9 Major Tax Reform Provisions Affecting Manufacturers (article)
Manufacturers traditionally have benefitted from special industry-specific tax incentives, and while some of these provisions were altered or eliminated as a result of sweeping changes to the tax law, many valuable opportunities are now available. Under the 2017 tax legislation known informally as the Tax Cuts and Jobs Act (TCJA), manufacturers have access to a host of benefits to help defray tax costs, but some of the provisions are temporary while others impose new restrictions on deductions that were once unlimited. The TCJA represents the most significant change to tax law since 1986, and manufacturers should reassess existing tax and business strategies to take full advantage of the new law.
Lower Tax Rates
Headlining the TCJA is the reduction of corporate and individual tax rates. Under the new law, C corporations saw the biggest drop with a 40 percent reduction in tax rates, from a top rate of 35 percent to a maximum 21 percent tax rate. Additionally, the TCJA repeals the corporate alternative minimum tax (AMT).
Pass-through manufacturing entities—S corporations, partnerships, LLCs, and sole proprietorships (collectively, pass-through entities or PTEs) —will also benefit from lower tax rates. Top individual tax rates decreased from 39.6 percent to 37 percent. Additionally, business owners can take a new deduction of up to 20 percent of their qualified business income (QBI) received from their PTE. The deduction is not available to certain service industries, but manufacturing should not be affected.
The QBI deduction is equal to the lesser of (a) 20 percent of QBI, or (b) the amount that is the greater of (i) 50 percent of W-2 wages paid by the qualified business or (ii) 25 percent of W-2 wages paid plus 2.5 percent of the unadjusted basis of qualified depreciable property used in the qualified business (the “wage plus property” limitation). And in no event can the deduction exceed 20 percent of taxable income less capital gains. As a result, the deduction cannot generate a loss.
For purposes of these limitations, W-2 wages do not include amounts that are not properly allocable to qualified business income. Qualifying property is limited to tangible property held by and available for use in a qualifying pass-through trade or business. The property is included in this calculation each year until its depreciation period has ended. If the property is no longer held by or available for use in the qualifying trade or business (for example it is sold during the year), it cannot be used in determining the “wage plus property” limitation. Manufacturers should be on the lookout for efforts from the IRS to develop anti-abuse regulations in the case of related-party transactions and sale-leaseback transactions.
Certain taxpayers are not subject to the W-2 wages or “wages plus property” limitations. Specifically, the limitation does not apply if the taxpayer’s taxable income (from all sources) does not exceed $157,500 ($315,000 for married taxpayers filing a joint return (MFJ)). The W-2 wages or “wages plus property” limitations are then phased in, and only apply fully when a taxpayer’s taxable income exceeds $207,500 ($415,000 if MFJ).
For manufacturers structured as PTEs that are subject to the top rate, the 20 percent QBI deduction can bring their effective tax rate down to 29.6 percent (37 percent individual tax rate applied to 80 percent of taxable income). It may be tempting to look at the 29.6 percent number and wonder whether converting to a C corporation may be more advantageous. Keep in mind, however, that C corporation shareholders remain subject to tax on dividends distributed from corporations, which must be made from after-tax corporate earnings and result in a second layer of taxation. This double tax results in a combined effective federal tax rate of 39.8 percent if shareholders are in the highest individual tax bracket.
Domestic Production Activities Deduction (DPAD)
The DPAD is repealed for tax years beginning after Dec. 31, 2017. The loss of the DPAD was a trade-off for the corporate tax rate reductions and the new QBI deduction.
Manufacturers can now take 100 percent bonus depreciation for property purchased and placed in service after Sept. 27, 2017, and before Jan. 1, 2023. The TCJA also expands the definition of qualifying property to include used property as well as new property. Bonus depreciation begins to phase down by 20 percent per year after 2022, and expires in 2027, so businesses should plan accordingly to make the most of the deduction.
