The decline of manufacturing in the U.S. was a prime topic of the 2016 election cycle. At the time, Candidate Trump promised to revive American production. The 2017 tax law, commonly known as the Tax Cuts and Jobs Act (TCJA), is regarded by some as a delivery on that promise. While this notion must stand the test of time, domestic manufacturers should explore the potential benefits and drawbacks under the TCJA now.
The TCJA provides many benefits for domestic manufacturers, but not all the news is good. For example, the law repealed the popular Domestic Production Activities Deduction (DPAD). The DPAD provided a nine percent deduction targeted for manufacturers and other domestic producers. And while the repeal of this tax benefit may be offset in part by tax rate cuts and a new Qualified Business Income (QBI) deduction, manufacturers accustomed to the DPAD will derive less benefit than industries not affected by the DPAD repeal.
To give a highly simplified example, consider a C corporation formerly taxed at the 35 percent rate whose taxable income of $21.8 million was reduced to $19.8 million by the DPAD. This corporation incurred a tax bill of $6.9 million, excluding possible tax credits and corporate AMT. This same $21.8 million of taxable income under the TCJA produces a tax bill of $4.6 million for a C corporation. The 21 percent rate is a significant reduction from the 32 percent effective under old tax law (35 percent less the nine percent DPAD deduction), but it is less than the advertised 14-point rate reduction for corporations. This is because corporations cannot claim the new QBI deduction and lose the benefits once provided by the DPAD.
Another drawback is a new limit on interest expense deductions under the TCJA. This provision may hit manufacturers particularly hard, as debt financing is an integral part of business for an industry dependent on large capital expenditures. The new limitation applies to businesses with average annual gross receipts in excess of $25 million over a three-year period, or to any business that is a "tax shelter." Affected businesses must limit interest expense deductions (net of any interest income) to 30 percent of adjusted taxable income. Adjusted taxable income for this purpose essentially is earnings before interest, taxes, depreciation, and amortization (EBITDA). Beginning in 2022 however, the pool of earnings used to calculate the 30 percent deduction limit will shrink to earnings before interest and taxes. This will result in an even smaller deduction at that time. While businesses under the $25 million threshold are exempt from these new rules, aggregation rules require related organizations under common control to combine their total gross receipts for purposes of the calculation. This may prevent each of these businesses from taking advantage of the exemption from this new limitation.
New loss limitation rules under the TCJA may also harm domestic manufacturers. For instance, net operating losses (NOL) no longer can be carried back to offset taxable income in a prior year and generate corresponding refunds. In addition to losing NOL carrybacks, a taxpayer's NOL generated in tax years beginning after Dec. 31, 2017 can offset only 80 percent of taxable income in subsequent years. As a consolation to these new NOL limitations, the carryforward period has been extended from 20 years to an indefinite carryforward period. Of course, the present value of a deduction 21 years in the future is not very valuable.
Excess business losses are also a new category of loss limitations under the TCJA. This new limitation generally prevents business losses incurred by individuals from offsetting taxable income. Such losses in excess of $250,000 ($500,000 MFJ) cannot be deducted currently, and convert to NOLs available in subsequent years that are subject to the new 80 percent NOL limitation.
Despite these varied drawbacks of the TCJA for domestic manufacturers, there are many positive features that, for most U.S. based manufacturers, will outweigh the negatives. As discussed earlier, the corporate tax rate cut will provide a net benefit (even after the elimination of the DPAD) for most corporate manufacturers. The QBI deduction attempts to level the playing field for non-corporate manufacturers that are taxed as partnerships, sole proprietorships, and S corporations — though not to the extent of the corporate tax rate reduction.
The repeal of the corporate Alternative Minimum Tax (AMT) may also provide a major benefit. The corporate AMT, much like its individual counterpart, was designed to prevent corporations from claiming large deductions that resulted in minimal or zero tax liabilities. Its repeal, paired with refund provisions for previous AMT credits, will be a major positive for domestic manufacturers. The corporate AMT repeal comes with a peripheral benefit of simpler tax calculations, because computations of this parallel tax no longer are necessary.
A major change to the U.S. tax system attributable to overseas income will benefit domestic manufacturers, as well. Prior to the TCJA, businesses were subject to tax on their worldwide income, meaning that profits from foreign sources were taxed in the U.S. And while businesses could defer tax on foreign income sources until foreign income was repatriated to the U.S. (through the payment of dividends, for example), this was an inconvenient option that arguably encouraged investment in overseas manufacturing operations. Under the new system, a U.S. corporation can exclude from U.S. tax 100 percent of foreign source dividends received from a controlled foreign corporation (CFC), provided that the U.S. corporation has at least a 10 percent ownership interest in the CFC. Although this exclusion is only available to C corporations, it will allow a U.S.-based corporate manufacturer to effectively sell products outside the U.S. without those sales being subject to U.S. taxation.
Manufacturers that historically deferred U.S. tax on foreign earnings by avoiding the repatriation of foreign earnings now have a tradeoff. To transition to the new U.S. tax system on global business income, the TCJA imposes a one-time deemed repatriation tax on prior balances of accumulated overseas earnings and profits. However, the impact of the "transition tax" is mitigated in two ways. First, the transition tax is assessed at a much lower tax rate (15.5 percent for cash and cash equivalents, and eight percent on all other earnings and profits). Second, taxpayers subject to the transition tax can elect to pay it in eight annual installments, with the largest payments due in the later years. The first installment generally is due with 2018 tax returns.
It should be noted that there are also new provisions under the TCJA designed to prevent abuse of its new international tax framework. These provisions generally will not affect domestic manufacturers whose only foreign activity is through sales of products through a foreign subsidiary.
The other provisions of the TCJA that will generally benefit domestic manufacturers relate to simplification of accounting rules and expanded deductions for capital expenditures. Under the TCJA, eligible businesses (including businesses with inventories) can now use the cash method of accounting regardless of their tax filing status. To be eligible for the cash method of accounting, businesses must have less than $25 million in average annual gross receipts over the prior three years, and cannot be a "tax shelter." Businesses eligible for the cash method of accounting are also exempt from the requirement to capitalize indirect costs to inventories under uniform capitalization rules. These changes will generally mean that manufacturers can defer the recognition of income associated with business done on account with customers, and can implement a simpler set of rules to determine the timing of income recognition or expense deduction.
The expanded deductions available under the TCJA take two forms. The first is a temporary provision that allows for 100 percent bonus depreciation. This expanded deduction provides an immediate deduction for eligible expenditures in the year the property is placed in service. Eligible property includes used property for the first time, and generally includes any property with a recovery period of 20 years or less. The expanded bonus depreciation provision will begin to phase out in 2023. The second form of expanded deductions comes through a more generous expensing deduction under Section 179. The Section 179 deduction limit is increased under the TCJA to $1 million for qualifying purchases, with a phase-out beginning for purchases that exceed $2.5 million. Generally, this expansion will not provide a substantial benefit until after 2022, as many of the changes to the bonus depreciation provisions overlap with the expanded Section 179 deduction.
The TCJA brings many changes to how the tax code will affect domestic manufacturing. Certain changes are designed to benefit manufacturing within the U.S., while others are detrimental. The expanded deduction provisions and the reduction in corporate tax rates (or the QBI deduction for non-corporate taxpayers) seem to be the most advantageous to the manufacturing sector. These benefits appear to allow manufacturers to increase capacity while also incentivizing the expansion of the manufacturer's sales base to foreign markets. Clearly, these provisions will benefit those manufacturers who are more adaptable to capitalize on the associated benefits. Contact us to learn more about the effects these provisions will have on your business.
Published on June 12, 2018