IRC Section 199A: Qualified Business Income Deduction

As the end of another business year fast approaches, it’s crucial to consider tax planning opportunities now for your manufacturing business. With proper planning, you may be able to defer, reduce, or even eliminate your tax liability for the year 2023. Here are some tax planning opportunities that your manufacturing company can take advantage of.

IRC Section 199A: Qualified Business Income Deduction

One of the most substantial tax savings opportunities offered under the Tax Cuts and Jobs Act (TCJA) is the Internal Revenue Code (IRC) Section 199A deduction for qualified business income (QBI). This deduction is available to manufacturers operating as S corporations, partnerships, LLCs and sole proprietorships in 2023. Section 199A deduction allows for up to a 20% deduction against taxable income for shareholders, partners and members of manufacturing companies that pass through qualified business income to their owners. This deduction is then reported on their individual income tax returns.

The Section 199A deduction is a great tax planning tool that manufacturing companies can utilize to reduce their owners’ tax burdens. The 20% QBI deduction does have limitations calculated based on the amount of wages paid during the year and the cost basis of the company’s property, plant and equipment. However, most manufacturing companies are unlikely to be affected by these limitations due to the amount of wages paid to their employees.  Keep in mind that the Section 199A qualified business income deduction will phase out after December 31, 2025, so it’s best to take advantage of this tax-saving strategy now!

IRC Section 179: Accelerated Expensing

For the 2023 tax year, the maximum amount of qualified capital expenditures that are eligible for Section 179 expensing has increased to $1,160,000. However, there is a phase-out for taxpayers who placed in service purchases exceeding the $2,890,000 threshold. In addition to the increased expensing limitations, there has also been an expansion of the types of property that are now eligible for Section 179 expensing.

Section 179 property includes qualified improvement property (QIP) and specific property improvements to nonresidential real property, including roofs, heating and air-conditioning property, fire protection, alarms and security systems. QIP is any improvement to an interior portion of a nonresidential building. The improvement must be placed in service after the date the building was first placed in service. QIP does not include the enlargement of the building, an elevator or escalator, or the internal structural framework of the building.

It’s worth noting that there is an unlimited Section 179 carryforward for any deduction that is not allowed in the current year due to limitations. To maximize the benefits of the Section 179 deduction, it is essential for you to effectively plan the timing and amount of your capital expenditures before the end of the year.

IRC Section 168(k): Bonus Depreciation

Like Section 179 expensing, bonus depreciation provides an accelerated deduction for capital expenditures made by manufacturers during the year. For qualifying property acquired and placed into service during the 2023 tax year, you are allowed to immediately deduct 80% of the cost of eligible property, which is down from 100% in 2022. The applicable bonus depreciation percentage that can be claimed by manufacturers will phase down to 60% in 2024, 40% in 2025, and 20% in 2026.

Qualifying property for the bonus depreciation rules is generally tangible personal property with a recovery period of 20 years or less. Under the law, qualifying property includes both new and used property.

On March 27, 2020, Congress passed the Coronavirus Aid, Relief and Economic Security (CARES) Act, retroactively changing the recovery period for QIP to 15 years. Thus, making all QIPs placed in service after December 31, 2017, eligible for bonus depreciation for tax years ended through December 31, 2026.

A major benefit of bonus depreciation is that, unlike Section 179 expensing, it is not subject to any phase-outs on purchases or statutory dollar limitations.

Cost Segregation of Buildings or Building Improvements

If you are planning to buy a building, construct one, or carry out a significant renovation, you can take advantage of a cost segregation study to accelerate your income tax deductions and receive cash flow benefits. These studies separate the costs of the building and land improvements into assets with shorter lives which can accelerate tax depreciation deductions, as well as separate specific expenses that be classified as repairs, resulting in a current year deduction. The IRS also allows a “catch up” for any previously missed depreciation deduction from prior years. With the availability of the Section 179 rules and 80% bonus depreciation under the tax law, the tax savings on cost segregation can be considerable if you qualify.

