Manufacturers and Distributors: Here’s How You Can Reap Tax Reform’s Rewards
Final tax reform legislation has been passed. The Tax Cuts and Jobs Act contains several business and individual rate cuts that manufacturers and distributors will find appealing. And though there are only a handful of days left in the year, you can still fit in a few last-minute actions to take advantage of them in 2017. And of course there are still plenty of strategies that can benefit you and your business in 2018 and beyond.
We offer several strategies below, but first here’s a summary of key aspects of pre-reform tax law compared to the new legislation.
|Pre-Reform Provisions||Final Tax Reform and Jobs Act Provisions|
|Personal tax rates1||Seven tax brackets: 10%, 15%, 25%, 28%, 33%, 35%, 39.6%||Seven tax brackets: 10%, 12%, 22%, 24%, 32%, 35%, 37%|
|Personal long-term capital gains and qualified dividend tax rates||Up to 23.8%||No change; rates tied to existing taxable income thresholds|
|Maximum pass-through tax rate||39.6%||
Ordinary rates with deduction of 20% of qualifying domestic income; limited deduction for income from lower-income service businesses. Service businesses excludes engineers and architects
|Maximum corporate tax rate||35%||21%|
|Personal standard deduction||Married filing jointly: $12,700
Head of household: $9,350
|Married filing jointly: $24,000
Head of household: $18,000
|Child tax credit||$1,000 per child||$2,000 per child (refundable to $1,400 per child); $500 for non-child dependents|
|Personal state income, sales tax, and property tax||Allowable as an itemized deduction2||Deduction for property tax and either income or sales tax limited to $10,000|
|Mortgage interest||Deductible on up to $1.1 million of debt; interest on second home deductible||Deductible on up to $750,000 of debt (including second home); no home equity interest deduction|
|Individual Alternative Minimum Tax (AMT)||Imposed when minimum tax exceeds regular income tax||Increases AMT exemption amounts and phase-out|
|Medical expenses||Deductible to the extent they exceed 10% of AGI||Deductible to the extent they exceed 10% of adjusted gross income (AGI) (7.5% of AGI for 2017 and 2018)|
|Alimony||Deductible to payor; taxable to recipient||Not deductible to payor; not taxable to recipient for decrees executed or modified after 2018|
|Individual health insurance mandate||Individuals penalized for failure to carry minimum essential health insurance coverage||Repealed|
|Depreciation||Fixed assets are generally capitalized and depreciated; In some cases, Section 179 immediate expensing of up to $500,000 is available||Immediate expensing of most new and used property (excluding structures) through 2022; section 179 limit increased to $1 million|
|Depreciable life of buildings||39 years for most non-residential buildings; 27.5 years for residential rentals||Unchanged|
|Net operating losses (NOL)||Generally carried back 2 years and forward 20 years||Carryback repealed except farms (two years); indefinite carryover deduction limited to 80% of pre-NOL income for losses generated after 2017|
|Excess business loss||No provision||Net businesses losses in excess of $500,000 ($250,000 single) are not deductible; they become a NOL carried over to the next year|
|Business interest||Generally deductible||Generally limited to the extent that interest exceeds 30% of income; unlimited carryover of excess. Determined at entity level, but spillover effects to owner. Limitation not applicable if average annual gross receipts do not exceed $25 million|
|Cash method of accounting||Generally limited to business with less than $1 million, $5 million, or $10 million in receipts depending on facts||Expanded to include businesses with less than $25 million in receipts with special rules for tracking inventory costs|
|Domestic production activities deduction||Domestic producers eligible for a deduction equal to 9% of their qualifying income||Repealed after 2017|
|Corporate AMT||20% corporate AMT||Repealed after 2017; AMT credits refundable from 2018 through 2021|
|Gift and estate tax||Tax of up to 40% imposed on gifts and estates, subject to a $5.49 million lifetime exemption per spouse||Lifetime exemption doubled; estate tax remains in effect. Step-up in basis retained|
- 1All individual provisions expire after 2025.
- 2The bill clarifies that a payment made in 2017 for 2018 state or local income tax will be deemed paid on December 31, 2018 (i.e., not deductible in 2017). A reasonable estimate of a 2017 tax liability, however, may be paid before December 31, 2017. Any overpayment credited to 2018 from the 2017 tax year is taxable in 2018 to the extent the overpayment provided a tax benefit. Furthermore, a 2017 overpayment credited to a 2018 state and local income tax liability will be subject to the $10,000 limit for the combined state and local income tax (or sales tax, in lieu of income tax) plus real property taxes.
