1.461–1(a)(2)(i). If an employer’s liability for a bonus does not become fixed until the bonus is paid, then the employer must deduct the bonus expense in the year of payment. See CCA 2002949040. [Update: If the amount of the bonus or the formula for computing it is fixed before the end of the employer’s tax year and the bonus is paid within the first two and a half months of the new year, the employer can claim a deduction for the earlier tax year. See Treas. Reg. 1.404(b)-1T; Rev. Rul. 2011–29. Thanks to Steve Rosenthal for flagging this point.]
What does this tell us about the recent raft of bonuses? Well, imagine you’re AT&T. Your fiscal and tax years match the calendar year, and you have plenty of taxable income. The new tax bill becomes law on December 22, 2017. So if you pay bonuses to employees in the next nine days [Update: (or determine the amount of the bonus within the next nine days but pay it before March 15, 2018)], you’ll claim the deduction in tax year 2017, when the deduction is worth 35 cents on the dollar to you. If you just increased pay in 2018, then the deduction for the extra wages would be worth 21 cents on the dollar to you. Perhaps unsurprisingly, AT&T announced in late December that it would pay bonuses right away (and then, somewhat more surprisingly, laid off thousands of workers starting in January).
Now imagine that you’re Home Depot. Your fiscal year runs from January 30, 2017, to January 28, 2018 (always ending on a Sunday). Your tax rate for that year is (337 x 35% + 28 x 21%)/365 = 33.9%, and then drops to 21% for the year beginning January 29. So you have a little bit more time to pay your bonus and still claim a deduction at 33.9 cents on the dollar. (In Home Depot’s case, the announcement came this past Thursday, January 25.)
More generally, if you’re a corporation, then however much you’re going to pay your workers over the next 12 months or so, you have a rate-based incentive to accelerate that payment so that the expense can be deducted in the tax year beginning before December 31, 2017. If you’re a calendar year taxpayer, you wanted to accrue the expense by New Year’s Eve. Otherwise, you want to accrue the expense in the straddle year.
Among non-calendar year taxpayers, the incentive to accelerate is especially strong if your tax year ends early in the calendar year, because then the difference in rates across years is large. By contrast, if your tax year is October 1 to September 30, then your blended rate for this tax year is 24.5%, compared to a rate for next year of 21% — the smaller rate difference means you’ll care less about the timing of deductions.
At the end of the day, total compensation for workers may be about the same as it would otherwise be, but the corporation gets tax savings from making the payment sooner rather than later.
Even more generally, and perhaps most importantly, the incentive to accelerate expenses is not limited to bonuses. For example, the new tax law allows immediate expensing for most business assets other than real property placed into service after September 27, 2017 (the day that the Trump administration and congressional Republican leaders introduced the blueprint that became the basis for last month’s law). So if Home Depot can place property in service by tomorrow (Sunday), it can claim a deduction for the full cost of the property worth 33.9 cents on the dollar (compared to 21 cents on the dollar if it waits until Monday). Income from the property — including if the property were sold soon thereafter — would be taxed at only 21 cents on the dollar. The result is a remarkable arbitrage opportunity: expensing property at a higher blended rate and then including income from that investment at a 21 percent rate. It is effectively a large, negative tax rate for such investment that goes away once the fiscal year turns over. A July 1-to-June 30 taxpayer has more breathing room, though less of a rate deferential.
One prediction: We should expect to see an artificial drop in corporate income for tax years starting in 2017, and then a spike in corporate income for tax years beginning in 2018 as corporations seek to shift deductible expenses to the prior year. And these $1,000 bonuses that we’ve seen over the course of the last several weeks? Don’t expect to find another one in your stocking next Christmas.
