Just before the December 2017 holidays, Congress passed and the President signed the Tax Cuts and Jobs Act (formally named An Act to provide for reconciliation pursuant to titles II and V of the concurrent resolution on the budget for fiscal year 2018).
The Act is a complex, 500-page piece of legislation that will have a major impact on how manufacturing businesses are taxed in the U.S. Its provisions affecting corporate taxpayers are permanent. Those for individuals and pass-through businesses generally expire after 2025.
Many of the Act’s provisions are helpful to manufacturers. Others not so much.
Tax Rates and Brackets
The Act reduces the tax rates for individuals and businesses of all types. The impact of these reduced rates is to decrease costs and increase profitability for manufacturers.
Individuals: The Act reduces the graduated federal individual income tax rate to a maximum of 37 percent while retaining the number of tax brackets. The top income levels that apply to each tax bracket are also increased, further reducing the applicable tax rate.
As the business income for sole proprietorships and pass-through entities — including partnerships, limited liability companies (LLCs) and S corporations — is reported on the owners’ individual income tax returns, the tax rate for these business entities is likewise reduced.
These changes apply only through 2025.
C corporations: The Act reduces the corporate tax rate from a graduated maximum rate of 35 percent to a flat 21 percent. This change is permanent.
Alternative Minimum Tax (AMT)
The Act eliminates the AMT for corporations while providing a refundable credit to those corporations with an existing minimum tax credit. This refundable credit, subject to limitations, applies through 2021.
The AMT for individuals is not eliminated. Instead, the Act limits its impact by increasing the exemption amounts. Changes to the personal AMT apply only through 2025.
Bonus Depreciation / Expensing
The Act’s expensing provision increases bonus depreciation from 50 percent of the cost of eligible property to 100 percent through 2022. In subsequent years, it decreases each year by 20 percent.
Bonus depreciation now applies to both new and used property. There are limited exceptions for property that is not subject to the limitation on interest expense and property with certain types of debt.
Section 179 Expensing
The Act increases the current expensing limit of $500,000 to $1 million (indexed by inflation after 2018).
It expands the definition of eligible qualified real property by including a range of improvements to nonresidential real property, such as security systems, fire protection and alarm systems, roofs, and heating/ventilation/air-conditioning systems.
The Act expands those eligible for cash-basis accounting by creating a new threshold below which cash basis can be used regardless of whether the purchase, production or sale of products is an income-producing factor. To qualify, the business’ average annual gross receipts must have been $25 million or less for the prior three years.
Businesses under this threshold can treat their inventory as nonincidental materials or as they are treated for financial accounting purposes. These businesses are also exempt from the uniform capitalization (UNICAP) rules.
Depreciation Recovery Periods
Under the Act, certain depreciation recovery periods are shortened. Various categories of qualified improvement properties are consolidated and depreciated over 15 years under the Act and become eligible for Section 179 expensing. This allows improvements to the interior of a nonresidential building that are made after the building is placed in service to be depreciated over a shorter period.
Qualified improvement property does not require that improvements be made pursuant to a lease. However improvements to enlarge a building or that are made to an elevator, escalator or the internal structural framework of the building are excluded.
The Act roughly doubles the federal estate tax exemption from the current inflation-adjusted $5.6 million ($11.18 million for married couples).
It also preserves the stepped-up basis rules for beneficiaries. For example, if you receive stock in the business as the beneficiary of an estate, your basis is generally the fair market value at the time of death. As a result, the difference between the decedent’s basis and your stepped-up basis as a beneficiary is never subject to tax.
Domestic Production Activities Deduction (DPAD)
The Act eliminates the domestic production activities deduction.
Deduction for Research Experimentation
Before the act, manufacturers could deduct or amortize certain research and experimentation for which they did not take a research tax credit.
Those expenses can no longer be expensed. They must be capitalized and amortized over five years. If the research is conducted outside of the U.S., the amortization period increases to 15 years.
Deduction for Business Interest
Under the Act, a business’ net interest expense deduction is limited to its business interest plus 30 percent of adjusted taxable income. Any disallowed amounts can be carried forward indefinitely. For pass-through entities, the limit is determined at the entity level — e.g., partnership, not partner.
Adjusted taxable income is calculated without regard to deductions allowable for business interest, depreciation, amortization and depletion; the net operating loss deduction; and the new qualified business income deduction.
Beginning in 2022, depreciation, amortization and depletion will be included in the adjusted taxable income calculation, significantly increasing the likelihood that the deduction will be limited for many manufacturers.
Any business with average annual gross receipts of $25 million or less for the prior three years is exempt from this provision.
Net Operating Losses
For net operating losses (NOLs) that arise after 2017, the Act limits the deduction to 80 percent of taxable income.
With limited exceptions, it also eliminates the two-year carryback and the special carryback provisions for NOLs, but allows them to be carried forward indefinitely.
Qualified Business Income Deduction for Sole Proprietorships and Pass-Through Entities
Income from sole proprietorships and pass-through entities is taxed on the owners’ tax returns at the owners’ tax rates. The Act reduced tax rates for non-corporate owners, thus reducing the amount of tax due on this business income. But the corporate tax rate reduction to 21 percent was a dramatically larger reduction.
To create a level of parity with the corporate tax rate, the Act establishes a new qualified business income deduction. This deduction is only available to the non-corporate owners of sole proprietorships and pass-through entities. Although potentially beneficial for owners of manufacturing businesses, the deduction itself involves a complex calculation, portions of which will require clarification and guidance in terms of implementation rules yet to be created by the IRS. Thus the ugly.
The amount of the new deduction is essentially equal to 20 percent of qualified business income (subject to wage limitations), plus 20 percent of qualified publicly traded partnership income and REIT dividends.
The wage limitation is either 50 percent of W-2 wages for the year, or 25 percent of W-2 wages plus 2.5 percent of the unadjusted basis of tangible depreciable property — i.e., buildings but not land.
This pass-through deduction is not available to specified service businesses, which include most professional service businesses such as lawyers, accountants, actuaries, health professionals, brokers, investment managers, financial planners, athletes and performing artists, to name a few. An exception was made for engineers and architects.
The Act also makes an exception for owners of pass-through businesses and sole proprietorships with incomes less than $157,500 ($315,000 if married and filing jointly). They are eligible for the deduction.
This deduction expires after 2025.
Given the magnitude and complexity of the tax rule changes in the Act — and the various limitations, thresholds, phase-ins, phase-outs and other exceptions that cannot be fully described here — you will likely benefit from professional advice regarding the Act’s impact on your tax situation.
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