Year-end tax strategies for yourself
With an increased standard deduction and repeal or limitation of several itemized deductions, many taxpayers will not itemize deductions starting in 2018. Consider these prepayment options for 2017:
Prepaying (by December 31, 2017) state income tax projected to be payable with the 2017 return if you are not subject to AMT;
Prepaying real estate taxes for 2017 and 2018, to the extent permitted under the timing of local property tax due dates, if you are not subject to AMT; and
Prepaying one or more years of anticipated charitable contributions in 2017 by making a contribution to the organization of your choice or to a self-directed donor-advised fund.
Year-end tax strategies for your business
Certain strategies suggested below will require action as 2017 draws to a close. Other strategies can be implemented in 2018. Collaborate with your tax advisor on any of these strategies to understand how they impact your business.
Pass-through entity basis
If you own a pass-through entity, you can deduct your share of the company’s losses to the extent of your basis in the entity (debt and equity). If you have been allocated losses in excess of your basis, consider making a capital contribution or taking other action before year end so you have sufficient basis to deduct allocable losses from the pass-through entity. Suspended losses carry to future years but may provide less benefit in a lower tax-rate regime.
Prior year capital expenditures
Beginning in 2016, the PATH Act created a new category of bonus depreciation for eligible property: qualified improvement property, or QIP. QIP is property that meets all the following criteria:
Any improvement to an interior portion of a building, which is nonresidential real property;
The improvement is placed in service after the building was first placed in service; and
The improvement is not attributable to the enlargement of the building, any elevator or escalator, or the internal structural framework of the building.
This effectively allows 50 percent bonus depreciation on certain 39-year building improvements placed in service after January 1, 2016. You should evaluate major capital expenditures placed in service after 2015 and make sure you didn’t miss any opportunities to carve out such expenditures as QIP. If you did, these could be corrected as a voluntary accounting method change, for which net negative adjustments are claimed in the year of change.
If you own a building or have invested in leasehold improvements, consider doing a cost segregation study in connection with your 2017 tax preparation process. The study can be completed any time before the filing of the 2017 tax return. A cost segregation study identifies building assets that can be depreciated at an accelerated rate using a shorter depreciation life. These can be newly constructed buildings or existing buildings that have been purchased or renovated. The result is a favorable catch-up depreciation deduction on your 2017 return. Given the decreasing rates environment in 2018, the value of the deductions on your 2017 tax return could be more beneficial than deferring such deductions to future years.
Current year capital acquisitions
Taxpayers may be able to immediately expense the cost of new and used equipment and other capital assets acquired and placed in service after September 27, 2017. Consider acquiring fixed assets before year end as a way to accelerate tax deductions. Any equipment purchased prior to September 27, 2017, and placed into service by the end of the year would remain subject to the 50 percent bonus depreciation allowed under current law.
Depreciation begins when the asset is in a state of readiness, available for its specifically assigned function. The tax benefit of deductions for capital expenditures is more significant in a high tax-rate environment. So, you should look to establish facts to indicate the fixed asset is ready and available for regular operation and income-producing use before the end of the year to maximize the depreciation benefits.
Clean up erroneous accounting methods
Methods of accounting generally refer to the regular practice or procedure for determining when to recognize items of income or expense. Voluntary accounting method changes could be strategically evaluated in light of a changing rate environment.
Changes in accounting methods generally require a Section 481(a) adjustment, which identifies the accumulated amount of income or deduction at the beginning of the year of change; this is necessary to prevent duplication or omission of income or deduction as your business converts from the former to the new method of accounting. The adjustment is computed based on the opening balance sheet for the year of change. A net positive (unfavorable) adjustment to voluntarily correct an impermissible accounting method is spread over four years; a net negative adjustment is claimed in the year of change.
However, if the IRS imposes an accounting method change, the net positive adjustment is recognized in a single year and in the earliest year being reviewed by the IRS. Many changes may be implemented without the imposition of IRS user fees under the automatic consent procedures, using Form 3115.
For any unfavorable methods, the benefits of making a change in 2017 could be two-fold. First, making an accounting method change generally provides audit protection for prior years, assuming the scope limitations of the revenue procures are met. Second, the adjustment is spread over four years. Therefore, while part of the adjustment would be picked up under the current rate structures, 75 percent of the adjustment would be spread to the three subsequent years and potentially taxed at lower rates. For favorable methods, the benefit of a change in 2017 would be taking the deduction against income in 2017. The cumulative deduction may have greater tax benefit in the current rate environment compared to proposed future tax regimes.
