Goodbye to Taxes as We Know Them (and to Season 3)
A proposal to tax companies based on book income instead of their tax income was tucked into the Inflation Reduction Act of 2022, and that sure got Steve Soter and Josh Gertsch talking. Catherine soaks in why it’s such a big deal for accounting teams.
Season 3, Episode 26: Goodbye to Taxes as We Know Them (and to Season 3) | Transcript
Catherine Tsai: Hello and welcome to Off the Books, where we surf the uncharted waters of accounting, finance, risk, and wherever else the waves take us. This episode is brought to you by Workiva, the risk, reporting, ESG, and compliance platform that simplifies your complex work so you can make sense of complicated things like this season of The Bachelorette. Check it out at workiva.com/podcast. My name is Catherine Tsai. I like learning new things and drinking venti soy chais, and I'm looking forward to debiting a great conversation. Happy to have you with us. I'm also happy to have Steve Soter joining me. Steve, remind people who you are.
Steve Soter: Certainly, Catherine. My name is Steve Soter, accounting enthusiast and Diet Coke aficionado. Catherine, what are we talking about today?
Catherine: Today we are talking about the Inflation Reduction Act, which has been in the news. And there's so much in this thing from addressing climate change to corporate taxes, and so this brought up the question of book income versus tax income.
Steve: Yeah, that's exactly right, Catherine. In an early draft of the legislation, there was a note about the way that taxes might be calculated under this act. So for some background for our audience, generally, the way it works in companies is you have a tax team and you have a financial reporting team. The tax team calculates your taxable income. They apply a tax rate, and that's what you owe. The financial reporting team, using generally accepted accounting principles (GAAP), calculates your—what we call—book income and then the profit that you would show on your 10-Qs or 10-Ks. What was really interesting about the draft legislation that we looked at is that they were going to take the income from your books and actually apply that to what you would pay in taxes. We weren't sure what to make of that, so we brought in Josh Gertsch, who is a longtime accountant, former auditor, and knows a bunch more about taxes than we do to break it down for us.
Catherine: And now our conversation with Josh. Steve, I'll ask you to tell us why Josh Gertsch is here on the podcast today.
Steve: It's because my self-esteem was getting a little higher than it probably should. So now's an opportunity to keep it in check. That would be reason number one. But reason number two, perhaps more important and relative to this, is that we are talking about book income versus tax income. Josh and I work together now at Workiva, but actually have a previous working relationship, and he was quite good and adept at income taxes. I am not, which relative to this subject, I feel like it'd be very helpful for us. So Josh, welcome to the podcast.
Josh Gertsch: I appreciate it. Catherine, to answer your question, Steve knows nothing about taxes. He's not even a qualified accountant, so I'm here to answer any questions as a certified professional accountant.
Catherine: All right. Guns blazing. Okay. Well, we are here to talk about book income versus tax income because the Inflation Reduction Act is moving through Congress and there's a bit in there about corporate taxes. And I know, Steve, this got you fired up—this awesome conversation on LinkedIn about it.
Steve: Well, it was just really interesting because notwithstanding how much I don't, according to Josh, know about taxes, you know, tax teams calculate taxable income and a tax rate and then what you're going to pay, and financial reporting teams calculate book income. But the way that this is written, which may by the time that this episode drops may have changed, but the way that this was originally written, they would actually use book income as the starting point for calculating taxes. And that's really different. I mean, that is definitely not how that works today. And that's interesting.
Josh: I'll be honest, this makes no sense to me. Like there's got to be something else going to I would hope there's some clarification coming on this on what it is, because this makes no sense to me. You have a tax code that's existed for, you know, decades upon decades that tells you, "Hey, here's how you calculate your income, and then we're going to apply a tax rate to it." To basically hold all of that the same, like, here's the tax code, adhere to this, but then pick this number out. We want you to use not that income number, but the income number from over here, which is calculated completely different, which is regulated by a different body, which can, quite honestly, in my opinion, can be manipulated far more than taxable income can. I have no idea why they're doing this because at the end of the day, if they're just trying to propose a minimum tax of 15% on profits, why don't they just change the tax code to do it? Why are we changing metrics that don't even exist within the regulatory framework that are used for taxes? I mean, this is crazy to me.
