A Review of the Tax Cuts and Jobs Act — Manufacturing and Distribution
Individual and Corporate Tax Rates
The Act lowers some individual income tax rates, relevant for businesses conducted by pass-through entities, beginning in 2018 and expiring after 2025. The Act reduces the highest marginal income tax rate applicable to ordinary income of individuals from 39.6% to 37%. However, the tax rates for capital gains and qualified dividends are left unchanged at 20%. Net investment income tax also remains unchanged at 3.8%.
For tax years beginning after December 31, 2017, the Act permanently sets the corporate income tax rate to a flat 21%. Accordingly, the aggregate effective federal income tax rate on the income of a C corporation distributed to its shareholders as a qualified dividend will be 36.8 % of pre-tax corporate income. The net investment income tax of 3.8 % also may apply to dividend income received by an individual.
Manufacturing and Distribution Insight: The choice of entity through which to conduct manufacturing and distribution activities again becomes an important decision. Among other things, key considerations include whether: (a) the asset base includes items like intangibles that are likely to appreciate over time; (b) the need to retain capital to grow the business; and (c) the likelihood of attracting capital from foreign or tax-exempt investors.
The substantial reduction in the corporate income tax rate requires issuers of audited financial statements to re-value their deferred tax assets and deferred liabilities. Historically, many companies have created net operating losses (“NOLs”) through a combination of net interest payments and other expense deductions. Many such companies have been announcing significant tax provision impacts from tax reform, since going forward their deferred tax assets in respect of NOL carryforwards will be reported at lower values, everything else being equal, because of the Act’s lower corporate income tax rate.
New 20% Deduction for Pass-through Income or Income Earned Directly
The Act adds Code Section 199A, effective for tax years beginning after December 31, 2017 and before January 1, 2026, that provides for a potential deduction/exclusion of up to 20% of “Qualified Business Income” (“QBI”) earned by an individual, trust or an estate from a partnership, S corporation, or sole proprietorship. QBI generally includes income from operating any trade or business, except for certain “specified service businesses” that may be limited by other wage and capital based measures, discussed further below. QBI does not include any wages earned by an employee of any business.
- There are no limitations for deducting 20% of qualified trade or business income earned directly from a pass-through entity for married filing jointly taxpayers with taxable income less than $315,000 and $157,500 for individuals filing single. However, the 20% deduction, without further limitation, is phased out ratably on taxable income above $315,000 and completely at taxable income of $415,000 for married filing jointly taxpayers, and on taxable income above $157,500 and up to $207,500 for single filers.
- For taxpayers with taxable income above the phase out threshold amounts discussed above, the following additional requirements apply to qualify for the 20% deduction:
- The business must not be a “specified service business” - generally defined as any trade or business activity involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, investing and investment management, trading, or dealing in securities, partnership interests or commodities, and more broadly any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners. Engineering and architectural services do qualify.
- The amount of the potential deduction for QBI cannot exceed the greater of - 50% of W-2 wages paid by the qualified business, or the sum of 25% of W-2 wages paid by the qualifying business and 2.5% of the unadjusted basis of tangible, depreciable property.
Manufacturing and Distribution Insight: Given that many manufacturing and distribution businesses are organized as pass-through entities, the analysis of this potential benefit will have broad application. When it comes to applying the limitations applicable to higher income earning taxpayers, a challenge is that certain segments of the distribution industry typically may have varying amounts of W-2 employees in comparison with other industries. On the other hand, the wage based limitation may be counter-balanced by the capital-intensive nature of a manufacturing business. Lastly, the nature of the manufacturing or distribution business must be considered when connecting these dots.
It will be also important to consider the nature of the income generated by the different sectors within the manufacturing or distribution business. On its face, the income from traditional integrated manufacturers with a comprehensive suite of intellectual property, workforce in place, goodwill, and other intangible assets would seem to have more potential benefit in comparison with fund managers and other investors that pursue capital appreciation. Fortunately for funds, the long-term capital gains rates are unchanged under the Act and remain at preferential rates in comparison with ordinary/operating income even after the application of the Code Section 199A deduction. Finally, the major challenge and some of the uncertainty in analyzing and applying these provisions as currently written pertain to applying the qualification standards in relation to specified service business definitions, and the quantification issues associated with allocating and matching employee wage payment arrangements with income streams, and unadjusted basis measures for capital investments.
There is a lot of uncertainty surrounding this new tax provision. For example, it is unclear as to all the various types of businesses that potentially qualify for the deduction, especially for the various service type businesses that are not specifically excluded. We will need to wait for federal guidance to address these areas of uncertainty.
