On December 27, 2017, President Trump signed Tax Reform legislation that changed both business and personal taxation. This article will highlight the federal Tax Reform changes that became effective in 2018 that affect businesses of all sizes, types and across all industries, especially manufacturers.
The corporate tax rate was permanently reduced to 21% for C corporations. Since many businesses are operated as partnerships and S corporations, a provision was included for owners of these businesses to take a 20% deduction on their individual income tax returns for eligible domestic business income generated in a trade or business. The deduction is intended to reduce the federal income tax rate on business income. For example, if a business owner is in the 37% bracket, after taking this deduction into account the effective tax rate is 29.6%. Limitations on the amount of the deduction are based on qualifying business income, the wages and property related to that income and the taxable income of the owner.
The corporate AMT was eliminated and the personal AMT exemption was increased. Corporate unused AMT credits can offset the regular tax liability for any taxable year after 2017 or can be refunded for any taxable year beginning after 2017 and before 2022 for 50% of the excess credit. The refund would be 100% after 2021. For business owners, many of the individual changes may cause the owner not being subject to AMT.
Manufacturers, and others, with average annual gross receipts of less than $25 million no longer need to record inventory. However, the inventory is treated as incidental materials and supplies and is expensed like inventory. The significance of this provision is that the manufacturer can use the cash method of accounting. When accounts receivable exceeds the accounts payable and accrued liabilities (accruals), after excluding inventory purchases and fixed assets, the manufacturer should switch to the cash method of accounting. The difference between accounts receivable and accruals would reduce taxable income this year. If the manufacturer receives significant advance payments, the manufacturer may want to stay on the accrual method of accounting to take advantage of the one-year deferral of reporting the advance as income.
Those same manufacturers with average annual gross receipts under $25 million no longer have to calculate UNICAP that required certain expenses to be capitalized as part of inventory for tax purposes. This adjustment will also result in a reduction in taxable income this year.
Accelerated Depreciation Expanded
Bonus depreciation has been expanded to 100% for those tangible personal property items purchased between September 27, 2017 and January 1, 2023. Both new and used property purchased is now eligible if the property was not used by the taxpayer before the purchase and it was not purchased from a related party. Congressional intent was to allow certain leasehold improvements to be eligible for bonus but there was a drafting error so until there is a technical correction bill passes leasehold improvements are not eligible for bonus. Another advantage of taking the bonus depreciation is that the deduction is not limited to taxable income.
Section 179, which also allows for a 100% depreciation deduction, has been enhanced to increase the maximum amount that can be expensed to $1 million and increases the phase-out threshold when eligible property placed in service exceeds $2.5 million. In addition, qualified real property, off the shelf software, and qualified improvements made to nonresidential real property and improvements to roofs, HVAC, fire protection systems, alarm systems and security systems are eligible for Section 179. The disadvantage of taking Section 179 is the deduction is limited to taxable income.
Business Interest Limited
Business interest may be limited to business interest income, 30% of adjusted taxable income and floor plan financials interest for the year. For taxable years through 2021, adjusted taxable income is taxable income increased by any net operating loss and any depreciation, amortization or depletion and decreased by non-business income, gain, deduction or losses. The good news is that businesses with average annual gross receipts of less than $25 million are not subject to this limitation.
Investing in a qualified opportunity zone (QOZ) fund after the sale of capital assets will defer the taxability of the gain until 2026. The gain on the fund itself may be reduced or eliminated based on the time the fund is held. Holding the fund for 5 years will result in 10% of the gain being eliminated. Holding the fund for 7 years will result in 15% of the gain being eliminated and holding the fund for 10 years eliminate the gain. The fund must hold at least 90% of its assets in QOZ property that would include QOZ stock, QOZ partnership interests or QOZ business property. The opportunity zone is an area designated as an economically distressed community. This incentive is to promote investment in the distressed communities.
Research and Development Credit
The research and development tax credit is even more valuable than in prior years. The lower corporate tax rate, eliminating the corporate AMT, the increase in the personal AMT exemption all allow more of the research and development credit to be used to offset the tax liability. Any expenses in connection with technological advances should be eligible for the credit. Record keeping requirements have been simplified.
Like Kind Exchanges
Tangible personal property is no longer eligible for like kind exchange treatment. Only real estate applies. Eliminating like kind exchange treatment will affect a manufacturer that trades in its machinery and equipment for updated models.
Significant changes were made for businesses owning foreign entities. The changes are beyond the scope of this article.
State taxation is also an important consideration but is not being covered here.
For more information on how these changes affect your situation, please ask your CPA or call Piccerelli Gilstein & Company, LLP at 401-831-0200 and talk to one of our knowledgeable tax professionals.