The Tax Reform Act’s Impact on Manufacturers
How much will the tax law changes actually impact your manufacturing business? As you probably are aware of the purpose behind the tax law was to reduce taxes across the board and to level the playing field for international business. So what will the impact be for you and your bottom line? That will depend on how your business is structured for U.S. tax purposes. Below are descriptions of some of the more prominent federal income tax changes which will impact manufacturers for 2018 and beyond.
If your business is structured as a C Corporation you will benefit from the flat 21% tax rate starting in 2018 and the elimination of the corporate level Alternative Minimum Tax (AMT). If you paid AMT in the prior year you will still be able to offset your regular tax liability with the credit. For tax years beginning after 2017 but before 2022 the prior year minimum tax credit can offset up to 50% of regular tax. For tax years beginning in 2021 the tax credit will be 100% refundable. As a tradeoff for the lower corporate tax rate, the Dividends received deduction was reduced. Dividends qualifying for the 80% deduction will now get a 65% deduction, and dividends qualifying for the 70% deduction will now be 50%.
If your business is held in a pass-through entity (partnership or S Corporation) you will also benefit from the reduced income tax rates at the individual level. Alternative minimum tax is still in existence for individual taxpayers; however, the AMT exemption phase-out was greatly expanded so many taxpayers plagued by AMT in the past, may be able to avoid it altogether.
If you have manufacturing operations in the United States you are likely familiar with the Domestic Production Activities Deduction (DPAD) under IRC 199. This deduction was equal to 9% of the lesser of Qualified Activities income if your business income was derived from property that was manufactured, produced, grown or extracted within the United States. The 2017 tax reform act repealed DPAD for all taxpayers for tax years beginning after December 31, 2017. If your business is held in a pass-through entity you may qualify for the new Qualified Business Income Deduction (IRC 199A) which was modeled after the DPAD but is greater in scope.
The Qualified Business Income (QBI) deduction is a new deduction available to sole proprietors and owners of pass-through entities under IRC 199A. This deduction is available to taxpayers who have qualifying business income and is equal to the lesser of 20% of taxable income or 20% of the combined qualified business income amount of the taxpayer. This deduction reduces taxable income, not adjusted gross income and is available to individual taxpayers regardless of whether or not they itemize deductions. There are limits to this deduction based on wages paid or capital investment by the business. Manufacturing businesses structured as pass-through entities will qualify for this deduction if they have income that is effectively connected to the United States.
The scope of this deduction is broader than that of the DPAD. If your manufacturing activities did not qualify for DPAD because production occurred overseas it’s possible the business may qualify for QBI. If your manufacturing business is held in a partnership or S corporation, you should consult your tax advisor about whether your company is structured to maximize the qualified business income deduction. Since this deduction is new for tax years 2018 through 2025, the practical application of the law remains unclear in many areas. The IRS has stated it will issue guidance this summer on numerous open items pertaining to the application of QBI.
Net Operating Losses (NOLs) for both individual and corporate taxpayers that are from prior tax years will continue to offset taxable income at 100% until they expire (20 years from the date of loss). Net operating losses incurred for tax years beginning in 2018 will carryforward indefinitely; however they can only be used to offset 80% of taxable income for any given year, and NOL carrybacks will no longer be allowed.
R&D Expenditures for tax years beginning after December 31, 2021, specified research or experimental expenditures including software development expenditures will no longer have the option of being deducted in the year paid. They will be required to be capitalized and amortized over a five year period (15 years if attributable to research conducted outside of the United States).
Entertainment Expenses will no longer be subject to a 50% limitation instead under the Tax Reform Act of 2017 no deduction is allowed for entertainment, amusement, or recreation membership dues for a club organized for business, pleasure, recreation, or other social purposes, including a facility used in connection with any entertainment purposes. The tax reform act further expands the 50% limitation on meals to also apply to food and beverages provided to employees through an eating facility meeting de minimis fringe benefit requirements. Expenses associated with meals provided for the employer’s convenience through an employer-operated facility are also no longer deductible. Transportation fringe benefits provided for parking and commuting are also no longer deductible. These changes to Entertainment and Meals are effective for tax years beginning after December 31, 2017, and are covered in IRC 274.
