The recently enacted “Tax Cuts and Jobs Act” will impact businesses of all sizes, in virtually all industries. There are a number of tax provisions in this new law that will have a significant effect on manufacturers and distributors, and this is another resource in our continuing Sikich Series on Tax Reform to help you keep abreast of the changes. One of the main goals of the new law was to make U.S. companies more competitive with those around the world, and also to promote economic growth and create jobs. This Insights article will address some of the changes impacting manufacturers and distributors, including: new tax rates for corporations and pass-through businesses; enhanced incentives for Capex; changes in accounting methods; new limitations on interest expense deductions; cut back in deductions for NOLs and meals and entertainment expenses; some tax incentives that were not changed, and several other revisions. The provisions included in the tax reform bill will have an immediate impact in 2018 on manufacturers and distributors, mostly in a favorable way, however, this will vary from company to company.
As the most comprehensive tax reform legislation package in over thirty years, the “Tax Cuts and Jobs Act” (the “Act”), impacts businesses of all sizes, in virtually all industries. There are a number of tax provisions in this new law that will have a significant impact on manufacturers and distributors. Here are a few selected key features for manufacturers and distributors:
Tax Rates for Corporations. The Act drops the top corporate tax rate from 35% to 21% and this new rate is effective in 2018. It also removes the lower graduated corporate tax brackets, and adopts just one 21% flat rate for corporations. This is a significant reduction in the tax rate and should reduce a manufacturer’s or distributor’s federal corporate tax liability in the coming years. This drop also makes U.S. businesses more competitive with their counterparts in other countries. In addition, the Act also repeals the corporate Alternative Minimum Tax (AMT) beginning in 2018.
Tax Rates for Pass-Through Businesses. Congress spent much time and effort trying to address how much tax relief and in what form to provide it to owners of pass-through businesses (Partnerships/LLCs, S Corporations, and Sole Proprietorships). The final tax bill produced a 20% deduction for “qualified business income.” However, the tax bill added a limitation to this 20% deduction that is set as the greater of:
- 50% of the wages paid by the business;
- Or, 25% of the wages paid by the business plus 2.5% of its cost of property used in the business.
This new, and yes, complicated provision (the full nature of these complexities is beyond the scope of this article) will provide a tax incentive for many manufacturers and distributors, small or large. In addition, the above limitation makes this new 20% deduction available for manufacturers or distributors that may have limited wage expense, but are very capital intensive. There is much to learn about this new deduction and manufacturers and distributors should watch for IRS guidance during 2018.
Please also see separate recent Sikich Special Alert article on the new 20% deduction for Qualified Business Income (click here).
Incentives for Fixed Asset Acquisitions (“Capex”)
100% Bonus Depreciation. The new tax law provides that 100% bonus depreciation is available for property acquired and placed in service after September 27, 2017. Thus, this is one of the few provisions that applies for the 2017 year, and manufacturers should evaluate all their 2017 fixed asset (or Capex) additions. Further, this 100% bonus depreciation applies for new or used property for the manufacturer or distributor. Previously, bonus depreciation rules did not permit used property to qualify for this deduction.
In addition, the Section 179 expensing rules were also increased from $510,000 in 2017 up to $1,000,000 in 2018, with overall additions of $2,500,000. The definition of Section 179 property was also expanded. Many manufacturers and distributors make significant capital investments into machinery and equipment, and these changes should provide them significant tax savings.
Observations: These new 100% bonus depreciation and Section 179 changes offer significant opportunities for manufacturers and distributors to fully write off all their fixed asset acquisitions. In addition, these new provisions are effective for the next five years (there are no scheduled changes until after 2022), so businesses can plan and budget for their Capex items. There is no limit on these new tax depreciation incentives, however, not all businesses may be interested in generating too much accelerated tax depreciation, especially with the lower tax rates now. Some companies may instead want to explore leasing options for their Capex additions as leasing companies will be able to take advantage of the new 100% bonus depreciation, and may therefore, pass on lower interest rates to their leasing customers.
