Year-End Tax Planning for Manufacturers
As the end of another business year rapidly approaches, now is the time to start thinking about tax planning opportunities for 2019. The Tax Cuts and Jobs Act of 2017 (“TCJA”), signed into law on December 17, 2018, provided numerous tax benefits for both corporations and individuals. With proper planning taxpayers may be able to defer, reduce or in some cases, even eliminate their 2019 tax liability. The following are a few of the tax planning opportunities available for manufacturing companies and their owners.
Section 199A – Qualified Business Income Deduction
One of the most substantial tax savings opportunities under the TCJA is the Section 199A deduction for qualified business income (“QBI”). The deduction is available to manufacturers operating as S corporations, partnerships, LLC’s and sole proprietorships in 2019. The Section 199A deduction allows for up to a 20 percent deduction against taxable income for the shareholders, partners and members of manufacturing companies that pass through qualified business income to their owners which then is reported on their individual income tax returns.
The Section 199A deduction is a great tax planning tool manufacturing companies can utilize to reduce their owners tax burdens. The 20 percent QBI deduction does have limitations calculated based upon the amount of wages paid during the year and the cost basis of the company’s property, plant and equipment. However, most manufacturing companies will not be affected by the limitations due to the amount of wages paid to their employees.
Section 179 Expensing
For the 2019 tax year, the maximum amount of qualified capital expenditures by taxpayers that are eligible for Section 179 expensing has increased to $1,020,000*. There is also a phase-out for taxpayers whose purchases exceed the $2,550,000 threshold. In addition to the increased expensing limitations, the TCJA also expanded the types of property that are eligible for Section 179 expensing.
Section 179 property now includes qualified improvement property and specific property improvements to nonresidential real property, including roofs, heating and air-conditioning property, fire protection, alarm and security systems. Qualified improvement property is any improvement to an interior portion of a building which is nonresidential real property if the improvement is placed in service after the date the building was first placed in service. Qualified improvement property does not include the enlargement of the building, an elevator or escalator, or the internal structural framework of the building.
Still in effect is the Section 179 unlimited carryforward for any deductions not allowed during the current year due to limitations. It is important to effectively plan the timing and amount of your capital expenditures prior to year-end to maximize the benefits of the Section 179 deduction.
Like the Section 179 expense, 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 2019 tax year, the TCJA allows manufacturers to immediately deduct 100 percent of the cost of eligible property. The 100 percent bonus depreciation amount can be claimed by manufacturers through 2022, with the deduction being reduced to 80 percent in 2023, 60 percent in 2024, 40 percent in 2025 and 20 percent in 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.
Tax Rate Reduction for C Corporations
The TCJA dramatically altered the tax structure for C corporations. For tax years beginning after December 31, 2017, the TCJA permanently changed the corporate tax rate to a flat 21 percent rate for all C corporations. Under the Pre-TCJA law, C corporations were taxed at graduated rates of 15 percent to 35 percent based on the company’s taxable income.
Certain C corporation manufacturing businesses operating in New York will also benefit from the special New York income tax rate of zero percent (0%), along with reduced capital base tax, minimum taxable income base tax and fixed dollar minimum tax rates. The special New York income tax rate (0%) is for qualified New York manufacturers who satisfy property and receipt tests and meet certain employment requirements. Paired with the new 21 percent Federal tax rate, qualified New York manufacturers will generate significant tax savings in 2019.
With the reduced Federal and New York tax rates for manufacturing businesses, there may be a planning opportunity to convert an existing S corporation, partnership or sole proprietorship manufacturing business to a C corporation. The benefits and tax implications of a conversion will greatly depend on the individual circumstances of the business and must be closely examined on a case by case basis.
Cost Segregation of Buildings or Building Improvements
Any building purchase, construction or large renovation project provides an opportunity to accelerate income tax deductions and provide cash flow benefits through a cost segregation study. 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 can be classified as repairs, resulting in a current year deduction. The IRS also allows a “catch up,” for any previously missed depreciation deductions from prior years. With the availability of the Section 179 rules and 100 percent bonus depreciation under the new tax law (discussed above), the tax savings on the cost segregation can be considerable.