Accounting methods relief for small businesses
The final reform bill provides simplifying conventions to tax accounting methods for small businesses (those with gross receipts under $25 million, based on a prior three-year average). Not only do the allowable methods provide simplification, but these methods can also offer accelerated tax benefits to manufacturing companies upon adoption in tax year 2018. The allowable changes in method include:
Change to the overall cash method of accounting;
Accounting for inventory as non-incidental materials and supplies; and
Exemption from uniform capitalization under Section 263A.
The research credit is one of the few business credits that the new legislation maintains. It is a federal income tax incentive providing a dollar-for-dollar reduction against a company’s computed federal tax liability. For flow-through entities, the benefit passes through to the owners and reduces their individual tax liabilities.
The research credit was enacted to keep jobs in the United States and to encourage companies to continually invest in new technologies. Federal research credits offer eligible companies significant tax and financial benefits, including reduced federal effective tax rates, increased cash flow, and the ability to fund future or additional research activities. Manufacturers that are developing new products and processes or improving the quality, reliability, and functionality of their products and manufacturing processes, generally benefit from this credit.
Work Opportunity Tax Credit (WOTC)
Another credit that remains in the new legislation is the Work Opportunity Tax Credit (WOTC), which rewards employers who hire various categories of disadvantaged workers with a credit ranging from $2,400 to $9,600 per qualifying hire. Qualifying hires include members of the following targeted groups:
Long-term unemployment recipients
Designated community residents
Vocational rehabilitation referrals
Supplemental nutrition assistance program benefits (SNAP) recipients
Supplemental security insurance recipients
Long-term family assistance recipients
International provisionsAmong the most significant changes in the new legislation are the international tax provisions.
Pre-reform international provisions
Under pre-reform law, U.S. companies were taxed on their worldwide income, whether derived in the United States or abroad. There was limited deferral of taxation of income earned by foreign subsidiaries of U.S. companies, and source-based taxation of the U.S.-source income of nonresident aliens and foreign entities.
Under this system, income earned from a separate legal entity operating a foreign business is subject to U.S. tax when the income is distributed as a dividend to the U.S. person, unless the foreign entity is treated as a pass-through entity for U.S. purposes, which results in current U.S. taxation. Certain anti-deferral provisions apply to foreign entities treated as corporations for U.S. purposes, which causes the U.S. owner to be taxed on a current basis if certain types of passive or related party income is earned by the foreign corporation, regardless of whether the income has been distributed as a dividend to the U.S. owner.
A foreign tax credit is also generally available to offset, in whole or in part, the U.S. tax owed on foreign-source income, whether the income is earned directly by the domestic corporation, repatriated as an actual dividend, or included in the domestic parent corporation’s income under one of the anti-deferral regimes.
Post-reform international provisions
The tax system is transitioning from a worldwide to a territorial system as a result of tax reform. Simply stated, an exemption will be allowed in 2018 and after for foreign source dividends received from a “specified 10-percent owned foreign corporations” by U.S. corporate shareholders will be excluded from the computation of taxable income. Because the foreign source dividend will not be subject to U.S. tax, a foreign tax credit or deduction will not be allowed with respect to such dividend. As foreign income will not be subject to any further U.S. taxation under this provision, transfer pricing becomes extremely important for all related-party transactions, as this will be one of the few items left from an international context the IRS can adjust taxable income through.
In order to transition to this territorial system described above, a transition tax will be imposed on U.S. shareholders on any post-1986 accumulated foreign earnings held in cash or cash equivalents at 15.5 percent, and on post-1986 accumulated foreign earnings held in illiquid assets at 8 percent. It is important to note that a U.S. shareholder includes: U.S. citizens; U.S. resident alien individuals; and domestic corporations, partnerships, trusts, and estates, even though the new territorial system only applies to U.S. corporate shareholders. Taxpayers will have the ability to pay the resulting tax over an eight-year installment period. Subchapter S corporation shareholders may elect to defer payment of federal income tax due each person’s share of foreign deferred income inclusions, until certain triggering events have occurred. In light of this transition rule, it will be important for manufacturers with post-1986 earnings in their foreign subsidiaries to thoroughly calculate the earnings, profits and foreign tax pools to ensure no over or underpayment of the resulting transition tax.
How we can help
Many provisions of the final reform will benefit manufacturers and distributors and their owners. With careful planning and strategy, you and your company can take full advantage of the new law’s provisions. CLA’s manufacturing and distribution professionals can help you evaluate your personal and business tax plan to reap the rewards of this legislation.