Note: For tax years beginning after Dec. 31, 2017, the domestic production activities deduction (DPAD) is repealed; (former Section 199). Under former Section 199 taxpayers could claim a deduction with respect to income derived from qualified production activities. Such income included income derived from - property manufactured, produced grown or extracted within the U.S.; qualified film productions; production of electricity, natural gas or potable water; and construction activities performed in the U.S.
Limitation on the Deduction of Net Business Interest Expense
The Act amended Code Section 163(j) for tax years beginning after December 31, 2017 to disallow deductions for business interest expense that exceeds the sum of 30 % of “adjusted taxable income” (“ATI”) plus the business interest income for the taxable year. ATI for taxable years beginning after December 31, 2017 and before January 1, 2022 is taxable income other than items not applicable to a trade or business, business interest income and expense, depreciation, amortization, and depletion, the amount of any 20% deduction for qualified business income, and NOLs. ATI can be thought of simply as an EBITDA-type measure until tax years beginning after December 31, 2021, at which point depreciation, amortization, and depletion would be deducted in the calculation of ATI, changing it into an EBIT-type measure. (A special rule is carved out for “floor plan financing expense” incurred by motor vehicle dealers and lessors). Also, though there is a small business exception enabling certain small businesses with average annual gross receipts under $25 million over three prior years to avoid having their interest deduction limited. However, those small businesses organized as partnerships for tax purposes may be unable to use the small business exception if losses above a special 35% threshold are allocated to certain partners.
Disallowed interest expense deductions will be treated as net operating losses (NOLs) and carried forward indefinitely and can be potentially utilized in subsequent years. Interest expense on existing debt instruments is not “grandfathered.” Special rules apply for partnerships and subchapter S corporations in computing the partner’s or shareholder’s business interest limitation. This limitation does not apply to “small business” taxpayers (other than tax shelters) with average annual gross receipts over a 3-year period of not more than $25 million.
Manufacturing and Distribution Insight: The limitation on deductions for net interest expense may be conceptualized as an issue of geography. Instead of adding interest expense deductions to NOLs, manufacturing and distribution businesses will have a separate net interest expense carryforward, which may be at least partially utilizable upon a liquidity event because of the additional taxable income that may arise from a disposition transaction. While this new treatment of net interest expense provides a separate and distinct limitation for many businesses, familiar tax planning concepts are still generally relevant with modifications.
Changes Regarding Depreciation
The Act increases the “bonus depreciation” deductibility percentage from 50% to 100% for property acquired and placed in service after September 27, 2017, and before January 1, 2023. Thereafter, the bonus depreciation percentage phases down by 20% per year for most assets, except for certain property with longer production periods. Hence first-year bonus depreciation will no longer be available after 2026. Importantly however, in a significant change from prior law, the new law allows assets eligible for bonus depreciation to apply to purchases of both new and used property.
Manufacturing and Distribution Insight: While certain real property trades or businesses must use the Alternate Depreciation System (“ADS”), bonus depreciation will still be available for eligible property, other than real property and qualified improvement property, with 100% depreciation available for property that currently qualifies for bonus depreciation and that is acquired and placed in service after September 27, 2017 and before January 1, 2023. But bonus deprecation will gradually phase down after December 31, 2022.
Section 179 Expensing
Code Section 179 was modified, increasing the maximum amount of “eligible property” that can be deducted to $1 million, from $500,000, and the phase-out amount was increased from $2.0M to $2.5 million.
Manufacturing and Distribution Insight: The increase in the amount can be expensed under Section 179 is meaningful, and the property eligible for expensing now includes certain improvements to real property.
Limitation on Excess Business Losses
The Act provides that, for years beginning after December 31, 2017 and before January 1, 2026, the excess business losses of a taxpayer other than a C corporation are not allowed for the tax year. An excess business loss is the excess of the taxpayer’s aggregate deductions from a trade or business over the sum of the taxpayer’s aggregate gross income from a trade or business plus $250,000 ($500,000 in the case of a joint return). Any loss that is disallowed as an excess business loss is carried over and treated as part of the taxpayer’s NOL carryforward. (Under the Act, NOL carryovers are subject to a limitation, see below). For partnerships and S corporations the excess business loss limitation applies at the partner and shareholder level. Note that the excess business loss limitation applies after the application of the passive loss rules.
Manufacturing and Distribution Insight: The excess business loss limitation basically limits the ability of non-corporate taxpayers to use trade or business losses to offset other sources of income.
