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On August 16, 2022, the Inflation Reduction Act (IRA) was signed into law. One provision that raised revenue (taxes) is a 15% Corporate Alternative Minimum Tax (CAMT) on corporations with average book income of $1 billion or more over the last three years. As an Alternative Minimum Tax (AMT), corporations subject to the tax will now pay income tax that is the greater of 21% of taxable income or 15% of book income.

History. In the United States, an income tax was imposed in the mid-1800s by the Revenue Act of 1861 to create revenue to pay for the Civil War. The tax was short-lived, as it was repealed just ten years later. In 1894, Congress enacted a flat rate tax, even more short-lived, being ruled unconstitutional the subsequent year. In 1909, the 16th Amendment was passed by Congress, and ratified on February 3, 1913. Since then, Federal government revenue has been generally based on taxable income, which is significantly different from ‘Book’ or Generally Accepted Accounting Principles (GAAP) income. Many corporations would report substantial earnings while paying very little taxes. The CAMT is intended to remedy that condition.

What is Book Income? According to the Tax Foundation, book income is the amount of income corporations publicly report on their financial statements to shareholders. Taxable income is the amount used to compute income taxes. Entities can use different methods to report their income to shareholders and lenders versus reporting their income to taxing authorities. There are many differences between the methods used to calculate book and taxable income, which can lead to higher book income than taxable income.

Cash basis versus accrual. A simple difference for many entities is when income or expenses are reported. Under cash basis, income is reported when cash is received, and expenses are deducted when they are paid. Accrual basis declares income when it is earned and expenses when they are incurred. In practice, a cash-basis taxpayer who finished a contract in December for $50,000 and didn’t get the check until January would not declare the income until the year it was received, but for book income an accrual basis entity would declare the income in the year it was earned. There are similar aspects in construction contracts, where the contract might not be included in income until it is finished, versus a percentage of completion.

Inventory: FIFO or LIFO. Another area of difference in book income versus tax income is inventory valuation. One common difference is First-In/First -Out (FIFO) versus Last-In/First-Out (LIFO). Under FIFO, the first items in are deemed sold first. Here’s an example from Investopedia:

By using the LIFO method in a rising price environment, the company declared $7,000 less of taxable income over book income.

Depreciation. Depreciation represents the accounting treatment of wear and tear on physical assets or the diminution of non-physical assets (called amortization). There is substantial difference in the way depreciation is treated with respect to taxable income versus book income. In addition, depreciation and amortization are non-cash expenses, they don’t have any cash outlay, so a company could have a massive depreciation deduction and still have substantial income and cash flow.

CAMT: The CAMT will hit companies with a 3-year average Adjusted Financial Statement Income (AFSI) over $1 billion. This tax is compared to the ‘regular’ 21% corporate income tax. The company pays the greater of the CAMT or regular tax. Groups of entities will aggregate their group income, and adjustments are made for financial reporting years that do not coincide with the tax years. There are also adjustments for partnership income and some foreign income. In the S&P 500, 61% of companies have book net income above $1 billion. Professor Reuven Avi-Yonah of the University of Michigan Law School estimates that only about 125 companies will be hit with the CAMT in 2023.

S&P 500 versus S&P 600? Prospectively more interesting is an overall look at the S&P 500, which are big companies, versus the S&P 600, which are small companies. The S&P 600 has certain criteria for inclusion that include liquidity and financial viability. Here is a comparison of the S&P 500 versus the S&P 600:

From this data, we might infer that the S&P 500 is significantly more exposed to CAMT than the S&P 600. There is no definitive study yet on the full effect of CAMT on earnings, but it might be safe to do the mental exercise that up to 61% of the larger index could see a decrease in earnings versus only 1% of the smaller index. For the last year, the two indices have tracked very closely (500 in blue, 600 in white):

Whether the CAMT has a significant effect is yet to be seen, but it could certainly be said that it will be a new ingredient in the mix for bigger companies.

Bottom Line: Watch what the CAMT could to do to 2023 corporate profits and adjust your asset allocation as you see fit. As always, I’ll try to answer questions: llabrecque@sequoia-financial.com.

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