This continues to be a tumultuous year for American manufacturers, with some just barely surviving and others experiencing modest slowdowns or limited growth. Despite the current environment, manufacturers need to begin to consider the tax implications of events that have already occurred, and that are expected to occur during the remaining days of 2022.
Here are some tax-planning strategies that manufacturers should be aware of during the planning process.
R&D Tax Credit
The pandemic has led manufacturers to transform their operating models and change their product offerings, manufacturing processes and technologies. Some even pivoted to production of personal protective equipment. Further, because of the Covid-19 pandemic, manufacturers invested in new areas of technology to let employees work remotely, as well as to create a touchless environment for work, services and products.
The tax credit for increasing research and development activities, known as the R&D tax credit, is available for manufacturers that develop new and innovative products, and that improve their production processes. The R&D tax credit provides a tax incentive for companies already engaged in R&D activities, and covers more
activities within a company than just the “lab coat” team. An Internal Revenue Service directive issued in late 2017 provides a safe harbor for certain large organizations to follow the accounting for R&D expenses as they are reported in the company’s financial statements.
The R&D credit is one of the most overlooked tax credits. It should be an integral part of every manufacturer’s 2022 tax-planning strategy.
Section 263A, Uniform Capitalization of Costs to Inventory (UNICAP)
Inventory is often one of the largest assets on a manufacturer’s balance sheet, and historic UNICAP methods are often complicated and out of compliance with IRS regulations.
There are two potential money-saving items with UNICAP for 2022. First, small companies with average gross receipts under $27 million can take advantage of the simplified accounting methods included in the Tax Cuts and Jobs Act. Qualifying companies are no longer subject to UNICAP and can change their accounting methods. UNICAP reserves from prior years may be written off and deducted.
Second, large companies can review the final UNICAP regulations to see if changes can be made to current methods of calculating the UNICAP reserve, and reduce the amounts required to be capitalized each year.
Historic Absorption Ratio
Related to UNICAP is the historic absorption ratio. HAR allows a manufacturer or distributer to analyze its UNICAP costs over the prior few years and, if criteria are met, elect to fix the capitalization rate to a percentage based on the prior year’s average. The fixed rate stays in effect for several years. Using HAR can eliminate the detailed UNICAP calculations every year, and can provide more predictability for projecting and estimating tax liabilities.
Evaluating Accounting Methods
Manufacturers should evaluate all tax-accounting methods from 2020 to increase losses and defer recognition of revenue in 2022, and to minimize 2022 tax liabilities. It’s also possible to create a net operating loss to take advantage of net operating loss planning.
A few accounting methods to evaluate include changing from the cash basis to accrual basis of accounting, or vice versa; doing inventory planning with UNICAP methodology and electing new inventory methods; accelerating deductions or electing to capitalize prepaid expenses; electing to recover self-developed software cost over 36 months or currently deduct; deferring amounts received from advance payments for goods and services; properly using the recurring-items exception for taxes, rebates and refunds; and accelerating recovery of real property through cost segregation or repair studies.
Last-In-First-Out Inventory Method
The LIFO inventory method should be evaluated for any manufacturer or distributor that is encountering rising prices. Inflation has picked up in several industries, and markets are affected by tariffs or the threat of tariffs. LIFO is still available and is most beneficial when a company is experiencing increasing prices or costs to inventory. Many considerations are involved with choosing and applying a LIFO method, but tax savings can be significant.
Corporate Tax-Planning Strategies
The Tax Cuts and Jobs Act reduced the corporate tax rate to 21 percent, and for pass-through businesses, the qualified business income deduction (QBI) effectively dropped the maximum tax rate of owners to 30 percent or less. Now that we have worked with the complex QBI rules for a year, there may be an opportunity to again consider the entity choice for operating the business.
Is a C corporation a good choice? Should the company operate as an S corporation or as a partnership? Can my partnership convert to a C corporation and enjoy the lower corporate 21 percent rate? What role do state and international considerations factor in my decision? What is the future exit strategy, and can I qualify as having qualified small business stock?
We can assist the company’s owners with these discussions by applying our Business Entity Analysis Model to various “what if” scenarios.
Pass-Through Qualified Business Deduction Planning Under 199A
Pass-through manufacturers are entitled to a deduction of up to 20 percent of their QBI for 2022 if taxable income exceeds $340,100 for a married couple filing jointly, or $170,050 for singles and heads of household. The amount of the limitation is based on the amount of W-2 wages paid by the trade or business, and/or the unadjusted basis of qualified property (such as machinery and equipment) held by the trade or business.
Manufacturers may be able to structure current-year income or deductions to maximize the benefit of QBI from year to year. Manufacturers may also look to adjust W-2 wages before year’s end if a limitation is expected.