Steve: But one question that I had, Josh, so by the way, I 100% agree with you, but if the purpose was to avoid companies from basically claiming zero taxable income and therefore paying relatively low taxes, companies are incentivized and obviously have very strong motivations for having favorable book income. That's what gets reported to the street. That's watching your Qs and KS and everything else. So if the stated goal was to say, "Look, we just want to avoid those who are dodging taxes. It's the tax code that has enabled that. So as a shortcut, why don't we just base this off a book income?" So when you report favorable book income, then, hey, apply this tax rate and there you go. I mean, again, I totally agree with what you're saying, but as a shortcut, would this not be at least a means to accomplish that?
Josh: Well, I agree with you. One thing we agree on, this is a shortcut. Rather than modifying the tax code, they are taking a shortcut to get to the answer that they want. I guess my question to you is, I don't know how this is. I'm a little bit surprised, like how alternative minimum tax doesn't come into play here quite frankly. I can go out there and like go into your statement of cash flow. You have all these non-cash items that run through there.
Catherine: All right. Let me press pause before Josh gets going here. So, Steve, tell me about the statement of cash flow and non-cash items.
Steve: Sure. So there are these sets of financial statements, which many of our listeners will probably be familiar with, like a balance sheet or an income statement or even a statement of equity. Well, the fourth is a statement of cash flow. And basically what it's meant to do is to take your income statement, which is not a representation of cash and turn it into what cash would look like, which basically takes all of the cash you brought in, nets all of the cash that you took out, reconciles the non-cash things on the income statement, and actually gives you a cash number.
Catherine: But can you give an example of a non-cash thing?
Steve: Sure. Depreciation is a great example and Josh will actually talk about that. When you buy an asset, you're going to deploy all of that cash out front, but you're not going to recognize all of that as expense on your income statement. So depreciation is the systematic way of recognizing that expense. So at the end of the life of the asset, the depreciation you recognized, which is the expense that you recognized, actually matches the cash that you spent. And the statement of cash flow is what helps you reconcile that as a user of financial statements.
Catherine: Okay. Let's go back to Josh.
Josh: Depreciation, amortization, stock comp, rent expense. You know, all I got to do is beef those up, give myself zero book income, and then reconcile that to my market on an EBIDTA metric. And I can still show people that I'm profitable, and I can still avoid income taxes. A tax strategy is not illegal by any means, and quite frankly, you're rewarded for it.
Steve: And unpack that just a little bit because you're talking about the statement of cash flows, and that's because you're analogizing that to tax income, which is largely a cash basis. I mean, I know that, but unpack that a little bit.
Josh: If they really wanted to go and find a metric and move quicker, which is what I think they're doing, they should have gone and looked cash from operations or something like that that told them, "Hey, how much cash is flowing in." Because basically, you know, the way it works—for Catherine—the point is basically the way the IRS works is they tax you on cash in and out. How much cash did you actually make this year? That's what we want to tax you on. With book income, you can have expenses that are not tied to cash.
Catherine: So if you did take your book income to zero, I imagine that wouldn't really give investors a good picture of how your business is actually doing. Is that correct?
Josh: That's correct. But what happens then on if you're disclosing your—like we had our quarterly results, you know—and you're saying, "Hey, for example, I had book income of net zero." Well, there's a common metric used. They call it EBITDA where it backs out basically all real non-cash expenses that come through.
Steve: Let me jump in here quickly and talk about EBITDA. We just talked about the statement of cash flows a second ago. Well, EBITDA is actually an even faster shortcut to that. It basically takes your earnings that you have on your income statement and subtracts the major non-cash things like depreciation and amortization and is a very important number for investors when they try to approximate the cash that you bring in.
