Positioning Investments For A Trump Tax Cut

According to his website, President-Elect Donald Trump plans to lower the corporate tax to 15%. I’m getting this figure from page 3 of his tax plan on his website titled: “Tax Reform That Will Make America Great Again.”

It contains the following paragraph:

“Too many companies – from great American brands to innovative startups – are leaving America, either directly or through corporate inversions. The Democrats want to outlaw inversions, but that will never work. Companies leaving is not the disease, it is the symptom. Politicians in Washington have let America fall from the best corporate tax rate in the industrialized world in the 1980’s (thanks to Ronald Reagan) to the worst rate in the industrialized world. That is unacceptable. Under the Trump plan, America will compete with the world and win by cutting the corporate tax rate to 15%, taking our rate from one of the worst to one of the best.”

OK, so the ghost of William Faulkner is not supplying the prose for Trump’s policy initiatives.

What can we expect from this?

Well, given Trump’s stated desire to cut taxes, and given that tax cuts are well supported by the Republican majorities in the House and Senate, the most likely assumption is that corporate tax rates will be lower next year than they are today.

If this proves true, which corporations benefit the most?

My view is that the corporations most likely to see an intrinsic value spike from a change in tax policy are those that generate “pure profit” and have not been relying on write-offs, impairments, and things that we often call loopholes to bring down their effective tax rate. You want to look for the businesses that are bringing in torrents of cash with nowhere to hide such that any decline in the tax rate amounts to pure profit that flows to the bottom-line for shareholders.

This means that you want to look at businesses like McDonald’s (MCD). About 85% of their locations are currently franchised, and McDonald’s has plans to increase that figure to 95% within the next ten years. For the bulk of their operations, the only costs are advertising expenses while the net profit figures we see are the rental income and royalties that get collected from franchisees.

Considering that advertising is the only notable expense that McDonald’s doesn’t offload upon franchisees, the company takes the $5 billion in net profits and uses it all to gobble up its own shares via buybacks and then returns the rest of it to shareholders via dividends. That is why McDonald’s actually found itself paying exactly 35% in taxes in 2014 (and was only able to take a point or two off in recent years as it reconfigures its international operations but still found itself paying 32%).

If there is a cut in taxes down to 15%, McDonald’s will actually see a corresponding rise in profitability. All of a sudden, McDonald’s could find itself bringing in $6 billion in net profits after a major tax cut. A mere tax change makes the fast food giant a $135 stock (absent a tax cut, it would probably take three to four years for McDonald’s to reach that value point absent a real estate spinoff).

Other companies wouldn’t see any benefit from a corporate tax rate cut. Take one of my favorite utility companies, Aqua America. Because it is always upgrading pipelines and making major capital expenditures to connect its acquisitions to a more centralized water grid, it perpetually secures tax breaks and tax deferrals as part of the tax code’s incentives to give the people good drinking water.

As a consequence, Aqua America only paid 7% in effective taxes this past year. It would not benefit in the slightest from a sticker reduction from 35% to 15% unless there were accompanying provisions giving it greater tax breaks. Any businesses that rely on heavy tax beaks don’t stand to see their intrinsic value increase sharply because their effective tax rate is already low.

As a general rule, you should look for companies with simple business models that generate pure profits and have high effective tax rates. They stand to benefit the most from a lower sticker rate. Meanwhile, heavily regulated businesses that regularly secure tax breaks and already have low effective tax rates stand to gain the least.

Even though the media talks about sticker tax rates with a primary focus on income tax rates, capital gain and dividend tax rates, and corporate tax rates, I think the underrated story of any Trump tax initiatives will revolve around more arcane provisions such as the discount rates applied to the transfer interests of family businesses.

For instance, most of you are aware of the $14,000 gift tax exclusion. Well, when a business is illiquid (not publicly traded on an exchange), there is variance about the discount rates that families can secure for transferring family assets. For instance, if a couple owns a million-dollar apartment complex, they can include a provision in their transfers to their kids that says something like “Your interest can only be sold for $99 within the next ten years, and thereafter, you shall have free alienability of your interest.” These alienability clauses enable families to apply high discount rates when transferring wealth to their children. With selling restrictions, you can apply a discount rate up to 40% and that enables you to transfer an additional $5,600 of value.

It may not sound like much, but it enables a two-parent household to transfer $39,200 in economic value to a child each year. Executed annually over a forty-year time period, this permits for a tax-free wealth transfer of $1,568,000 before you even get to the estate tax allowances (with $627,200 of that transfer being a result of the application of a discount rate to illiquid assets). And it will probably be more than that since the annual gift exclusion regularly rises—it was $10,000 per year in 2000, it is $14,000 now.

My basis for this speculation is the influence of Wilbur Ross on Trump’s economic policy, who has created significant wealth for himself by taking advantage of special discounting rates and tax breaks that are applied to illiquid assets in industries that secure major tax breaks. Because these provisions are so fact specific and complex, they evade public scrutiny and quite literally amount to a gifting to the rich that does not draw the kind of attention that, say, General Electric paying a near-zero U.S. income tax liability in 2010 gets from the media.

The obvious downside of this is that wealth inequality between the typical demographic of people who voted for Trump and the wealthy people who will benefit from these policy changes will accelerate at a rapid clip. Politics aside, it will provide yet another reward for those who spend their time hiring professionals and studying strategies that maximize the benefits permitted by the tax code which is a major energy distraction from building wealth the old-fashioned way by growing something. At this point, it is still a hunch, but I suspect the greatest payoffs will await those who own shares of corporations with pure profits paying high effective tax rates right now as well as those that own illiquid assets that they intend to transfer, acquire, spin off, or otherwise modify in a manner that is a taxable event.


Originally posted 2017-01-15 06:35:09.

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