In addition, the combination of a 100% bonus depreciation threshold coupled with the expansion to cover used property presents a significant change in the merger and acquisition area. Any manufacturer or distributor looking at an asset purchase of another business may be able to get an immediate write-off of the purchase price allocated to the machinery and equipment, rather than settle for a 5 to 7-year write-off. Many deals will be revised as a result of these Capex provisions in the Act, and we can assist in transaction structuring.
Business Interest Expense. The Act adopts a new limitation on the deductibility of business interest expense. The new rule will limit the deductibility of business interest to 30% of “Adjusted Taxable Income” (“ATI”). ATI is similar to “EBITDA,” and is defined as the taxable income of the business, excluding: any business interest income of the company; any Net Operating Loss (NOL) of the business; any tax depreciation or amortization deductions of the company; and the deductible business interest expense. (Please note, this depreciation and amortization modification is removed after 2022 which will lower ATI and may then result in more interest expense being disallowed in the future.) The 30% deduction limitation begins in 2018 and applies to manufacturers and distributors that are C Corporations. There are also special complex rules for calculating this 30% limitation for pass-through businesses and their owners. Further, there is a general exception to these new interest limitation provisions for a “small business” which is defined by the new law as a business with gross receipts of less than $25,000,000 (average of prior three years’ gross receipts). Thus, a smaller manufacturer or distributor does not need to be concerned with these new interest limitations. Any disallowed interest expense under this new 30% limitation carries forward indefinitely.
Observations: This new interest limitation impacts companies that are highly leveraged, but also companies that have a “down year,” and thus this new limitation may cut their interest expense deduction. Many companies may revisit how they will finance their future business operations; whether through debt or equity, and this analysis becomes more complicated as interest rates start edging up. Finally, pass-through businesses will need to address these new interest rules at both the entity level (Partnership/LLC and S Corporation) and owner level, and this will involve some complex reporting and calculation issues.
There were also several accounting method changes included in the Act that may impact manufacturers and distributors:
- First, another special provision for small manufacturers and distributors (with “small” being defined again as an average of less that $25 million in gross receipts). Manufacturers and distributors have long suffered through the Uniform Capitalization (“UNICAP”) rules. These cumbersome rules required manufacturers and distributors to analyze their general and administrative costs and allocate some of these costs to their inventory. Not only did it increase a company’s taxable income for the deferred deduction capitalized into inventory, but it often was a challenge to come up with the amount of these costs under the various allocation methods. The new tax law removes the UNICAP requirement for smaller manufacturers and distributors. For tax years beginning after 12/31/2017, there is no need to capitalize these overhead costs any longer, and any prior capitalized costs can be deducted. This change will be welcome news for many small manufacturers and distributors.
- There is also another change that impacts businesses (including manufacturers and distributors) that receive advance payments for goods and services with their contracts. The change made by the Act would apply to advance payments on orders for goods and services. A portion of the advance payments for an order is recognized in the year of receipt, and the balance of the payments would be included in taxable income in the subsequent year. This may be a change from what some businesses had done in the past. This change applies to all businesses regardless of size for tax years beginning after December 31, 2017. Manufacturers and distributors that receive advance payments for any contracts or orders will need evaluate this new provision.
- Further, the Act also revises the rules associated with the timing of the recognition of income. Specifically, the provision requires an accrual method taxpayer subject to the “all events test” for an item of gross income to recognize such income no later than the taxable year in which such income is taken into account as revenue in an applicable financial statement or another financial statement. This new provision, however, also provides an exception for taxpayers without an applicable financial statement (thus, continues use of the “all events test”). This is another item that could apply to a manufacturer or distributor if it has an unusual situation with how income is recognized on its financial statements, and thus may now (due to the change made by the Act) have an impact for tax purposes. Further guidance will be needed from the IRS on how to apply this change.