A taxpayer’s NOL deduction arising in 2018 or later is now limited to 80% of the taxpayer’s taxable income. In addition to this limitation, the Act generally eliminates the ability to carryback NOLs to prior tax years. However, the Act now allows NOLs to be carried forward indefinitely, in comparison to the general 20-year carryforward limit under prior law. These new rules apply only to newly created NOLs. As a result, pre-Act NOLs are still subject to the 20-year carryforward limitation.
Manufacturing and Distribution Insight: Analyzing the timing of deductions will be important to determine whether deductions that may go unused and create an NOL in one year, may then be limited in future years that have significant projected income, as well as the interplay with the newly enacted limitation on the deduction of net interest expense. For example, it may be less beneficial to take accelerated depreciation for a value-add investment with a significant projected gain on disposition if there is relatively low net operating income before depreciation projected during the holding period.
Interest and depreciation deductions are two of the more significant manufacturing and distribution related deductions that should be analyzed in relation to the NOL limitation. This interplay becomes even more pronounced in 2022 when adjusted taxable income for purposes of the interest expense limitation transitions from EBITDA to EBIT.
Further, the relationship between the business interest deduction and ADS depreciation limitations discussed above are interactive variables in regards to this analysis. Once again, potentially unused accelerated depreciation deductions may be less beneficial than preserving tax basis which would not be subject to the NOL limitation. Note that there is flexibility in the tax planning associated with asset classification and choice of depreciation method that impacts the timing and amount of depreciation deductions. Individual manufacturing investments held in separate corporate form will be particularly important to analyze (including the typical “leveraged blocker structure” that many offshore investors in US portfolio company activities utilize) to avoid the risk of having NOLs or interest expense carryforwards go permanently unutilized, for example because of a transaction implicating Section 382 limitations.
State Tax Caveat
Taxpayers must check the extent to which their respective States have adopted some or all the new provisions in the Act.
Deemed Repatriation Mandatory Income Inclusion
U.S. shareholders of controlled foreign corporations (“CFCs”) and certain other specified foreign corporations are required to recognize on their 2017 tax returns their pro rata shares of the deferred foreign earnings of such CFCs to the extent not previously subject to U.S. tax. The amount of the tax will be based roughly on the CFC’s retained earnings, modified in accordance with U.S. tax principles. Such amounts will be taxable to domestic C corporations at a rate of 15.5%, to the extent of the CFC’s cash, cash equivalents, and net accounts receivable, and 8% to the extent of any deferred earnings more than the CFC’s cash position (slightly higher rates apply to individuals). An election is available to defer the payment of such tax over eight annual installments. Shareholders of subchapter S corporations are eligible to defer payment indefinitely, until the occurrence of certain liquidity events, so long as the deferred tax liability is reported on the 2017 return.
The amount of the deemed repatriation mandatory income inclusion tax must be carefully estimated right away, with the first installment payment due on April 15 of this year.
Manufacturing and Distribution Insight: Underpayments of the deemed repatriation mandatory income inclusion tax and other foot-faults in compliance are among the enumerated triggering events that may cause acceleration of tax liability. Therefore, prompt attention to this matter is of the utmost importance.
Expansion of Subpart F via Newly Created “GILTI” Rules
The Act expands the “subpart F” regime of currently taxing certain activities of CFCs by establishing a new class of subpart F income, known as “GILTI,” which is short for global intangible low-taxed income. Such GILTI is determined on a formulaic basis, as roughly the amount of a US shareholder’s pro rata shares of net CFC profits more than 10% of investment in tangible assets. Since most CFCs have incomes greater than 10% of fixed assets, most CFCs will have GILTI that will need to be included on the US shareholders’ returns.
Manufacturing and Distribution Insight: The Act’s expansion of the subpart F regime has significance for manufacturing and distribution because such a large share of the incomes of fully integrated manufacturers are effectively attributable to workforce in place, goodwill, going concern value, and other intangible assets. The formulaic calculation of GILTI as the excess of profits earned, over 10% of fixed assets, makes it harder to plan around GILTI, since shifting assets and activities among different CFCs would have little or no effect on the net GILTI determination.
Deductions for Deemed Intangible Income of Domestic C Corporations from International Activities
The Act establishes certain incentives for investments in intangible assets, somewhat analogous to the patent box regimes enacted by other countries. The Act permits domestic C corporations to deduct a sizeable portion of GILTI and FDII (the latter of which stands for “foreign-derived intangible income”). Such special deductions make the effective tax rates on deemed intangible income of domestic C corporations much lower than the corporate tax rate of 21%.
