The 2017 Tax Cuts and Jobs Act (the “Act”) has overwhelmed many on an individual and business level with the unending question: what will I really be paying in taxes and what is my most advantageous strategy to implement in 2018? The focus of individuals and businesses should not solely be on the next year but must include a long-range viewpoint considering the future years’ impact on strategic planning.
In particular, for the manufacturing and distribution community, there are several changes, both beneficial and not, that should be considered. See below for a summary of the larger scope of tax code updates in the Act:
DPAD (Domestic Production Activities Deduction)/Section 199
DPAD consisted of a tax incentive to manufacturers that manufactured property in the United States. The DPAD tax incentive was repealed in the final Act, which while a negative overall, is expected to be recouped with the significant reduction in the overall corporate tax rates. This is effective beginning for years after December 31, 2017.
Corporate Tax Rate & Corporate Alternative Minimum Tax (AMT)
The corporate tax rate was reduced from 35% to 21%. This is a significant win for many companies, including manufacturers. Additionally, the Corporate AMT was repealed. This is effective beginning for tax years after December 31, 2017.
Pass-Through Tax Treatment/Section 199A
Historically, many manufacturers have chosen the pass-through structure. Previously, owners of S Corporations, partnerships and sole proprietorships (i.e. – Pass-Through entities) paid taxes at an individual rate, with a maximum tax rate of 39.6%. Under the Act, a new deduction of up to 20% of qualified pass-through earnings of the business to the individual owners’ tax returns was introduced. The deduction is limited based on certain wage and/or fixed asset criteria as well as overall taxable income and the trade or business of the company. The deduction is effective for tax years beginning after December 31, 2017.
Section 1031 Like-Kind Exchanges
Under the new Act, like-kind exchanges were not impacted for real estate/real property. However, they were eliminated for all personal property assets, such as vehicles, large equipment, certain intangibles, etc. You can still benefit from a like-kind exchange of personal property if you entered into the exchange before the December 31, 2017 year end by meeting certain requirements.
Interest Deductibility
Under the new Act, there are new limitations for deductibility of interest expense for companies with average gross receipts over $25 million. This change can be of concern to manufacturers and distributors with significant financing arrangements supporting their operations. Under the Act, a cap on interest deductions was implemented to include the sum of a company’s interest income; 30% of the adjusted taxable income with certain limitations considered; and the company’s floorplan financing interest for the year. Interest not allowed in a current year can be carried forward for an indefinite period by the company (or its owners if a pass-through entity). This is effective for tax years beginning after December 31, 2017.
Research & Development Deduction
The Act implemented procedures to reduce immediate deduction of research and development (“R&D”) costs by amortizing these R&D costs over a five year period and a fifteen year period for foreign R&D costs. Additionally, clarification was provided that all costs associated with the development of software should be considered R&D costs. This is effective for tax years beginning after December 31, 2021.
Research & Development Tax Credit
The R&D tax credit was preserved under the Act, which retained an important tax credit that provides ongoing incentives for qualified R&D costs to manufacturers.
Net Operating Losses
Under the Act, the net operating losses (“NOL”) of a company are generally limited to 80% of the company’s taxable income in years beginning after December 31, 2017, and no NOL carrybacks will be allowed. This change to the NOL carryback rules can be a significant concern for some companies, including manufacturers, which have relied on the ability to apply NOLs available to prior years’ operating taxable profits, and recover tax refunds.
Capital Expenditures Treatment
The Act allows for expensing of 100% of certain business property (including used property) acquired and placed in service after September 27, 2017 and before January 1, 2023 (or January 1, 2024 for certain longer production period property and certain other business property). This expensing is phased-out at 20% per year through tax years ending in 2023 through 2026.
Additionally, under Internal Revenue Code (“IRC”) Section 179, the maximum amount a taxpayer may expense increased to $1,000,000 for qualifying assets placed in service, for taxable years beginning before January 1, 2023, and increases the phase-out threshold for qualifying asset expenditures to $2,500,000 for taxable years beginning before January 1, 2023. Included in the capital expenditures treatment revisions are also increased limitations on the depreciation deduction for business-use vehicles acquired and placed in service after December 31, 2017 and before January 1, 2023.
Both the bonus depreciation and Section 179 increased limits are a great incentive for manufacturers and distributors to expand infrastructure and invest in the growth of their business.
Taxation of Foreign Income
The tax law prior to the Act treated earnings of foreign subsidiaries of United States (“U.S.”) multinational corporations as not being taxed until the income was repatriated (i.e.-paid as a dividend) in the U.S. Under the new Act, the U.S. moves away from a worldwide taxation of U.S. corporations towards a territorial tax system, in which dividends received from foreign subsidiaries are not subject to regular U.S. tax. The new participation exemption system provides a deduction of 100% of the dividends received from specified foreign corporations by U.S. shareholders, which are C-corporations. What does this mean for manufacturers? This system is viewed to positively impact manufacturers with foreign operations, which are often located in lower-tax jurisdictions. Taxing earnings only once in the country they are earned allows for available capital to move more easily between the various locations, or to be brought back and re-invested in the U.S.
The cost to transition to the participation exemption system is a mandatory transition tax imposed on accumulated foreign earnings from certain foreign corporations. The tax is 15.5% for earnings held in cash and cash equivalents and 8% for earnings held in other liquid assets. The deemed distribution provision affects all U.S. persons and taxpayers will need to make the first installment of the tax due by April 18, 2018 (the due date of 2017 tax returns for calendar year C-corporations and individuals) and they may elect to pay the tax in installments over the next eight years.
As part of the international reform, the Act repealed the foreign tax credit for exempt dividends and modified certain Subpart F provisions. The Act also introduced a category of income called Global Intangible Low Taxed Income (“GILTI”), which will be taxed in the year it is earned, as well as the Foreign Derived Intangible income that will be taxed at lower beneficial rates. Finally, a new base erosion anti-abuse (“BEAT”) minimum tax will apply to certain companies with gross receipts greater than $500 million, whom which make cross-border payments to related foreign entities.
What Next?
There are many positive impacts the new Act provides to manufacturers. We are beginning to peel away the layers of understanding and impact this will have at the federal level for companies, and continuing to be proactive in what the states will be implementing in conjunction with the Act.
To understand the implication of these changes, considering the complexity of the new reform and the individuality of each company’s strategic planning and financial position, be proactive and please contact your qualified tax advisor.