Availability of the Cash Method of Accounting
Under the pre-TCJA tax rules, certain industries were not able to use the cash method of accounting due to the nature of their business. Specifically, manufacturers, retailers, wholesalers and other similar businesses that have inventories were extremely limited in their accounting method choices. Due to the presence of inventories, the taxpayers were required to use complex accounting rules pursuant to Internal Revenue Code Sections 471 and 263A, which govern the capitalization of overhead costs and certain selling, general and administrative expenses.
The TCJA amended the Internal Revenue Code to provide much more latitude to the use of the overall cash method of accounting. Under the new rules, for years beginning after December 31, 2018, taxpayers with average gross receipts (average of the prior three tax years) that do not exceed $26 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 $26 million gross receipts exemption, the TCJA also amended Internal Revenue Code Sections 471 and 263A, which govern the treatment of inventory costs. Under the TCJA rules, the amended Tax Law provides a small business exemption where these complex rules would no longer apply to taxpayers meeting the $26 million gross receipts test. Due to the new exemptions, the TCJA will allow manufacturers, retailers, wholesalers, and other taxpayers who do not exceed the $26 million gross receipts test to use the overall cash method of accounting.
With the availability of the cash method of accounting for many manufacturers, it is extremely important to analyze the potential impact of a change to the cash method of accounting. There are many planning opportunities available for a change in accounting method to the cash method that could result in extensive tax savings. It is crucial to examine these items prior to year-end for the manufacturer to take the appropriate steps to maximize the available tax savings.
Credit for Increasing Research Activities (R&D)
The Credit for Increasing Research Activities was written permanently into the tax law under the PATH Act of 2015 and was not modified by the TCJA. Many manufacturers performing R&D activities are unaware these activities 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.
The most important element in computing the R&D tax credit is determining the specific expenditures of the company that qualify for the credit. Internal Revenue Code Section 41(b)(1) defines “qualified research expenses” (QREs) as either “in-house research expenses” or “contract research expenses” of the taxpayer. Section 41(b)(2) defines “in-house research expenses” as expenses for wages paid or incurred to an employee for “qualified services” performed by such employee, amounts paid or incurred for supplies used in the conduct of qualified research, and amounts paid or incurred to another person for the right to use computers in the conduct of qualified research.
Previously, manufacturing companies that generated R&D credits that were passed through to their owners were often limited due to the alternative minimum tax (AMT) applied at the individual tax level. Under the TCJA, through increased AMT exemption amounts and the limitation on certain itemized deductions (previously added back for AMT purposes), the AMT limitations on the R&D credits will be significantly reduced, allowing taxpayers to claim more R&D tax credits against Federal income tax.
In addition, under the TCJA, for tax years beginning after December 31, 2021, research and experimental expenditures may no longer be deducted currently and must be capitalized and amortized over five years. This change in the law may dramatically impact the tax benefits for research and experimental expenditures starting in 2022.
Work Opportunity Tax Credit (WOTC)
Manufacturers looking for an additional way to take advantage of tax savings in 2019 should consider taking advantage of the Federal Work Opportunity Tax Credit Program (WOTC). The WOTC, which has been extended multiple times and is set to expire at the end of 2019 barring any changes in the law, is a non-refundable tax credit rewarding employers that hire individuals from certain disadvantaged targeted groups. Some of the targeted groups of the WOTC include veterans, families receiving certain government benefits and individuals who receive long-term family assistance.
The WOTC is generally 25 percent – 40 percent *** of a worker’s first year wages from $6,000 to $24,000 depending on the individual’s hours worked and their specific targeted group. For long-term family aid recipients, the credit is equal to 40 percent of the first $10,000 in qualified first year wages and 50 percent of the first $10,000 of second year wages.
Another benefit of the WOTC program is that it currently has no limitations on the number of individuals an employer can hire from these targeted groups during the year to claim the credit. It is important to note that in order to claim the credit, an employer must file a “Pre-Screening Notice Form” for the eligible employee with the Department of Labor within 28 days of the date of hire.
* Section 179 expensing is $1,020,000 per tax year, with a dollar for dollar phase-out of the deduction beginning at $2.55 million of qualifying fixed asset purchases (adjusted for inflation).
** Qualifying property for the bonus depreciation rules is generally tangible personal property with a recovery period of 20 years or less. Under the new law, qualifying property includes both new and used property, while the prior law restricted qualifying property to only new property.
*** The credit is equal to 25% of employee wages for employees that work at least 120 hours during the year and 40% if the employee works over 400 hours.