Thoughtful planning is required to navigate the complex rules related to QBI, specifically if the manufacturer has Paycheck Protection Program loan forgiveness occurring in 2022. Planning for year-end 2022 should include discussion of salaries, timing and distribution of income.
Also, be aware that taxpayers who claim the QBI deduction must now show how they calculated QBI using Form 8995. Each business must stand separately and will require its own Form 8995.
Capital Expenditure Expensing Under Section 179
In addition to the 100 percent bonus depreciation, there is a higher Section 179 expensing election available for 2022. The threshold has been increased to $1,080,000, and the point at which qualified purchases are phased out is $2.7 million for 2022.
This deduction applies to most depreciable property (other than buildings) and off-the-shelf computer software. A recent change in the rules affects the eligibility to deduct qualified improvement property (any interior improvement to a building’s interior, but not for enlargement of a building, elevators or escalators, or the internal structural framework) for roofs, and for HVAC, fire protection, alarm and security systems.
The expensing limit that applies this year means that many manufacturers that make timely purchases will be able to currently deduct most if not all their investment for machinery and equipment. An added benefit is that taxpayers can plan to place assets in service at the end 2022, but still enjoy a full deduction up to the 2022 limitation threshold. Thus, property acquired and placed in service in the last days of 2022 can result in a full Section 179 expense deduction for 2022.
Maximize Deductions With Asset Capitalization Policy
The tangible property regulations issued a few years ago instituted one more opportunity for deducting equipment costs. Manufacturers with established capitalization policies can expense small purchases of equipment and supplies up to $2,500 per item or per invoice when the company does not have an applicable financial statement; and up to $5,000 if the company does have an applicable financial statement. These purchases can be directly deducted if rules are followed for financial accounting and tax return reporting.
CARES Act Employee Retention Credit
The Employee Retention Credit (ERC) continues to provide a wide variety of employers with lucrative, refundable payroll tax credits for qualified wages paid to employees in 2020 and through Sept. 30, 2021. Businesses can still apply for the ERC by filing an amended Form 941X (quarterly federal payroll tax return) for the quarters during which the company was an eligible employer.
As the end of the year approaches, manufacturers that have not claimed the credit still have an opportunity to review whether they are eligible and can amend returns to claim credits not previously reported.
Covid-Related Employee Compensation and Benefit Impact Analysis
Many manufacturing workplaces have undergone shifts in 2022 with the Covid-19 pandemic. Manufacturers need to understand and evaluate the long-term impact of having remote workers. All these changes have tax implications.
In addition to the assistance-related measures, manufacturers need to consider these workforce-related areas in year-end planning: employer payroll tax deferrals; equity compensation changes; deferred compensation payments; employee home office or other remote work expenses; paid time off policies, including donations of paid time off; and retirement plan adjustments.
Changes in these areas may have already been implemented, but nevertheless need to be evaluated for year-end tax-planning purposes. Remember, these areas can help manufacturers with liquidity situations, or to further assist employees.
Foreign Derived Intangible Income Deduction (FDII)
FDII is a new incentive from the Tax Cuts and Jobs Act for corporations that export goods. For corporations, FDII has the effect of cutting the net tax rate on foreign source income companies to as low as 13 percent. This tax incentive is not available for businesses operating as partnerships and corporations, which is another reason to consider the choice of entity for operating the company. A well-qualified tax team can assist in evaluating whether the FDII incentive is available and practical for your situation.
Multinational manufacturers will want to consider foreign tax credit (FTC) planning throughout 2019 and 2021. There are many FTC regulation packages that set forth rules and elections that may limit the ability to use excess FTCs going forward. Accordingly, manufacturers with significant FTC carryforwards should carefully consider how their unused FTCs may be limited. The CARES Act granted taxpayers an extended carryback period for net operating losses. Manufacturers taking advantage of these new carryback periods need to consider how this affects FTC positions.
For companies with Covid-19 remote workers, an additional consideration is the nexus and withholding analysis. Because of mandatory stay-at-home or shelter-in-place orders, many employees lived or spent time during the pandemic in states and localities that are different from the home office or manufacturing facility, especially when located near state borders. Nexus could be established by the presence of an employee in a state, even if activities of the employee are home-based; shifting of employee responsibilities to remote locations could affect apportionment of income, depending on the specific state rules; and as a rule, a day spent working from home in a state because of the pandemic may be counted for purposes of allocating state wages for withholding tax purposes. Each state has different rules and exceptions, including specific Covid provisions.
Manufacturers should consider a review of their employee locations, payroll systems, withholding responsibilities and unemployment obligations considering the remote employee activities.
Manufacturers should consider these tax-planning strategies regarding credits, deductions and other tax-savings opportunities in their 2022 current and year-end planning strategies.
This article was originally published in the June 2022 issue.