THE SUSTAINABILITY EDGE: BUSINESS BENEFITS OF EMBRACING ESG
ANDREW DOMBRO, CPA
Today corporate sustainability is grounded in a conscious and conscientious approach to capitalism — a belief system positing that when value is created to share with all stakeholders, more value is generated over the long term. The rise of sustainability as a strategic imperative — and the integration of environmental, social and governance (ESG) factors into decision-making — are as much about the demands of the business as they are about the demands of society and the desire to make a positive impact on the world.
Addressing the interconnected challenges of our global society is a shared responsibility and an opportunity to drive improved environmental, social and business outcomes. Evidence shows that integrating ESG into a company’s core business strategy ensures that the organization is more resilient and better positioned to adapt to change. Leading and governing with an ESG mindset reprioritizes long-term value creation and recognizes that purpose is the path to sustained profits and success.
Five ways ESG creates long-term business value
- Attract Talent and Improve Employee Loyalty
People want to work for organizations whose values align with their own. Career decisions are increasingly values-based, with “pandemic epiphanies” putting purpose front and center for many employees. As competition for employees continues, companies with strong ESG profiles are likely to have greater success with recruitment and retention, especially with younger generations. Nearly six in ten (58%) employees consider a company’s social and environmental commitment when deciding where to work. Research from the Forbes 2021 100 Best Companies to Work For list also found that employees at companies with generous and lasting corporate social responsibility efforts were 15.6 times more likely to say that their company was a great place to work.
Capture This Benefit: Providing a reason for being is inextricable to ESG. The why your business exists — and for that “why” to be differentiated — it needs to deliver impact beyond economic value. Once defined, the purpose should be engrained into your culture, your business strategy and your decision-making compass. To put purpose into practice, live it and lead with it. Promote your purpose through regular employee engagement and measurable commitments. Solicit employee feedback as commitments evolve over time.
- Increase Customer Loyalty and Safeguard Brand Integrity
Customers vote with their wallets and research has shown that they are more likely to support sustainable businesses. In a 2021 survey conducted by the Chapman & Co. Leadership Institute, 60% of U.S. consumers said brand values (including a commitment to diversity and positive company culture) influence their purchasing decisions. 64% of Americans also say that they would be willing to pay more for a sustainable product and 62% of U.S. and UK consumers say that they would join a customer loyalty program if they knew the rewards contributed to social causes they cared about.
Capture This Benefit: To attract new customers and retain existing supporters, businesses must not only address customer needs, but customer values. Align services, products and customer offerings with the company’s own broader ESG priorities and ensure that ESG commitments account for and reflect the issues customers care about most.
- Deliver Greater Shareholder Returns
The savviest investors know it is the long game that matters. Short-term measures to meet quarterly earnings targets that result in environmental or social degradation or come at the expense of investment in future growth will harm performance over time. Shareholders’ economic interests are better served by a commitment to ESG and a long-term view of value creation that takes broad stakeholders into account. A Harvard Business School study reviewing 2,000 companies over 21 years found firms that improved on material ESG issues outperformed their competitors. On average, publicly traded companies with strong ESG profiles also tend to outperform the stock market and have lower volatility. Research from Rockefeller Asset Management indicates that ESG “improvers” — firms that show the greatest improvement in their ESG footprint — have greater potential for generating returns uncorrelated to the rest of the market over the long term.
Capture This Benefit: Capturing this benefit may involve bringing in a wider group of shareholders and a proactive dialog with older ones. Engaging shareholders and stakeholders in a discussion about the benefits of ESG as well as your internal milestones, commitments and progress reports will bring transparency and trust to your efforts. Reporting your ESG metrics in alignment with an established ESG reporting framework will allow great communication with stakeholders and customers about your efforts.
- Drive Higher Profitability
As companies shift their focus away from optimizing for short-term profits, profitability actually increases over the long term. There may be short-term cost increases incurred when shifting to sustainable sourcing, investing in research and development, or raising pay, but those costs are offset by the advantages they may bring. Stronger ESG practices correlate to higher margins, according to a study from Institutional Shareholder Services. The study shows that high ESG performers spend more on research and development, but less on capital expenditures. How? Adopting ESG measures can save costs by using resources more efficiently, lowering overhead expenses and reducing waste.
Capture This Benefit: Review your operations and identify opportunities to streamline resource usage, reduce water and energy consumption, and eliminate harmful waste, such as unnecessary travel or on-site data storage. Collaborate with stakeholders up and down the value chain to assess where there may be critical issues and opportunities to design new products and services that deliver ESG outcomes and redesign existing offerings by integrating ESG practices. For example, many companies are redesigning their products — and the packaging for their products — to be recyclable and reusable.
- Mitigate Risk and Build Resilience
Companies with strong ESG practices are not only more resilient in times of adversity, but they also face fewer material adverse events to begin with. By proactively identifying and addressing ESG-related threats, businesses can reduce incidence risk. A Wharton study found that strong ESG performers have a much lower incidence rate of fraud, litigation, customer attrition and revenue shortfalls. On the other side of the coin, companies with unaddressed ESG-related risks are more exposed to potential erosion in financial and operational performance over time, even if they do not experience a business or reputational crisis. The opportunity cost in terms of the competitive landscape and market perception may also be significant. Research from Bank of America Merrill Lynch suggests that stronger ESG strategies would have helped prevent as much as 90% of the bankruptcies in the S&P 500 between 2005 and 2015.