Josh: And so most companies already report that. And so you could take your book net income down and then come back and be like, "Oh, by the way, all we had was more non-cash expenses. But our earnings, if you back all that out, is still very profitable." And that's actually what investors used to adjust their stock evaluations anyway as they look at revenue and they look at EDITBA metrics. I mean, I'm not even sure net income is used in the public markets as a real driver of profitability at this point. So I assume somebody much smarter than me has thought about this, and I'm sure there's some clarifying guidance coming. But as it reads today, I'm not sure that this gets you any bit closer to getting, you know, increased taxes from these big corporations. In fact, I think they can manipulate it more. I think they can satisfy investors and what they're looking for and still reduce their taxable income with that book income metric.
Catherine: So, Steve, why is cash from operations most like tax income?
Steve: Sure. Well, as Josh has been talking about, tax income is really meant to approximate cash that you bring in or that you generate in terms of your profits. On that statement of cash flows, there actually is a line called cash from operations, which really approximates just that. It's how much money did I bring in? What did I spend in order to make that money? And then what I'm left with is cash from operations. It includes things like financing, if you took out a loan and brought in a bunch of cash or if you spent a bunch of money on capital investor on capital investments like new property, plant, or equipment. That's a pretty good approximation for what you would calculate as your taxable income. And that's why Josh is talking about it.
Steve: I guess my question is then, do you think just again, throwing this out there, the cash flow from operations on a GAAP statement of cash flows might actually be a better basis to start with your taxable income. I mean, if you really wanted to go like straight to cash, could you theoretically start there and then apply your rate and go from there? So the tax really was truly based on cash.
Josh: Yeah, you could. As you say this, Steve, I can see an argument there. Like, there are some non-cash expenses on taxable income as well or the tax basis. Probably what you're doing is just changing your rate of when those expenses hit.
Catherine: Before we jump to a commercial, Steve, what is FASB versus tax code depreciation?
Steve: Sure. Well, as I mentioned at the top of the episode, you have those who are calculating taxable income, which is your tax team, and then you've got your financial reporting team, which is calculating book income under generally accepted accounting principles. Basically, FASB is a body that sets what those generally accepted accounting principles are, and they don't really talk a lot or care much, frankly, for how the government using the Internal Revenue Code, or the IRC, says that you should calculate your taxes. This legislation might actually blur the lines between the two, and that's why it's so interesting. Now, with that, let's get to our commercial, and we'll get right back to our conversation with Josh Gertsch.
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Catherine: And we're back with Josh Gertsch and Steve, talking about taxes.
Steve: I feel like it might also make sense. You had used a term alternative minimum tax, or you know, you and I would call it AMT. I wonder if it might make sense to bring in that. And maybe, Josh, if you could tell us just for a baseline for our audience and listeners what AMT is. And then part two of that question is, do you think there is a scenario where maybe there's an AMT that's based on, if not book income, then cash flow from operations?
Josh: Yeah, I see your point Steve. That would actually make a little bit more sense, but AMT—and I'm just going to say this in generic terms because it can be a fairly complex calculation that far better tax accounts than me can do better. It's basically saying, "Hey, at the end of the day, under the existing tax code, a company will calculate their tax income off their tax books." Say there's a corporate 30% tax rate. What alternative minimum tax is saying is basically based on the type of income you have and if you have a sufficient amount, it's almost like it's going to say rather like, yeah, we're going to tax you on that 30%, but we're also going to tax you on an additional 10 or 20. So, I mean, it's I guess it's almost it's almost identical to kind of what they're proposing here where, "Hey, if your profits are so much or your taxable income is so much, you know, we're not just going to let you avoid taxes. We're going to tack on an incremental tax at the end." And that's why I'm a little unclear on why that's not just addressing this problem.
