The Inflation Reduction Act of 2022, signed into law by President Joe Biden on Aug. 16, 2022, will change the way large corporations are taxed. This new law will impose a minimum tax of 15% on the book income of corporations that made an average of $1 billion a year over the past three years.
The objective of the minimum book tax is to ensure that firms pay some taxes when they are making a profit. The Joint Committee on Taxation estimates that about 150 corporations would be subject to the minimum tax each year. The committee also estimates that this tax will result in a gain of $222 billion over 10 years. The new tax takes effect in 2023.
According to a Congressional Research Service report, about 30% of the Fortune 500 corporations could be subject to the minimum tax. It also states that about half the tax revenue would be collected from manufacturing companies (with about 16% from chemical manufacturing) and about 11% each from information and holding companies.
What are book income and taxable income?
Corporations report income in two different ways: book income and taxable income. The minimum tax of 15% imposed by the Inflation Reduction Act applies to book income with some modifications.
Taxable income is reported to tax authorities, such as the IRS, and has a maximum tax of 21%. Corporations can reduce their taxable income by deducting the cost of certain expenses from their gross income, such as investments and salaries.
If a company’s deductions are greater than its taxable income, that results in a net operating loss. Firms can carry over net operating losses from previous years and use that to report lower taxable income for the current year up to 80% under the new law.
Book income reports current losses and profits over a period of time. This is reported in financial statements to shareholders and governed by generally accepted accounting principles (GAAP). Book income generally has fewer deductions and credits applied than taxable income. While taxable income is determined by state and federal tax codes, which change over time, book income is governed by GAAP and changes infrequently.
Book income accounting treats asset depreciation differently from taxable income accounting standards.
For example, say a firm buys a machine to facilitate a manufacturing process. The machine has a life of five years, over which the value of the machine decreases. That loss of value can be deducted from the firm’s taxable income over those five years. Under the tax code, firms can deduct a greater percentage of the asset’s value in the earlier years, which often benefits the firms. This tax provision is called accelerated depreciation. The way this loss of value is deducted over time is different for book income under GAAP. For book income, the company cannot deduct a greater percentage of the asset’s value early on.
Under the new law, when corporations have high amounts of tax credits and deductions that reduce taxes owed to less than 15% of book income, they will be subject to an additional tax. The additional tax is the difference needed to reach the 15% minimum.