2020 has been a tumultuous year for American manufacturers with some just barely surviving while others are 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/or events expected to occur during the remaining days of 2020.
Below are more than 15 tax planning strategies and considerations that manufacturers should be aware of during 2020 year-end planning:
1. R&D Tax Credit
The pandemic has led many manufacturers to dramatically transform their operating models and change their product offerings, manufacturing processes, technology and even pivot to the production of PPE. Further, as a result of the COVID-19 pandemic, manufacturers likely invested in new areas of technology to enable employees to work remotely, create a touchless work environment, and provide services and products.
The tax credit for increasing research and development activities (“R&D tax credit”) is available for manufacturers that develop new and innovative products and 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 IRS 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 and is an integral part to every manufacturer’s 2020 tax planning strategy. Watch this video on R&D Credit with Ron Wainwright for more information.
2. Section 263A, Uniform Capitalization of Costs to Inventory (“UNICAP”)
Inventory is often one of the largest assets on the balance sheet of a manufacturer, and historic UNICAP methods are often complicated and out of compliance with IRS regulations.
There are two potential money-saving items with UNICAP for 2020. First, small companies with average gross receipts under $26,000,000 can take advantage of the simplified accounting methods included in the Tax Cuts and Jobs Act (“TCJA”). 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.
3. Historic Absorption Ratio
Related to UNICAP is a method entitled the Historic Absorption Ratio (“HAR”). This method allows a manufacturer or distributor 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 provide more predictability for projecting and estimating tax liabilities.
4. Deductions and Revenue Planning by Evaluating Accounting Methods
Manufacturers should evaluate all tax accounting methods in 2020 to increase losses and defer recognition of revenue in 2020 and to minimize 2020 tax liabilities, while also potentially creating a net operating loss so as to take advantage of net operating loss planning under the CARES Act.
A few of accounting methods to evaluate include:
- Changing from the cash basis to the accrual basis of accounting, or vice versa
- Inventory planning – UNICAP methodology and review 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, refunds
- Accelerating the recovery of real property through cost segregation or repair studies
5. CARES Act Net Operating Loss Planning
The CARES Act gives temporary reprieve from TCJA provisions that stopped the carryback of net operating losses (“NOLs”) and limited their use to 80% of taxable income. Regarding NOLs, the CARES ACT:
- Grants a five-year carryback period for NOLs arising in tax years beginning January 1, 2018 and ending December 31, 2020.
- Temporarily suspends the 80% of taxable income limitation on the use of NOLs, allowing taxpayers to fully offset taxable income during the allowed tax years, regardless of when the NOL was generated.
- Corporations that wish to waive the NOL carryback period for 2018 and 2019 tax years may do so for the first taxable year ending after March 27, 2020.
Manufacturers should evaluate taking advantage of the carryback by amending or modifying tax returns for tax years dating as far back as 2013 and unlocking higher pre-TCJA tax rates.
6. Last-In-First-Out (“LIFO”) 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 impacted 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.
7. Disallowed Deductions
TCJA instituted lower tax rates and many tax incentives. But to pay for these rates and incentives TCJA also disallowed certain business deductions and limited others. Year end is an excellent time to consider the impact of interest expense limitations, entertainment expenses, and the cost of providing employee parking. Make sure you consider these limitations when reviewing your year-end planning.
8. Corporate Tax Planning Strategies
TCJA 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, this 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% 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 (“BEAM”) to various “what if” scenarios.
9. Debt to Equity Planning to Minimize Interest Expense Limitations under 163(j)
Section 163(j) generally limits a manufacturer/taxpayer business interest expense deduction to the business interest income for the year and 30% of the adjusted taxable income. The CARES Act increased this to 50% for certain years depending on the taxpayer entity type. Final regulations were released in July 2020 that provides for a taxpayer-favorable change from the 2018 regulations and includes the following:
- Adding back depreciation, depletion and amortization capitalized under 263A in computing adjusted taxable income
- Applying a narrower definition of interest
- The increasing availability of the real property trade or business elections
Prior to the end of the year, manufacturers should consider converting debt to equity or refinancing debt in order to reduce the amount of interest subject to the 163(j) limitation.
10. Pass-Through Qualified Business Deduction Planning under 199A
Pass-through manufacturers are entitled to a deduction of up to 20% of their QBI for 2020 if taxable income exceeds $326,600 for a married couple filing jointly, $160,700 for singles and heads of household, and $163,300 for married filing separately. 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.
To the extent possible, 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 end if a limitation is expected.
Thoughtful planning is required in order to navigate the complex rules related to QBI, specifically if the manufacturer has PPP loan forgiveness occurring in 2020. Planning for year-end 2020 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.
11. Capital Expenditure Expensing under Section 179
In addition to the 100-percent bonus depreciation, there is a higher Section 179 expensing election available for 2020. The threshold has been increased to $1,000,000 and the point at which qualified purchases are phased out is $2,550,000 for 2020.
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 now deduct qualified improvement property (generally, 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 2020, but still enjoy a full deduction up to the 2020 limitation threshold. Thus, property acquired and placed in service in the last days of 2020 can result in a full section 179 expense deduction for 2020.
12. 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 set rules are followed for both financial accounting and tax return reporting.
13. CARES ACT Employee Retention Credit – Not Too Late to Take Advantage
The CARES Act Employee Retention Credit provides a refundable payroll tax credit for 50% of qualified wages (up to $10,000 of wages) paid or incurred by employers between March 1, 2020 and December 31, 2020.
As the end of the year approaches, manufacturers that have not claimed the credit and did not receive a Paycheck Protection Program Loan still have an opportunity to review whether they are eligible and can amend returns to claim credits not previously reported.
14. COVID-related Employee Compensation and Benefit Impact Analysis
Many manufacturing workplaces have undergone fundamental shifts in 2020 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
- 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.
15. Foreign Derived Intangible Income Deduction (“FDII”)
FDII is a new incentive from TCJA 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 S corporations, which is another reason to consider the choice of entity for operating the company. Cherry Bekaert’s International Tax team can assist in evaluating whether the FDII incentive is available and practical for your situation.
Additional Consideration: Multi-National Manufacturers – Foreign Tax Credit (“FTC”) Planning
Throughout 2019 and 2020, Treasury has issued many FTC regulation packages setting 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 NOLs. Manufacturers taking advantage of these new carryback periods need to consider how this affects FTC positions.
Additional Consideration: COVID-19 Remote Workers – Nexus and Withholding Analysis
COVID-19 caused many manufacturers to change how employees perform their duties with mandatory stay-at-home or shelter-in-place orders effective in every state. Many employees may have 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.
Manufacturers should consider the following:
- 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.
- As a general rule, a day spent working from home in a state due to the COVID-19 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, unemployment obligations considering the remote employee activities.
Conclusion
Manufacturers should take time to consider if these policies, deductions, credits and other tax savings opportunities apply to their 2020 year-end tax planning strategies. Consult with credits and accounting professionals for advice and guidance.