Temporary 100% expensing of assets via bonus depreciation and expanded Section 179 is a part of the tax reform act which will be very beneficial to manufacturers and other capital-intensive businesses. The Tax Reform Act allows for 100% bonus depreciation for property that is both acquired and placed in service after September 27, 2017 through December 31, 2022. After that, the bonus rate reduces by 20% per year through December 31, 2026. The definition of property eligible for bonus depreciation was expanded to apply to the purchase of used property that was not previously used by the taxpayer. Additionally, the section 179 limit was increased from $500,000 to $1M for tax years beginning in 2018. The reform act increased the phase-out threshold from $2M to $2.5M. Both of these limits will be indexed for inflation for tax years beginning after 2018. Also for 2018 and beyond, section 179 expense will be available for improvements to non-residential real property on roofs, HVAC, fire protection, alarm systems and security systems.
Accounting Method Changes
The tax reform act of 2017 redefined some relief provisions applicable to small business. Under the new tax law, a small business is defined as one with average annual gross receipts under $25M for the three preceding tax years. This is a significant increase from the previous amount of $10M. If your business falls under this threshold it is wise to take a second look at the accounting methods you have been using to see if a change is warranted. When an accounting method change occurs there is usually an adjustment made the year of the change, this is addressed in IRC 481(a). Generally, if the change increases the taxable income you can generally pick up that income over a period of four tax years. If the change in method is favorable and reduces taxable income you generally claim the adjustment in the year of change.
Cash vs Accrual Method – Prior to the 2017 Tax reform act C corporations or partnerships with C corporation partners were precluded from using the cash method of accounting. Also, the cash method was not allowable if the purchase production or sale of merchandise was an income-producing factor. These restrictions have been removed.
Accounting for Inventories – Prior to the 2017 tax reform act taxpayers with annual receipts of less than $1M were permitted to account for inventory as non-incidental materials and supplies. The limit on the use of this accounting method has been increased to $25M. As a result, taxpayers may be able to avoid IRC 471 inventory accounting and either begin treating inventories as non-incidental materials and supplies or conform to whatever inventory method they are using for financial reporting purposes.
UNICAP – Under the uniform capitalization rules (UNICAP) manufacturers must either include in inventory or capitalize certain direct and indirect costs associated with the production of real or personal property. This rule also applies to businesses that acquire property for resale. The exception from UNICAP was available for small businesses defined as those with $10 Million or less in average annual gross receipts for the preceding 3 taxable years.
Effective for tax years beginning after December 31, 2017, this exemption is now available for taxpayers with $25 Million or less in average annual gross receipts for the preceding three tax years. This amount will be indexed for inflation for years after 2018. This change creates an opportunity for manufacturer’s whose average gross receipts fall between $10 Million and $25 Million to request an accounting method change so that they no longer need to comply with the UNICAP provisions under 263(a). Further guidance from Treasury has not yet been released on the manner of how these method change should be made and whether the deduction for prior capitalized items will happen in the year of change or spread over a span of tax years. The presumption is that this will be an automatic method change filed via Form 3115 under IRC 481.
A change to your overall accounting method should not only be based upon tax savings, a thorough review of the impact on your overall profitability analysis should also be considered.
The 2017 tax reform act included many international tax provisions which have an impact on many U.S. businesses engaged in global commerce. If your manufacturing business is engaged in any activities outside of the United States it’s possible that you may have to pay U.S. income taxes on your accumulated offshore earnings whether or not the earnings have been distributed or repatriated to the United States. If you have any international activity you should consult one of MKS&H’s International Tax Advisors and have them review your international business model to ensure your company’s compliance with U.S. tax law.
The tax reform act of 2017 has many provisions not discussed in this article. If you have not had your particular tax situation reviewed by a tax professional now is the time. As you can see from the descriptions above there are many tax planning opportunities available for your manufacturing business. If you have any questions about anything presented in this article please don’t hesitate to contact one of our tax advisors at MKS&H. You can also learn more about tax and accounting issues by visiting our website at https://mksh.com/blog/.
Article Contributed by: Jennifer Milas, CPA, MST