Limitations on Certain Losses and Deductions
There were a number of other provisions in the Act that will impact businesses, including some deductions that were scaled back. Here are some of the changes that will likely affect manufacturers and distributors:
- NOLs. It is not unusual for businesses from time to time to incur Net Operating Losses, or NOLs. The tax rules in the past provided some tax relief for businesses as they were able to carry these losses back to prior years to get refunds of taxes paid in these earlier years. Then, any remaining NOL would be carried forward. Manufacturers or distributors that incurred NOLs (regardless of the reason) were able to soften the blow of the loss by using the NOL carryback provisions. The Act, however, restricts the use of NOLs by only allowing these NOLs to be carried forward, and thus will no longer permit any NOL carrybacks. This change first applies for NOLs generated in tax years beginning after 12/31/2017. In addition, these NOLs can only offset 80% of a company’s income in future years, which could result in some out-of-pocket tax cost for companies that have available NOL carryovers. Manufacturers and distributors need to monitor these new NOL rules.
- Limitation on Large Excess Losses for Individuals. Before the Act, an individual taxpayer could deduct losses of any amounts on their individual tax return, provided they navigated the passive loss rules; the basis rules; and the “at-risk” rules for their investments in a partnership or an S Corporation. This often included a manufacturer or distributor that was operated as a pass-through business, and thus the loss passed through to its owners was deductible on their individual tax returns. These tax losses could offset other income of the owner. The new law, however, imposes a $500,000 limitation (and $250,000 for a single taxpayer) in a year for all business losses the owner may have. The balance of the excess loss will carry forward and be treated as a NOL. Owners of manufacturing or distribution businesses that expect large losses, may not be able to fully utilize these losses in the current year beginning in 2018.
- New Limitation on Deduction for Meals and Entertainment Expenses. As with most other businesses, manufacturers and distributors often incur various expenses for meals and entertainment. Previously, business entertainment expenses were 50% deductible, however, under the Act, entertainment expenses will no longer be deductible. Further, business meals were not changed by the Act, and are still 50% deductible. Meals for the convenience of the employer had been 100% deductible, but will now be 50% deductible. Finally, company picnics and holiday parties are unchanged by the new law; and thus these remain 100% deductible. These changes are effective for amounts paid or incurred after December 31, 2017, regardless of a company’s fiscal year.
Observations: These changes apply for expenses incurred after December 31, 2017, so manufacturers and distributors should begin tracking these expenses now. Impacted businesses may perhaps want to set up accounts in their general ledger as follows:
- Meals and Entertainment Expenses – 100% deductible;
- Meals and Entertainment Expenses – 50% deductible;
- Meals and Entertainment Expenses – 0% deductible.
Finally, we have a separate recent Sikich Special Alert article on the new limitations on business meals and entertainment (click here).
- Contributions to the Capital of a Corporation. Occasionally, a manufacturer or distributor may expand or relocate their business and be offered property from a local municipality or state government, and this could be done without the corporation recognizing any income. The Act preserves the provision that a corporation’s gross income does not include contributions to capital, however, it further provides that the term “contributions to capital” does not include:
- Any contribution in aid of construction or any other contribution as a customer or potential customer; and
- Any contribution by any governmental entity or civic group (other than a contribution made by a shareholder as such).
This new provision applies to contributions made after date of enactment (December 22, 2017). There is an exception if there was a “binding contract” for a master development plan with a government agency that was in effect prior to the date of enactment.
Observations: Manufacturers or distributors should be aware of this change in their expansion plans. While income may be recognized now for these capital contributions from government entities, the company can offset this income with the accelerated tax depreciation changes mentioned above (100% bonus depreciation and Section 179).