Catherine: How do you get to creating these guardrails for how you report book income so you can't just zero it out?
Steve: Yeah, you were pretty aggressive on the ability to manipulate the numbers, which is strange coming from the former auditor. I don't know, maybe you know the tricks and that's why you're so confident.
Josh: You know, I think you can put a strategy together where you can look at certain rates of depreciation and amortization where you can basically strategize that if you purchased an asset now, what that amortization would be or what that expense would be over the future life of it, where you could effectively reconcile book income to zero again, just like we do in the tax world. You know, you would forecast out like what would it take to get book income to zero? What would I have to buy in my rates of expense under the FASB framework versus the IRC, or Internal Revenue Code, framework? And you could do the exact same thing. I mean, maybe I'm missing something like I think I am, because usually these guys don't mess up. But like, my gut reaction is it's just a shortcut. You know, it's a shortcut to to get more tax sooner versus actually just fixing the code.
Catherine: Well, are we looking at more legislation then to make sure people don't get down to zero?
Josh: Well, yeah. I mean, in my opinion, that's all this is. Effectively they're trying to pick something else up. It will take companies a couple of years to put these strategies in place, like, say, we use book income today. Yeah, people will get hit with more taxes like full stop. But within the next three or four years they would probably like look down the road. They would implement some strategies and they would they would figure out how to reduce that and minimize it.
Catherine: Well, if we fast forward in time a little bit and this gets signed into law. How does this change the conversations that are happening internally at companies between tax teams and financial reporting teams?
Josh: To me, it it aligns them more to some degree, or it shifts some of the responsibility of the tax team over to the financial reporting team, which, you know, which would be interesting.
Steve: I think it makes it more complicated, in my opinion, because today it's actually a great question, because it dovetails with the question I was I was going to ask you, Josh. Today, the tax team is going for a very specific target, right? I want to reduce my taxable income as much as possible. I want to apply the lowest tax rate possible so that I am paying the least amount of taxes. Full stop. That's the goal. Financial reporting teams are, I think, doing something very different, which is to maximize. Now, we could probably argue how much manipulation could they really have? And I think the answer is some, but maybe not a ton. And so I think it actually convolutes it because I want to minimize my taxes, but I want to maximize my—whether it's EBITDA or, you know, cash flow from operations or whatever—I want that to look as good as possible. So to me, if this were to happen, I think that makes it more challenging. But I actually suspect that's the point with whoever proposed this bit of legislation was to tie those together, whether or not that's the right approach. And that's what we're debating here. Because, Josh, I agree with your points at the top of the episode, but I think it actually makes it a little more difficult because I don't think our listeners and audience can—they should appreciate the lengths to which companies go to minimize taxable income. One very current example is when Warner Brothers just recently scrapped Batgirl. It was a new movie series as part of the DC Comics. Didn't do particularly well with audiences, so already that was a little bit in jeopardy. But one of the questions was, hey, if they scrap this, this actually ends up becoming a reduction of taxable income, and maybe Warner Brothers somewhere else had some windfall or something. And so they needed to reduce their taxable income and said, "Hey, you know what? Audiences probably won't like it, and we could use the benefit to taxes. So, hey, we're going to walk away from it. We are not even going to put it on streaming. We're just going to completely walk away from it." Companies make those kind of moves if needed to reduce taxable expense. And if this too, if this thing were come together, the proposed legislation, it makes that very, very difficult to do.
Josh: Well, what's interesting about that point, Steve, is to your point, by switching the metric, you're going to change the behavior of the company to some degree. I mean, companies will figure that out within a matter of months, what those what those changes are. And it's going to change spending behavior. It's going to change, you know, a number of things that way.
Catherine: Are you saying if this becomes law, we can actually see Batgirl?
Josh: I don't think Batgirl is ever coming back.