Capture This Benefit: Conduct a materiality assessment and identify the strategies and actions needed to mitigate your organization’s priority ESG risks. Every organization’s priorities are unique, based on the potential impact — positive or negative— of specific ESG topics on your business and your stakeholder ecosystem. A materiality assessment provides a mechanism to hear from stakeholders about what matters most to them. That feedback, as well as a quantitative assessment of the potential impact of ESG issues, is critical to determine strategic importance.
Organizations that adopt a sustainability mindset and embed ESG into corporate strategy and operations build businesses that are better in every sense of the word: Better prepared. Better performers. Better stewards of their impact on the world. Better creators of value — for all stakeholders and for themselves.
Tax Cuts and Jobs Act update: Big changes for 2022 and beyond
SEAMUS M. DONOGHUE, CPA, MST
It has been four years since the Tax Cuts and Jobs Act (TCJA) was signed into law, but it is still having an impact. Several provisions take effect this year and next. Here is a brief overview of these changes and the implications for many manufacturers.
The TCJA will affect manufacturers with significant research and development (R&D) costs. Starting in 2022, Internal Revenue Code (IRC) Section 174 “research and experimental” expenditures must be capitalized and amortized over five years (15 years for research conducted outside the United States). Previously, businesses had the option of deducting these costs immediately as current expenses.
The TCJA also expands the types of activities that are considered R&D for purposes of IRC Sec. 174. For example, software development costs are now considered R&D expenses subject to the amortization requirement.
Manufacturers should consider the following strategies for minimizing the impact of this change:
- Analyzing costs carefully to identify those that constitute R&D expenses and those that are properly characterized as other types of expenses (such as general business expenses under IRC Sec. 162) that continue to qualify for immediate deduction.
- If cost-effective, moving foreign research activities to the United States to take advantage of shorter amortization periods.
- If cost-effective, purchasing software that is immediately deductible, rather than developing it in-house, is now considered an amortizable R&D expense.
- Revisiting the R&D credit if you have not been taking advantage of it. (See “Take Another Look at the R&D Credit” below.)
As of this writing, there are proposals in Congress that would delay or eliminate the amortization requirement. Your ORBA CPA is monitoring legislative developments and can help adjust your tax strategies accordingly.
Related Read: Is It Time To Revisit the R&D Credit?
Starting in 2023, bonus depreciation will gradually be phased out. Currently, businesses may immediately deduct 100% of the costs of eligible equipment and interior improvements to commercial buildings in the year they are placed in service. That percentage drops to 80% in 2023, 60% in 2024, 40% in 2025 and 20% in 2026. After 2026, absent new legislation, bonus depreciation will no longer be available.
As a result, manufacturers that plan to purchase equipment or make building improvements should consider placing those assets in service this year to take full advantage of the tax benefits of bonus depreciation. However, be aware that increasing depreciation may restrict your ability to deduct business interest, so it is important to balance these potentially competing tax breaks.
Business interest deduction
The TCJA’s limit on business interest deductions is more restrictive this year. This will increase borrowing costs for larger manufacturers.
Prior to the TCJA, most business-related interest expense (such as interest on business loans) was deductible. The TCJA placed a limit on business interest deductions, except for small businesses (defined as those with average annual gross receipts for the preceding three years of $25 million or less). This threshold is adjusted annually for inflation. For tax years beginning in 2022, the inflation-adjusted limit is $27 million.
If your average annual gross receipts exceed that threshold, then your deduction for business interest is limited to: Your business interest income, plus your floor plan financing interest, plus 30% of your adjusted taxable income (ATI).
Typically, manufacturers do not have business interest income or floor plan financing arrangements, so the business interest deduction is generally equal to 30% of ATI. For tax years beginning in 2018 through 2021, ATI was essentially earnings before interest, taxes, depreciation and amortization. Under TCJA changes, for tax years starting in 2022, depreciation and amortization will be deducted from earnings in calculating ATI. This change will reduce business interest deductions for many manufacturers.
Manufacturers with significant interest expense should consider strategies for reducing interest expense, such as relying more heavily on equity rather than debt financing. If your business owns debt-financed real property, another option is to transfer such property to a separate entity — such as a partnership or limited liability company you control — in a sale-leaseback transaction. That entity can opt-out of the interest limitation as a real property business. However, for this strategy to work, there must be a legitimate business purpose for the transaction (such as liability protection) other than tax avoidance.
Also, if you are contemplating investments in equipment or building improvements this year to take advantage of 100% bonus depreciation, increased depreciation may adversely affect your ability to deduct the business interest. To identify the optimal tax strategy, you will need to balance the benefits of increased depreciation deductions against the cost of reduced interest deductions.
The big picture
These changes complicate tax planning for manufacturers. Your ORBA tax advisors can help develop a comprehensive tax strategy for your particular circumstances. They can also help you prepare to shift gears in case Congress passes any relevant tax legislation later this year.
Sidebar: Take another look at the R&D credit
The recent expansion of the research and development (R&D) credit, together with limitations on the deductibility of R&D expenses, make it a good time to revisit the R&D credit. For example, start-up businesses (less than five years old with less than $5 million in gross receipts) can use the credit to offset up to $250,000 in payroll taxes. And small businesses (those with average gross receipts under $50 million) can use the credit to reduce their alternative minimum tax (AMT) liability. Although the TCJA eliminated corporate AMT, pass-through entities may benefit from the AMT credit.
Note that under a change made by the TCJA, qualified research eligible for the credit is limited to expenditures that are treated as “specified research or experimental expenditures” under IRC Sec. 174. So, when classifying expenditures for purposes of deduction or amortization, manufacturers should also consider the potential impact on the credit amount.