New Business Tax Reform
What Does The New Business Tax Reform Mean For Startups?
After going back and forth for weeks, the House and Senate passed the final version of the tax reform bill on December 20th. This $1.5 trillion tax bill, otherwise known as H.R.1, the Tax Cuts and Jobs Act, is the largest tax reform to take place in the past 30 years. Containing a long list of tax rate reforms and changes, businesses and individuals are all wondering how it will affect them and impact their day-to-day life. While the tax reform certainly makes a difference to the individual in general, depending on tax bracket and personal equity, it is in general a huge red carpet roll-out for big business.
Between all of the back and forth and the last minute changes there has been a lot of confusion on how this reform will actually affect businesses. Startups were initially worried about one of the items under discussion that proposed to tax stock options when they vest rather than when they are exercised. This would have had a huge impact on startup employees and how they are paid, as well as their ability to take the risk that comes with working for a startup. This item was thankfully nixed before the final bill was signed. So what else can startups expect from this bill? Will we see any changes in startup forecasting over the next year?
Corporate tax rate reductions across the board
As a general rule there will be a reduction in the corporate tax rate from 35% to 21%, and all of the important loopholes and deductions will remain. Pass-through businesses will be able to deduct 20% of the first $315,000 of earnings (a much lower rate than the previous 39.6%), and corporations will now be allowed to bring overseas cash back into the US at a reduced rate of 15.5%. The bill also includes a 10.5% tax on future foreign profits, which is a huge benefit to large, multinational, and international companies.
On paper this sounds pretty promising, especially for large corporations. Lower tax rates will encourage entrepreneurship and innovation. There is the possibility of a huge amount of foreign cash being reinvested in the US, which could then be used to fund new businesses. And the R&D tax credit remains, which incentivizes entrepreneurs. But if you read between the lines it is painfully obvious that this tax reform does anything but level the playing fields in terms of big and small business: on the contrary corporate giants will benefit from much lower tax rates than startups. Before this bill was passed tech giants were already paying lower tax rates than an average business (24% or lower), so this is only going to get better for them, but won’t really change anything for startup revenue forecasting.
More money for startup investment?
The ability for corporations to now invest their foreign cash domestically won’t affect startups seeing as most, if not all, of their money is made in the US. This does however mean that there will be a larger pool of funds to invest in startups, which can then encourage entrepreneurship. Tax savings are mainly going to richer investors and corporations so this will also mean that there will be more investment capital available. We may therefore start to see a rise in startup acquisitions, something that has been pretty stagnant through 2017. The downside in all of this extra investment cash is that it may push valuation up to unsustainable levels. In any case this all relies on the health of the US economy and investors’ confidence and willingness to take a chance with startups.
Will new startup hubs appear?
We may start to see a shift in startup locations, as the bill curbs deductions in high-tax areas such as New York and San Francisco, and the cost of living in these places continues to rise. Entrepreneurs may not be so willing to risk all in places that are becoming increasingly too expensive to live in. Other states, such as Texas and Utah, will most likely see a rise in tech start-ups, which can definitely be seen as a positive trend. This type of change may create a fresh wave of innovation, pushing entrepreneurs to really extend their horizons.
The three year holding impact
Another possible impact that will become more apparent over the next few years is that the tax reform retains the carried interest loophole for investments held over a three year period. While this doesn’t necessarily change anything for seed investors who usually pass the three year period, the higher tax rate for investments that are held for less time may impact how startup investments are done after initial seed funding.
The bottom line is the only way startups are directly going to see a positive impact from this tax reform is if they are profitable. As most aren’t it is doubtful that the reform will make much difference to their everyday workings. However it will most likely affect the entire ecosystem of a startup, changing how investments are made, and how willing investors are to take the plunge. So while the final bill doesn’t contain any items that would immediately impact startup funding, development, and success negatively, only time will tell how much of an overall difference it will make.
For the Startup Financial Model, you need to make sure that your tax assumption corresponds to your currency. For the changes use the flat tax assumption and use the new US Corporate tax rate of 21%.