Tax Reform’s Impact on the Manufacturing Industry

Bonus depreciation

The Act allows manufacturers that place qualifying property in service after Sept. 27, 2017, and on or before Dec. 31, 2022, to expense 100 percent of the cost. Beginning Jan. 1, 2023, the amount of qualified property that a manufacturer can expense will decrease 20 percent per year. A significant change from prior law is that the TCJA defines qualifying property to include most used property (as well as the new property that previously qualified).

Section 179 depreciation

The TCJA increases the amount of Section 179 depreciation that a manufacturer can claim on qualifying property to $1 million. Qualifying property is generally tangible property that does not include structures. The new law also increases the threshold for phase-out to $2.5 million and indexes it for inflation.

This is a big win for the manufacturing industry. Not only will it allow taxpayers more options for immediately reducing their taxable income, this provision will hopefully spur capital spending, thus driving up demand for manufactured items.

The new law created Code Section 199A, which, while far from simple, gives a 20 percent deduction for “qualified business income” for all taxpayers except corporations. Generally, this income will come from a pass-through entity such as a sole proprietorship, partnership, limited liability company, or S corporation and will be taxed to the individual owners as ordinary income.

“Qualified business income” is defined as “domestic income from a pass-through entity” but does not include investment income (e.g., dividends, capital gains, and investment interest), reasonable compensation, or guaranteed payments.

This pass-through deduction is further limited to the greater of:

• 50 percent of the taxpayer’s share of W-2 wages paid by the pass-through entity to its workforce, or
• The sum of 25 percent of the taxpayer’s share of W-2 wages paid by the pass-through entity to its workforce plus 2.5 percent of the unadjusted basis of all qualified property.

However, these limitations do not apply if an individual taxpayer’s taxable income does not exceed $315,000 for married-filing-jointly filers or $157,500 for single filers.

Many manufacturers are structured as pass-through entities. This provision keeps flow-through entities on par or ahead of C corporations given the rate reduction addressed below for corporations.

Under prior law, C corporations were taxed based on a graduated system with a top rate of 35 percent. The TCJA eliminates that system and replaces it with a flat 21 percent income tax rate for tax years beginning after Dec. 31, 2017. The new law also repeals the corporate alternative minimum tax for tax years beginning after Dec. 31, 2017. However, corporations with prior year minimum tax credits will continue to be able to carry forward the credit and offset it against the corporation’s regular tax liability.

In certain circumstances, flow-through entities should consider electing to be taxed as a corporation to take advantage of the lower rate. Manufacturers who have substantial capital expenditures planned for the next several years or are prohibited from distributing free cash flows to owners and instead must use that cash flow to service debt should consider the impact of a conversion.

The Section 199 domestic production activities deduction (DPAD) has been part of the Internal Revenue Code since 2004 and was a tax incentive to encourage domestic manufacturing. Manufacturers were eligible for a nine percent deduction of their taxable income from qualifying activities.

The TCJA repeals this deduction for all tax years beginning after Dec. 31, 2017.

The impact will be somewhat muted by the reduction in the corporate tax rate (addressed above) as well as the new pass-through tax treatment (also addressed above) and lower individual tax rates.

Effective for tax years beginning after Dec. 31, 2017, the TCJA generally limits the amount of interest expense that businesses may deduct. The deduction for business interest will be limited to the sum of:

• Business interest income plus
• 30 percent of the manufacturer’s taxable income calculated without regard to deductions for depreciation, amortization, or depletion.*

*Note that for tax years beginning after Dec. 31, 2021, the calculation of the 30 pecrent income cap no longer excludes depreciation, amortization, or depletion expense.

Businesses that have average annual gross receipts of $25 million or less for the prior three tax years are exempt from this limitation on the interest deduction.

Any business interest expense that is not allowed as a deduction in a year may be carried forward indefinitely.

Depending on their level of income and depreciation deductions, this could be a troubling provision for manufacturing companies that rely heavily on debt financing. It will be important for companies in this position to consider this new limitation in their income tax and cash flow planning.

The TCJA creates a new limit on business losses and disallows “excess business losses” in any single tax year.

To determine the “excess business loss,” the taxpayer determines the excess of aggregate trade or business deductions over the taxpayer’s aggregate gross income or gain plus the taxpayer’s threshold amount. The taxpayer’s “threshold amount” will be $500,000 for married-filing-jointly filers or $250,000 for single filers. These amounts are indexed for inflation.

Any “excess business loss” can be carried forward under the net operating loss provisions discussed below.

These new rules add unnecessary complexity and stop taxpayers from creating a loss via depreciation that might eliminate other sources of income.

The TCJA changes the treatment of net operating losses (NOLs). Under the new law, any NOL created in tax years after Dec. 31, 2017*, will not be permitted to be carried back to generate a refund of taxes previously paid. Instead, the NOL will be carried forward until used (indefinite carry forward period).

Another significant change in the treatment of the NOL is that the carryforward that can be utilized in any one tax year is limited to 80 percent of a taxpayer’s taxable income in that year.

*Note that NOLs incurred on or before Dec. 31, 2017, will maintain the 20-year carryforward and are not limited by the 80 percent cap as they are governed under the prior law.

Taxpayers will no longer be able to generate cash from tax refunds by carrying back losses from current year to a prior profitable year. This is detrimental to taxpayers whose manufacturing companies see major fluctuations from year to year.

Under the old law, a taxpayer was allowed a 50 percent deduction for expenses incurred for entertainment, amusement, or recreation activities. The TCJA eliminates this deduction, although there are a few exceptions. This means that unless you qualify for one of the exceptions, there will be no deduction for tax purposes for these expenditures.

The law retains the existing 50 percent deduction limitation on food and beverage expenses.

Effective for tax years beginning after Dec. 31, 2025, the TCJA also eliminates the deduction for meals furnished for the employer’s convenience on the employer’s business premises.

As a practical matter, manufacturing companies will now need to account for food and beverage expenses separately from entertainment expenses as the classification will affect deductibility on a go-forward basis.

The uniform capitalization rules under Internal Revenue Code Section 263A require that certain direct and indirect costs that are normally expensed instead be capitalized as part of inventory for purposes of calculating taxable income. For tax years beginning after Dec. 31, 2017, any taxpayer (regardless of industry) that has average gross receipts of less than $25 million for the prior three tax years is exempt from these rules.

This is a win for smaller manufacturers with gross receipts under $25 million as they will not be subject to capitalizing certain costs.

The TCJA narrows the type of property that qualifies for deferral under the like-kind exchange rules of Internal Revenue Code Section 1031. Under the new rules, only real property that is not held primarily for sale will be eligible for deferral. All other trades that are completed after Dec. 31, 2017, will be subject to the new rules.

This may be viewed as a loss for the manufacturing industry, but from a practical perspective, the short-term impact will be offset by new depreciation rules. If a taxpayer is forced to recognize gain on the trade of a piece of equipment, the subsequently higher basis in the replacement equipment will be eligible for bonus/Section 179 depreciation. This will have a negative impact from a state perspective as most states will not follow the Federal rules regarding dereciation.