The outlook for manufacturers so far in 2018 has been improved by a number of provisions from the new Tax Cuts and Jobs Act, which could mean greater investment in everything from automation to data capabilities.
It remains to be seen the degree to which tax reform efforts can attain the stated goal of creating factory jobs in America. Of particular interest will be the extent to which manufacturers use the tax incentives for capital investment in order to automate operations and, actually, undercut hiring on the factory floor
But as manufacturers have had some time to analyze the complexities of the new tax rules, some of the benefits—and a couple of drawbacks—have become apparent.
For manufacturers navigating this new tax framework, here’s the lay of the land:
Incentives to Invest in Equipment
Tax reform may not just stimulate the manufacturing sector, but may also be a boon for firms selling new manufacturing technologies. Many manufacturers, who often operate in brutally competitive segments, are looking to catch up after years of underinvesting.
The tax code changes substantially lower the after-tax cost of capital expenditures through generous depreciation and capital equipment expensing provisions.
Under revised Section 179, businesses can immediately depreciate up to $1.5 million of capital equipment (new or used), rather than the previous limit of $510,000. In addition, they now have the option to expense capital assets through 100% “bonus” depreciation retroactive to September 27, 2017.
Like Section 179, 100% “bonus” depreciation allows taxpayers to immediately depreciate the full cost of qualifying property (new or used) without a dollar limitation. That will leave more after-tax dollars to reinvest for growth.
With business loans still available at attractive interest rates, these changes should encourage manufacturers to make capital investments by taking larger loans—with the strong trade-off being that the new tax law severely limits deductions for interest on corporate debt.
The interest expense deduction is now limited to 30% of adjusted taxable income (essentially “tax EBITDA”) for companies with more than $25 million in average gross receipts. That’s a big potential negative for manufacturers, since the majority of them typically leverage up their balance sheet with debts against capital equipment.
However, companies can overcome the negative impact of the change by adjusting how they structure the ownership of equipment. Rather than owning capital equipment, firms may opt for operating leases instead, in order to deduct the cost of the lease rather than the interest on debts. This change may provide a boost for companies offering operating leases on equipment (as no interest is typically included, though the favorable expensing provisions for capital equipment would be unavailable).
Another alternative is reducing interest expense by issuing equity instead of taking on more debt. In fact, a recent report suggests that companies may use tax breaks to invest in R&D, funded in part by equity.
The research and development tax credit, which allows relatively new companies to use R&D credits to offset payroll taxes (like early-stage biotech and life science manufacturers), remains in place.
While the forced “repatriation” of foreign earnings may cause some heartburn for U.S. companies in the short-term, we expect that the removal of this tax barrier (the inability of U.S. companies to spend dollars earned internationally in the U.S. without incurring a 35% tax) will result in more investment within the U.S. in the long-term. The U.S. remains the dominant economy in the world and we believe that investors, both foreign and domestic, will want to move their capital here as a result of the stability of our government and economic system.
Company Structures: A New Order
The decrease in the overall corporate tax rate, from 35% to 21%, is a positive for manufacturers that are organized as “C” corporations. Most small- to medium-sized manufacturers are organized as pass-through entities — either taxed as partnerships or “S” Corporations — so their income is subject to tax at individual rates. (This structure is common for manufacturers in food and beverage, craft brewing and distilling, etc.).
Individual tax rates, as well as the income brackets, were also impacted favorably by the new legislation, albeit not as much as corporate rates. The net effect of the rate changes has been to put “C” corporations on a more even footing with pass through entities and individual taxpayers (after considering the second layer of tax on corporate earnings which are passed out as dividends).
A new provision under Section 199A of the tax code provides a 20% deduction for many pass-through businesses. This new deduction will benefit manufacturers organized as pass-through entities by lowering the effective tax rate on their income (at the highest individual bracket this deduction will mean pass-through income is subject to tax at approximately 32.68%, a 20% discount from the “headline” rate of 39.6%). Combined, the lower individual rates and new 199A deduction should make the tax burden between corporations and pass-through entities roughly even and marginalizes income tax burden as a consideration for choice of entity among middle-market businesses.
Many Provisions to Note
The new law also pares back an unfriendly provision of the income tax code: the Uniform Capitalization (UNICAP) rules of Section 263A. The provision was seen as onerous by many manufacturers and distributors, and increased complexity when it came to their income tax filings.
But, the new rules exclude businesses with average receipts of less than $25 million. As a result, companies with gross receipts below that threshold that had previously been subject to Section 263A can now remove those capitalized costs from their tax balance sheets and deduct them for a current tax savings.
The tax reforms kept in place what has been an important provision for exporters, the IC-Disc benefit, which was on the potential chopping block during negotiations. An Interest-Charge Domestic International Sales Corporation is a separate legal entity that receives a commission from the exporting entity. That commission is then taxed at a lower rate as a dividend to the owner of the IC-Disc. The IC-Disc does not pay any tax. Of course, with lower income tax rates, the benefit of the IC-Disc is reduced.
Manufacturers will also benefit from rules about net operating losses. Net operating losses will now carry forward indefinitely (rather than expiring after 20 years.) The downside to this “indefinite life” is that companies can only offset 80 percent of their future income with NOL deductions, paying tax on the remaining 20 percent.
The new regulations also contain some items that are, unfortunately, limiting for manufacturers.
The Domestic Production Activities Deduction under Section 199 is eliminated. That had acted as an incentive to increase production in the United States. This strategy was utilized by many outdoor and sporting goods manufacturers that manufacturers goods in the U.S. and dealt with higher labor costs. However, lower overall tax rates should make up for the loss, as do other improvements to the tax code.
The tax reform effort has been nothing short of a grand experiment, and by the end of this year we’ll truly see if it’s starting to reach the goals set, or if there will be unintended consequences to come.
Kreg Brown is a partner at consulting firm EKS&H, where his clients include manufacturing, oil & gas, mining, and technology companies. Mike Fitzgerald is an EKS&H partner focusing on federal and state income tax planning and compliance related to mergers and acquisitions.