Section 179 expensing benefits are also expanded. The TCJA increases the expensing election to $1 million per year for qualifying purchases, with a phase out beginning for purchases that exceed $2.5 million. Property eligible for Section 179 expensing includes nonresidential real property improvements such as roofs, HVACs, fire protection and alarm systems, and security systems. As a result of the bonus depreciation provisions, the Section 179 provisions are made largely irrelevant until 2022; however, certain real property improvements not eligible for bonus depreciation are eligible under Section 179 (under the current law definition of qualified improvement property, together with the new types of qualifying property).
Business Interest Limitations
The new tax law modifies some tax provisions to offset the cost of others, and one example of this is the new limit on deductions of business interest expense. Starting in 2018, businesses may only take an interest deduction up to the amount of their interest income plus 30 percent of the business’s adjusted taxable income (essentially earnings before interest, taxes, depreciation and amortization). Businesses with average annual gross receipts of less than $25 million for the prior three tax years are exempt from this limitation. Strict aggregation rules apply, so businesses under common control must pool their gross receipts for purposes of the exemption. The new interest expense limitation does not provide for any grandfathering rules with respect to debt held before the law change, and may warrant a fresh look at equity capitalization versus debt financing.
Net Operating Losses
Another provision limits the deduction for net operating losses (NOLs). For NOLs that arise in tax years beginning after Dec. 31, 2017, businesses may only deduct such NOLs against 80 percent of their taxable income. For NOLs generated in tax years ending after Dec, 31, 2017, the ability to carry back such NOLs is also eliminated, but these NOLs can be carried forward indefinitely. NOLs created in tax years beginning before Jan. 1, 2018 may still be carried back two years or carried forward 20 years. Manufacturers that have historically relied on NOL deductions as part of their tax mitigation strategy will need to plan for compliance with these new rules.
Excess Business Losses
Similarly, the new law places limitations on how individuals can use “excess business losses.” An individual’s aggregate trade or business loss, including those allocated from pass-through businesses, will be limited to $250,000 ($500,000 for MFJ) annually. Such excess business losses are added to the taxpayer’s NOLs, which means they are limited to 80 percent of taxable income in subsequent years. The annual gross amount limitation would not apply to the NOL, however. Again, if losses allocated to individuals from pass-through businesses previously played a prominent role in a tax mitigation strategy, it may be time to adjust strategies to limit business deductions that cannot otherwise be used against an individual’s income.
Research and Development Costs
The research and development (R&D) tax credit continues in the new law. Furthermore, corporate businesses formerly subject to the AMT (now repealed) may now be eligible to claim R&D tax credits to offset federal income tax liabilities. Using R&D credits may also provide a good alternative for corporate taxpayers that are now subject to NOL deduction limitations.
A slight modification was made to R&D expenses under the new law. Starting in 2022, R&D deductions must be capitalized and amortized over five years, and offshore R&D costs must be capitalized and amortized over 15 years. Internally developed software will also be subject to these new rules. Manufacturers may want to consider electing the reduced R&D credit available under IRC Section 280C to avoid this treatment.
Accounting Method Provisions
Enhanced access to popular and beneficial methods of accounting are now available to manufacturers. Any business (including C corporations) with average annual gross receipts of $25 million or less for the prior three years is now eligible to use the cash method of accounting. This also includes businesses that maintain inventories as an income-producing factor. Small manufacturers with inventories are also exempt from the requirement to capitalize indirect costs to inventories under uniform capitalization rules. These methods of accounting cannot be used by businesses classified as “tax shelters,” however (among other situations, a tax shelter includes a business that allocates more than 35 percent of losses to owners who do not actively participate in management).
A slight modification in the TCJA limits like-kind exchanges to real property. Manufacturers may no longer defer a gain on trade-ins of vehicles or equipment for the purchase of a new vehicle or item of equipment.
The extent of the changes in the TCJA will make planning for manufacturers essential for 2018 and beyond. Consult your tax advisor to learn how you can optimize the new provisions for your specific situation. For more information, please contact your local CBIZ tax professional.
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