Helping Manufacturers Understand the New Tax Law
posted Feb 13, 2018 by Paul Oliveira, CPA in the Global Tax Blog
The Tax Cuts and Jobs Act (TCJA) represents the biggest change to the federal tax rules in three decades — and it’s nearly 500 pages long. That’s a lot to digest. Where should you start? Here’s an overview of the most relevant provisions of the new law for manufacturers.
Lower Business Tax Rates
Under the TCJA, federal income tax rates for C corporations have been reduced to a flat 21%. Under the prior graduated corporate tax rate structure, rates topped out at 35%. The 20% corporate alternative minimum tax (AMT) has also been repealed. These changes go into effect in 2018.
Individual tax rates have also been lowered under the TCJA, but not as much as corporate tax rates. To help achieve some parity with C corp rates, pass-through entities are generally eligible for a 20% deduction for qualified business income (QBI). This functions like other business deductions. But there are some restrictions and exceptions that primarily target service businesses. (Basically, these safeguard against employees who try to shift W-2 wages to business income to lower their taxes.)
So, if your manufacturing business operates as a sole proprietorship, partnership, S corporation or limited liability company (LLC) taxed as a partnership, chances are good that you’ll qualify for the QBI deduction. Also, if you own an interest in a pass-through entity, beware: The individual AMT hasn’t been repealed; it’s just been temporarily modified to affect fewer individuals through 2025.
Expanded Depreciation Deductions
Depreciation deductions have significantly increased under the new law. The Section 179 limit has been doubled to $1 million (from $500,000 under prior law), and the phase-out threshold has been increased to $2.5 million. Both increases are permanent, though the amounts will be adjusted annually for inflation.
In addition, through 2022, the new law allows 100% expensing in the first year an asset is placed into service under the bonus depreciation program. (This deduction isn’t subject to any spending limits or income-based phase-out thresholds.) Starting in 2023, bonus depreciation percentages decrease by 20% annually. The program is generally set to expire on January 1, 2027, unless Congress takes further action.
These changes are good news for the manufacturing sector, which incurs a high degree of capital expenditures each year. Higher depreciation deductions decrease taxable income, leaving more money in the bank account to invest in growth opportunities and continued modernization of production processes and facilities.
For example, you might use the extra cash flow from these expanded deductions to purchase additional equipment, upgrade your facilities or hire new workers. Alternatively, you might opt to share the savings with employees, as some large companies have, by increasing wage rates, giving out bonuses or contributing more to their retirement funds.
Interest Expense Limitation
The cash flow boost from acquiring fixed assets is further enhanced if your business finances the purchases, rather than paying cash up front. That’s because you can immediately deduct the full cost of items you finance — even though they’re not yet paid for — and then you can deduct interest expense as you pay down the loans, subject however to new limitations outlined below.
Starting in 2018, the new law limits interest expense deductions to 30% of adjusted taxable income (ATI). (For pass-through entities, ATI is computed at the entity level, not the individual taxpayer level.)
Through 2021, ATI is computed without regard to deductions for depreciation, amortization or depletion. Beginning in 2022, ATI will be decreased by those items, further limiting the interest expense deduction for companies with significant depreciation deductions. (Important note: The interest expense limitation applies only to businesses with more than $25 million in average annual gross receipts.)
The interest expense limitation, along with changes to how ATI is calculated, could impact whether larger manufacturers decide to pay cash or take out loans for equipment purchases — or lease these items — over the long run.
Expanded Tax Base
The new law contains some provisions that are unfavorable for manufacturers. For example, the new law:
- Repeals the domestic production activities deduction (or “manufacturers’ deduction”) in 2018 for pass-through entities and 2019 for C corporations.
- Requires companies to capitalize specified research and experimentation costs and amortize them over five years (15 years if conducted outside of the United States), starting in 2022. (The research tax credit has been retained, however.)
- Imposes new limits on net operating losses (NOLs) and deductions for employee fringe benefits, such as entertainment and, in certain circumstances, meals and transportation.
Expanded provisions for offshore operations will also generate additional tax revenue for the government. As a result of these and other changes, some companies will report more taxable income starting in 2018.
A Top Priority
KLR’s 2017 Manufacturing Industry Outlook report revealed that taxes are a major concern for manufacturers. Most respondents were hopeful that tax reform efforts would lower taxes and simplify the rules. Small and midsize manufacturers tend to feel especially overwhelmed by the complicated federal tax rules.
Fortunately, the TCJA offers some relief for small manufacturers. In addition to providing various pro-business tax breaks, the new law increases the threshold for qualifying for simpler reporting methods. Starting in 2018, companies with gross receipts of $25 million or less may qualify for cash basis tax reporting and the exemption from the uniform capitalization (UNICAP) rules. As a result of the higher threshold, some smaller manufacturers may switch to simpler reporting methods under the new rules.
Regardless of your company’s size, our tax professionals understand how these changes will affect manufacturers. Contact us to discuss your specific situation and brainstorm ways to lower taxes on your business income under the new law.