New Family and Medical Leave Tax Credit. This new credit applies for tax years 2018 and 2019. It is available to companies that pay their employees during a family or medical leave. If an employer provides at least two weeks per year to a full-time employee for family or medical leave, then a tax credit of 12.5% of their wages paid during the family leave is available if the wage paid during the family leave is at least 50% of the employee’s normal wage. This credit is increased if the wage paid to the employee is above the 50% limit. Several requirements for this new tax credit:
- The Company needs to have a written plan;
- The paid leave for the credit applies to employees that have been at the Company for at least one year; and
- The credit only applies to employees earning $72,000 or less per year.
Thus, this new credit could provide significant tax benefits to any manufacturer or distributor that offers such paid family and medical leave programs.
UPDATE on 4/18/2018: Many businesses are interested in learning more about this new incentive as the credit has a short two-year life span, applying only for 2018-2019 (although the credit could be extended by Congress). On Monday, April 9, 2018 the IRS released its first form of guidance regarding this new credit. This guidance was offered in a list of frequently asked questions on the new employer credit for paid family and medical leave (“Section 45S”). The FAQ addressed, in part, who qualifies for the credit; what is described as “family and medical leave” for purposes of this credit; and how the credit is calculated. In addition, the IRS plans to provide further guidance and more details on other outstanding questions on this credit.
Prior Tax Incentives Preserved
It is important for manufacturers and distributors to analyze all the changes made by the new tax law. However, it is also important to take note of several tax incentives that were not part of the Act. There was speculation and discussion on the following items, but these were not part of the final tax bill:
- Last-In-First-Out (LIFO) Inventory. The LIFO Inventory method was preserved. There was concern that LIFO would be repealed or curbed, but no changes were made. Many manufacturers and distributors faced with rising inventory costs have utilized the LIFO method over the years to provide much needed working capital for their businesses.
Observation: With the newly announced tariffs on certain imported steel and aluminum, many product costs could rise significantly in the near future. The LIFO method may, in turn, present a significant tax planning opportunity for manufacturers and distributors with their inventories.
- Research & Development (R&D) Credit. Manufacturers (and even some distributors) have increasingly used the R&D Credit as they strive to develop new products and processes to stay competitive in the marketplace. The R&D Credit was not impacted at all by the new tax law, thus manufacturers should continue to analyze and document their research efforts.
- Work Opportunity Tax Credit (WOTC, or Jobs Credit) and the New Markets Tax Credit (NMTC). The House version of the tax bill would have eliminated these credits, but the final version of the Act did not repeal or modify these credits in any manner. Thus, these invectives are still available for manufacturers and distributors.
- Interest Charge-Domestic International Sales Corporation (IC-DISC). The IC-DISC offers a tax incentive for manufacturers that export their products out of the U.S. This tax savings opportunity was not changed by the Act, but the net tax savings are slightly less due to the new lower tax rates (addressed above) for manufacturers and distributors.
One other major part of the Act that could have a significant impact on manufacturers or distributors is for businesses that have extensive international operations or holdings. There were wholesale changes in the overall regime of international tax matters, and several of these changes take effect immediately. In some cases, a deemed repatriation tax is imposed on a business with cumulative foreign earnings generated by a foreign subsidiary. Going forward, however, foreign subsidiaries will operate under a new “territorial” tax structure in which there will be generally no tax on the foreign income that is distributed back to the U.S. parent. This is an entirely new format for how foreign operations and holdings are taxed. A full analysis of these complex tax changes by the Act is beyond the scope of this article, but any affected manufacturer or distributor should carefully address the tax impact these changes may have on their business in near term and beyond.
* * * * *
In summary, manufacturers and distributors should closely evaluate the Tax Cuts and Jobs Act that was enacted at the end of 2017. There are a number of provisions that will directly impact their business; mostly in a favorable manner. Further, while most of these changes first apply for 2018, a few items are effective in 2017 and could produce some permanent tax savings due to the higher tax rates in 2017 compared with 2018. Therefore, a manufacturer or distributor should analyze their particular tax situation with their tax advisor and see what opportunities might still exist for the 2017 year. Please contact your Sikich tax advisor with any questions.