IRC Section 448: Availability of the Cash Method of Accounting

Under the tax rules prior to the TCJA, certain industries were not able to use the cash method of accounting due to the nature of their businesses. Specifically, manufacturers, retailers, wholesalers and other similar businesses that have inventories were extremely limited in their accounting method choices.

The TCJA amended the IRC to provide much more latitude in the use of the overall cash method of accounting. According to the new rules, taxpayers with average gross receipts of the prior three tax years that do not exceed $29 million (adjusted for inflation) are now eligible to use the overall cash method of accounting, where they may have been limited previously.

In addition to the $29 million gross receipts exemption, the TCJA also brought changes to IRC Sections 471 and 263A, which determine how inventory costs are treated. Under the TCJA rules, the amended law provides a small business exemption where these complex rules would no longer apply to taxpayers meeting the $29 million gross receipts test.

With the availability of the cash method of accounting for many manufacturers, it is extremely important that you analyze the potential impact of changing to this method of accounting. There are many planning opportunities available that could result in extensive tax savings. Therefore, it is essential to examine these items prior to year-end and take the appropriate steps to maximize the available savings.

IRC Section 41: Credit for Increasing Research Activities & IRC Section 174: Research and Experimental Costs

The Credit for Increasing Research Activities (R&D) was written permanently into the tax law under the Protecting Americans from Tax Hikes (PATH) Act of 2015. Many manufacturers performing R&D activities are unaware they qualify for the R&D tax credit. Generally, if a manufacturer designs or improves a product, or has improved its production process, the costs related to the project will qualify. There are several different methods available to compute the R&D tax credit which may reduce a significant amount of income taxes. Essentially, the R&D credit allows an eligible manufacturer a credit of up to 10% of eligible expenses.

In addition, under Section 174, for tax years beginning after December 31, 2021, research and experimental (R&E) expenditures may no longer be deducted in the year incurred. Instead, they must be capitalized and amortized over five years. This change in the treatment of R&E costs has drawn significant backlash from the manufacturing community. As a result, there is a current push in Congress to temporarily delay or repeal the implementation of this detrimental Code Section. This is an area that should be on your radar if you are currently claiming the R&D tax credit.

IRC Section 51 – Work Opportunity Tax Credit

Manufacturers looking for an additional way to take advantage of tax savings in 2023 should consider the Federal Work Opportunity Tax Credit Program (WOTC). This non-refundable tax credit rewards employers that hire individuals from certain disadvantaged groups, including veterans, families receiving certain government benefits, and individuals who receive long-term family assistance. The WOTC has been extended multiple times and is set to expire at the end of 2025.

The WOTC is generally 25% to 40% of a worker’s first-year wages from $6,000 to $24,000 depending on the individual’s hours worked and their corresponding group. For long-term family aid recipients, the credit is equal to 40% of the first $10,000 in qualified first-year wages and 50% of the first $10,000 in second-year wages.

Currently, the WOTC program has no limitations on the number of individuals an employer can hire from these targeted groups during the year to claim the credit. Employers who are looking to claim this credit must file Form 8850, Pre-Screening Notice and Certification Request for the Work Opportunity Credit, for any eligible employee with the Department of Labor within 28 days of the date of hire. It is important to note that generally the wages that are used to calculate the WOTC cannot be used to calculate other wage-based credits. However, an eligible employer may be able to claim multiple wage-based credits for the same employee, if the wages used to calculate the WOTC are not also used to calculate another wage-based credit.

Contribution Author: Mickel Pompeii, CPA, CDA, is a tax partner with 15 years of experience in taxation and tax planning for individuals and closely held companies. He is responsible for overseeing tax engagements for a variety of the firm’s clientele. For more information on this topic, contact Mickel at mpompeii@dmcpas.com or (315) 472-9127.