Tax Reform’s Unintended Impact on Hospitality

New rules for entertainment deductions and pass-through structures have long-term implications for the hotel industry, contends a veteran real estate attorney and hospitality expert.

David Scharf_1068x1343The hospitality sector has generally applauded the newly-enacted Tax Cuts and Jobs Act (TCJA).  A  study by Oxford Economics for the American Hotel & Lodging Association (AHLA) estimates that tax reform could produce more than $131 billion in economic activity for hotels and allied industries over the next decade. Factored into this figure are projected higher room demand, a reduced corporate tax rate, a lower rate for pass-through entities (LLCs and partnerships), as well as reduced depreciation for commercial properties and the maintenance of carried interest and 1031 exchanges.

Yet this outlook does not take into consideration two potential consequences of the tax plan—both unintended, both difficult to gauge in advance. 

First, the TCJA’s elimination of business entertainment deductions could negatively impact hospitality spending, which might significantly lower pre-tax revenue. Second—and pulling in the other direction—the TCJA’s reduced rates for certain real estate pass-through companies will encourage hospitality companies to restructure themselves. That, in turn, will generate increased deal activity as a strategy for increasing post-tax net profits.

How these two conflicting trends will impact the hospitality industry will pose a significant question for years to come.

Lost Deductions

The AHLA study posits that the tax plan will lead to 3 percent GDP growth in 2018 and increase direct hotel guest spending by some $57 billion over the next five years, both at the property and at local restaurants, stores and attractions.

But these assumptions overlook the potential effect of removing the advantageous tax provisions for business entertainment. Under the old rules, companies could deduct 50 percent for a variety of expenses, such as client meals, event tickets, charitable event tickets and membership fees. The new law allows no deduction for activity generally considered to be entertainment, amusement or recreation. Nor does the TJCA permit deductions related to a facility used in connection with those categories, or for membership dues at any club organized for business, pleasure, recreation or other social purpose.

As a result, companies will scrutinize budgets carefully. Does the client really need that lavish dinner? Does the golf outing still make sense? Should that stadium suite be renewed? Particularly at smaller and midsized firms, the decreased deduction will likely reduce business entertainment spending.

It’s not just lunch, either. Business entertainment impacts the big business of conferences and conventions, which produced nearly $30 billion in revenue worldwide in 2014 and 2015, according to Statista. At the same time, sending employees to meetings and conferences is expensive—$609 per person on average in 2015. Factor in the added cost of entertainment—a key component of trade shows—and hospitality venues in U.S. destination cities could take a hit. There could be a broader local impact, as well; in 14 percent of host cities, meetings generate $10 million or more in economic activity, Statista notes.

Arguably, decreased revenue from less tax break-subsidized business spending can be offset if more people (particularly wealthy people) have more after-tax cash and spend it on hospitality. But that is a second-order effect that is harder to measure, and it’s unlikely to offset the negative results of eliminating this deduction.  

Pass-Through Potential

Another aspect of the tax reform that will affect the hospitality industry is the lower rates for real estate pass-through companies, which create incentives to adopt the structure. At the margins, as the economists would say, the pass-through provision could step up restructuring and deals.

First, companies may be able to reorganize themselves in order to separate parts of the business that are “qualified” for the pass-through rates from parts that are not. Take the example of a restaurant chain organized as an S Corporation. Under certain circumstances, the company may be able to reorganize itself as a pass-through that handles the qualified real estate portions of the business, and a separate “service” restaurant business. Depending on a great many factors—structures, cash flow, etc.—the overall net tax burden may be lower. Beyond tax savings, the reorganization’s impact on the business itself may be limited.

Second, the lower tax rate makes it easier for a pass-through entity to acquire the assets of a non-pass through company. The new rates and exclusions may make some deals more attractive at the margins, boosting M&A activity.

Third, the new tax law may prompt spinoffs. To meet the definition of a real estate pass-through, an entity must be a “qualified trade or business,” which might not include certain hospitality sectors. A conglomerated hospitality company may find it advantageous to sell certain parts of the business in order to reduce overall taxes.

These reorganizational incentives are at the margins, and it’s too early to tell the size of those margins. But if there is room for clever tax lawyers, corporate lawyers, and other advisers to reduce tax burdens, the resulting activity will lead to a lot of secondary effects, impacting jobs, revenue, profitability, and tax revenue in ways that are as yet unexplored.

It remains to be seen, of course, whether eliminating the business deduction will reduce hotel revenues, or a wave of tax structure planning will boost post-tax profits. In the meantime, the hospitality industry must prepare for less revenue from business entertainment under the new law, and should explore whether structural reorganization or deal-making will minimize its tax bills. 

Y. David Scharf is a partner at Morrison Cohen LLP in New York, where he is a practice group leader in the firm’s hotel and hospitality practice, a member of the business litigation department and chair of the real estate restructuring and finance practice.