Steve: Which is to Josh's disappointment. I mean, he has told me many times how much he was looking forward to the release of that movie. I'm sorry. So, Josh, appreciate the insights always good to have you. I think at the end, you and I actually ended up aligning more than we didn't align, which is a little bit unfortunate because my self-esteem is still somewhat intact, although I will give you one more opportunity to make me feel bad of myself. Before we end the episode, closing question of the day. We have been talking about taxes. I assume most of us would like to reduce the amount of taxes that we pay just generally. But Josh, what is one tax that you would be happy to pay if you knew that it would go to support that one thing, whatever that thing is?
Josh: Like whatever good initiative was out there, what money would I be willing to pay taxes in that the government could support it or provide infrastructure too?
Steve: Yeah, exactly.
Josh: Oh, you know, I think anything like from a resource standpoint, you know, power, water, anything that can kind of help us, you know, do it better, do it more efficiently, give, you know, that we can basically be more sustainable kind of going forward, I think is something important to think about long term.
Steve: It's a very excellent and timely answer. Catherine, how about you?
Catherine: I'm okay with paying gasoline tax because I think our roads and bridges need support. And then if it encourages people to ride their bikes more or walk more, then I'm cool with it. What about for you, Steve?
Steve: Well, I was actually going to say the same thing. I appreciate nice, smooth, well-developed roads. So to the extent that taxes go to that, that seems like a very common sense thing that taxes should support. And I actually have no understanding whatsoever about how much money I pay that goes directly to the roads in front of my house and the cities and freeways around me. So, yeah, no clue. But if I knew, maybe I'd be willing to pay a little bit extra. Maybe a Diet Coke tax that I knew would go to fixing the potholes down the street.
Josh: Question, And I know we're wrapping up, but Catherine, you live in Colorado. Steve, you live in Utah. From November to March, I hope to see you guys out on your bikes. Like, I want to see your money where your mouth is.
Catherine: No problem. I'll do it.
Josh: I am going to travel to Colorado, and I'm going to travel to Utah. And I hope that wherever you're going, when you drive down to the store to get that Diet Coke or whatever, not drive, I want to see you riding that bike.
Steve: Hey, whoa, whoa, whoa. Time out. I didn't say I wanted to hop on a bike. I said I would be willing to pay more for so I could stay in the comfort of my car and not hit the potholes. You ride a bike more than I do, Josh. I know that for a fact.
Josh: So, Catherine, it's on you. I'm coming to watch you ride a bike to work.
Catherine: I will totally do it. And you should come ride your bike with me.
Josh: When it when it's like -10 in Colorado this year, like you're going to get like a 6:00 a.m. text saying like I hope that bike is heated up and ready to roll.
Catherine: You know, in that circumstance, I'll just go out by dog sled.
Josh: Well, that's respectable.
Steve: There you go. Josh, thank you so much for joining us on the podcast. Always good to have you. Appreciate the insight as well.
Josh: Yeah, thanks for having me, guys. Appreciate it.
Catherine: Thanks to Josh Gertsch for chatting with us.
Steve: And they thanks to you, dear listener, for surfing along this episode.
Catherine: Steve, can you tell the listeners the big Off the Books news?
Steve: Yes, I certainly can. This is the concluding episode for season three. We are already getting excited and working very hard on season four.
Catherine: So you can look forward to an episode wrapping Amplify, which is Workiva's annual conference. We're going to be watching a lot more accounting movies and talking about it on on the podcast when we return in October.
Steve: Absolutely. Starting off with a joint episode with Mandi McReynolds from ESG Talk breaking down what we heard at Amplify, as well as what we can expect in all things ESG, financial reporting, and everything in between.
Catherine: I'm Catherine Tsai. That was Steve Soter. This has been Off the Books presented by Workiva.
Steve: Please subscribe, leave a podcast review, tell your buddies if you liked the show, and you can email us at firstname.lastname@example.org to tell us what you think about this season as well as what you'd like to see in season four.
Catherine: Surf's up and we'll see you on the next wave and the next season of Off the Books.