In short, the special deduction for GILTI applies to the deemed intangible income of CFCs held by domestic C corporations, while the FDII deduction is based on the deemed domestic intangible income that a C corporation derives from foreign sales (excluding sales of foreign branch activities). Both the GILTI and FDII rules are subject to special conditions and limitations requiring careful analysis of forward-looking tax planning as well as annual tax compliance.
Manufacturing and Distribution Insight: From a planning perspective, it is especially important to consider that the FDII deduction arising from the portion of deemed intangible income of a domestic C corporation attributable to foreign sales and services revenue is subject to significant limitations. For example, income derived from the domestic corporation’s foreign branch activities is technically excluded as a component of the FDII deduction. Moreover, the foreign branch income of a domestic C corporation and the GILTI income of its CFCs are treated as new, separate foreign tax credit limitation baskets of the US shareholder, thereby decreasing possibilities for cross-crediting among multiple foreign activities. Thus, planning to optimize the relative FDII and GILTI deductions will implicate several technical trade-offs and will require financial modeling.
Limited Participation Exemption for Certain International Activities Conducted via CFCs
To the extent a CFC’s income is not otherwise included as subpart F income or GILTI of the U.S. shareholder, the Act provides that dividends paid by a CFC, in respect of its non- previously taxed, foreign-source earnings, may qualify not to be taxed as a dividend by U.S. shareholders that are domestic C corporations, thereby potentially favoring the use of domestic C corporations to hold CFCs.
Manufacturing and Distribution Insight: The Act’s new participation exemption is subject to several important limitations. For example, individuals do not qualify for the participation exemption. Moreover, dividends received from a foreign corporation in respect of hybrid financing arrangements qualify for neither the participation exemption nor foreign tax credits. Nevertheless, in many typical situations CFC dividends received by domestic C corporations should qualify for the participation exemption. The combination of the newly enacted GILTI and FDII deductions described above, along with the participation exemption may prompt many businesses to restructure their international activities into domestic C corporations.
New Base Erosion Anti-Avoidance Tax (“BEAT”)
The Act includes a new add-on tax in respect of outbound payments (e.g., interest expense, royalties and other license fees, certain services, etc.) made by large domestic corporate groups to non-U.S. entities. The base erosion minimum tax amount is the excess of a percentage of the modified taxable income over the taxpayer’s regular tax liability, ignoring a portion of certain general business tax credits, which has the effect of severely limiting certain tax credits for taxpayers subject to the BEAT.
Manufacturing and Distribution Insight: The impact of the new BEAT tax is not limited to foreign-owned multi-nationals. The BEAT also applies to certain outbound payments made by U.S. multi-nationals to CFCs, such as cost center entities outside the U.S. Currently, the BEAT’s general business credit limitation carves out the R&D tax credit, so we continue to recommend that innovative companies perform R&D credit studies to qualify for all of credits for which they are eligible.
Financial Statement Considerations
In December 2017, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 118 ("SAB 118"), which provides guidance on the accounting for certain tax effects of the Act. SAB 118 may be applied by both public and private companies and addresses when a company is unable to complete its income tax accounting for the Act’s enactment in time to meet financial reporting deadlines. SAB 118 applies to tax effects whose accounting is incomplete and, therefore, a company’s financial statements must reflect the specific income tax effects of the Act for which the accounting under ASC 740 has been completed. SAB 118 provides a measurement period, which cannot extend beyond one year from the enactment date, for companies to complete their initial income tax accounting for the Act. SAB 118 may only be applied to tax effects for which a company does not have the necessary information available in reasonable detail to complete its income tax accounting under ASC 740, Income Taxes. Under SAB 118, a company would recognize provisional amounts in its financial statements for specific income tax effects of the Act that are incomplete, but for which reasonable estimates can be made. If a company cannot make a reasonable estimate for an incomplete income tax effect, ASC 740 would be applied to the incomplete tax effect based on the provisions of the tax law in effect immediately before the enactment date. Companies applying SAB 118 will adjust provisional amounts based on additional information that, if had been known, would have affected the income tax effects reported as provisional. Further, SAB 118 requires provisional amounts to be recognized during the measurement period for incomplete tax effects for which reasonable estimates could not initially be made. All provisional amounts are subject to adjustment during the measurement period. SAB 118 also includes specific disclosure requirements.
