Year-End Tax Planning Considerations for Manufacturers
As the close of another business year quickly approaches, now is the time to think about tax planning opportunities for 2021. With proper planning, taxpayers may be able to defer, reduce or in some cases, even eliminate their 2021 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 Tax Cuts and Jobs Act (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 2021. 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 2021 tax year, the maximum amount of qualified capital expenditures by taxpayers that are eligible for Section 179 expensing has increased to $1,050,000*. There is also a phase-out for taxpayers whose purchases exceed the $2,620,000 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 (QIP) and specific property improvements to nonresidential real property, including roofs, heating and air-conditioning property, fire protection, alarm and security systems. QIP is any improvement to an interior portion of a building that is a nonresidential real property if the improvement is 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.
Still in effect is the Section 179 unlimited carryforward for any deduction 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.
Bonus Depreciation
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 2021 tax year, the TCJA allows manufacturers to immediately deduct 100 percent of the cost of eligible property. The applicable bonus depreciation percentage that can be claimed by manufacturers is 100% for property placed in service on or before December 31, 2022, and phases down to 80% in 2023, 60% in 2024, 40% in 2025, and 20% in 2026.
On March 27, 2020, Congress passed the Coronavirus Aid, Relief and Economic Security (CARES) Act, retroactively changing the recovery period for Qualified Improvement Property (QIP) to 15 years. Thus, making all QIP placed in service after December 31, 2017, eligible for bonus depreciation for tax years ended through December 31, 2026.
The CARES Act brought forth the long-awaited technical correction regarding the depreciable life of qualified improvement property. The CARES Act corrected the errors created by the TCJA and restored the depreciable life of qualified improvement property to 15 years, making the property eligible for 100% expensing under Section 179 or bonus depreciation (for tax years ended through 2022), as originally intended by the TCJA.
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
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.
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, 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 the 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.
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. Essentially, the R&D credit allows an eligible manufacturer a credit of up to 10% of eligible expenses.
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 2021 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 2025, 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 in 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. In order to claim the credit, an employer must file a “Pre-Screening Notice Form,” Form 8850, for the 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 more than one wage-based credit for the same employee, provided that any wages used to calculate the WOTC are not also utilized to calculate another wage-based credit.
Employee Retention Credit (ERC)
Similar to the WOTC, the Employee Retention Credit (ERC) is a wage-based credit, eligible to manufacturers. The ERC is a tax benefit included in the CARES Act, aimed to help employers keep employees on their payroll during the pandemic. While the ERC became eligible to manufacturers in March of 2020, the eligibility of the credit posed several limitations. Most notably, the CARES Act prevented employers from utilizing the ERC in conjunction with a Paycheck Protection Program (PPP) Loan. However, with the passing of the Consolidated Appropriations Act (CAA) in December of 2020, the exclusivity provision was eliminated and the thresholds for qualification were expanded. Under the CARES Act, for 2020, the credit was equal to 50% of qualified wages up to $10,000 per employee for all quarters (maximum credit of $5,000 per employee), for an eligible employer who was in operation during 2020 and experienced a full or partial shutdown due to government restrictions or a significant decline in gross receipts. For 2020, a significant decline in gross receipts was measured as receipts less than 50% of the company’s gross receipts in the same calendar quarter of 2020 when compared to those of 2019.
Fortunately, the CAA expanded both the maximum ERC and the definition of a significant decline in gross receipts for 2021. The maximum credit for 2021 is equal to 70% of qualified wages up to $10,000 per employee, per quarter (maximum credit of $7,000 per employee, per quarter). For 2021, a significant decline in gross receipts was measured as receipts less than 20% of the company’s gross receipts in the same calendar quarter of 2021 when compared to those of 2019. Additionally, employers can elect to use the gross receipts test for the preceding quarter to qualify for the current quarter.
* Section 179 expensing is $1,050,000 per tax year, with a dollar-for-dollar phase-out of the deduction beginning at $2.62 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.
Contributing Authors: Shawn T. Layo, CPA, is a tax partner with over 20 years of experience in taxation and planning for individuals and closely-held companies. He is responsible for overseeing tax engagements for a variety of clientele with a focus on manufacturing, construction, retail automotive, multi-state corporations and high net worth individuals. This article was also co-authored by Kaitlyn L. Mariano, a tax senior at Dannible & McKee, LLP. For more information on this topic, you may contact Shawn at slayo@dmcpas.com or (315) 472-9127.