Our overall view is that the manufacturing and distribution sectors on a net basis have fared well under the Act by the reduction in the federal corporate income tax rate, notwithstanding having been tempered by the Act’s adverse changes in business taxation. Aside from certain ancillary changes to the U.S. federal taxation of international activities, we believe there are substantial benefits that were either retained or created by the Act for manufacturing and distribution investors, owners and operators. In our view, the most significant manufacturing and distribution related items that the Act provides are the:
- Deduction of up to 20% of qualifying pass-through business income that may apply to certain manufacturing and distribution related income;
- Retention and, in some cases, improvements to the property cost recovery rules;
- Deductions for the foreign deemed intangible income of domestic C corporations directly derived (not through branches);
- Deductions for the deemed intangible income of domestic C corporations’ CFCs;
- Limited participation exemption for certain international activities conducted via CFCs.
We are currently advising our clients to analyze the impacts of the Act in relation to existing investments, business strategies and entity structures. As we move into 2018, the effective dates of the provisions become immediately relevant, requiring quick analysis to evaluate the tax issues and opportunities that may require the execution of structural changes.
With the corporate tax rate reduced to 21%, establishing C corporations as tax structuring entities may now become more of a consideration for ordinary-income producing investments. However, the attractiveness of the comparatively low corporate tax rate must be balanced with the double taxation that applies when corporate dividends are taxed in the hands of the shareholders. Capital preservation and reinvestment strategies for the deferral of gain recognition will be more of a consideration as opposed to opportunistic value-creation and exit strategies. Additionally, operational and management oriented businesses may be worth considering using corporate structures, whereas previously flow-through LLCs and S corporations were traditionally considered the primary choice entity-types.
First, the short list of items that we feel are most advantageous to analyze quickly are, the eligibility for a 20% deduction for pass-through QBI earned by principals of pass-through entities, factoring in structurally how and where employees and capital investment exists within a manufacturing or distribution business platform. A fresh analysis of the existing structure of a multi-strategy private equity platform will undoubtedly highlight benefits and burdens under the Act because of the income and deduction quantification and qualification criteria contained in the arguably two most significant provisions that impact the manufacturing and distribution sectors.
On the opposite side of the legal-entity choice continuum, the new deductions available to domestic C corporations for foreign derived deemed intangible income as well as the deemed intangible income of CFCs will cause many domestic pass-through entities to consider establishing corporations to hold foreign activities. Going a bit deeper, the international activities of U.S. multinational organizations in many cases can be structured more efficiently because of the changes brought by the Act. In some cases, these structuring choices will involve tax-technical trade-offs requiring financial modeling based on the taxpayer’s anticipated activities.
As an overview of private equity considerations, at the fundraising stage U.S. tax issues are faced by investors and investment sponsors utilizing typical structures interposed between the capital and the ultimate private equity investment. Our initial view is that many of the tax strategies and structures implemented to manage tax liabilities for investors in U.S. private equity will remain intact and in many cases, will be positively impacted by the Act’s tax rate reductions. For example, the reduction of the corporate tax rate to 21% results in less tax burden for those offshore investors in U.S. private equity that have traditionally invested through corporate structures.
During the value-creation period of the private equity or portfolio company investment continuum, cost segregation studies will continue to be effective for analyzing and properly documenting fixed asset classification, and maximizing depreciation deductions using accelerated cost-recovery methods and 100% bonus-depreciation. Lastly, R&D expense studies continue to be the best path to identify tax incentives for which innovative manufacturing and distribution companies generally qualify.
Entering the disposition phase of a private equity or portfolio company investment, reduced individual tax rates on ordinary-income producing investment, and reduced corporate tax rates will improve after-tax internal rate of return on existing investments that were underwritten considering higher tax rates under prior law. For example, the reduced corporate tax rate will significantly benefit non-US investors that hold US investments in US corporate structures. Accordingly, reduced income tax rates and the preservation of long-term capital gains rates may prompt certain U.S. investors to reconsider their portfolio disposition strategies. Finally, it is difficult to talk about tax reform in the private alternative investment community without discussing the issue of “carried-interest.” As mentioned above, provided the underlying investment generating long-term capital gain was held for more than three years, the carried interest allocation of the capital gain will retain its long-term capital gain character in the hands of the fund sponsor. Fortunately, in most cases, the value created by fund managers during the typical private equity investment continuum occurs over an investment holding period of 3 years or more.
This has been prepared for informational purposes, is general guidance only and does not constitute legal or professional advice. You should not act upon the information contained in this publication without first obtaining professional advice specific to, among other things, your individual facts, circumstances and jurisdiction. No representation or warranty (express or implied) is made as to the accuracy or completeness of the information contained in this publication, and CohnReznick LLP, its partners, employees and agents accept no liability, and disclaim all responsibility, for the consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it.