After reading through the various articles that have been written about tax reform, we all understand there were a lot of changes made to the tax laws by the Tax Cuts and Jobs Act. While the Act contained many provisions aimed at lowering tax rates and accelerating deductions, it also included provisions targeted to raise tax revenue by deferring or eliminating certain deductions. What may not have caught your attention is the interplay, or give and take, that was created among several of the new tax law changes.
There is a new tax law interplay that may have a direct effect on those entities operating a manufacturing trade or business. This could create the need for study and projections, because just theorizing about how this interplay could change taxable income will be difficult. This difficulty lies in the new 30 percent limitation on the deduction for business interest expense and the ability to fully depreciate new equipment purchases in the year placed in service.
Business Interest Expense Limitation
For certain manufacturers (we’ll get into the qualifiers shortly), allowable net business interest expense will be capped at 30 percent of what is defined as “adjusted taxable income.” In this case, that term is generally defined as taxable income computed without regard to:
Unfortunately, the proposed guidance on these new rules provides that depreciation, amortization or depletion included in a business’s cost of goods sold (“COGS”) is not allowed as an addition to taxable income to compute a business’s adjusted taxable income. For many manufacturers, a significant portion of their depreciation expense relates to equipment and facilities used in their manufacturing process and is typically included in their COGS. As a result, many manufacturers have a limited ability to add back their depreciation expense when computing their adjusted taxable income, leaving them with a lower allowable interest expense deduction.
Concern for Manufacturers
There are three elements to consider when testing whether the 30 percent limitation on business interest expense should be of concern to a manufacturing business.
The first relates to gross receipts. The 30 percent business interest limitation does not apply to a taxpayer (other than a “tax shelter”) who has annual gross receipts of $25 million or less over the three prior tax years. If a manufacturing trade or business can meet that test (after considering the gross receipts of commonly controlled businesses), they will not need to limit their business interest deduction for that particular year. However, for those over the $25 million gross receipts test level, they move to the second test element.
Test element two requires that a determination of business interest available for deduction be made. The point here is that not all interest expense may arise from business activities, and any interest expense that is not considered business-interest-related, such as investment interest expense, can be excluded from the limitation for all taxpayers other than C corporations (for C corporations, all interest is “business”). For a manufacturing business, there will often be interest expense from financing equipment or inventory, as well as from funding plant additions and operations, so there will be business interest expense to contend with. Test two is rather simple: no business interest, no limitation concerns. If business interest expense is present, move on to test element three.
The third and final test element requires the calculation of adjusted taxable income, as defined above. Once the appropriate adjusted taxable income has been determined, that amount is multiplied by 30 percent. The resulting 30 percent amount is then compared to the business interest expense calculation determined in test two reduced by any business interest income. If the net business interest expense amount exceeds the 30 percent calculation, then the excess is not currently deductible. This excess becomes a carryover item to the next year and continues to be a carryover over item to succeeding years until finally used up. That brings us to the interplay with the increased ability to fully deduct equipment purchases in the year placed in service.
Full Expensing of Equipment Purchases
Operating a manufacturing business requires the replacement of equipment or the addition of new equipment as production needs develop. The new tax laws related to depreciating these items provide the ability to claim a higher depreciation amount when calculating taxable income. The additional depreciation may reduce the ability to deduct business interest expense due to the 30 percent limitation. In addition, most of these new equipment items will be financed, which will generate more business interest expense subject to the 30 percent limitation. That’s the interplay between these two new tax rules. That’s also why it is important to plan for these events, rather than just let them happen. No one likes not being able to deduct an otherwise deductible item like business interest expense. The ability to carryover any excess business interest for use in a future year should eventually provide a tax deduction, just maybe not as quickly as desired.
Planning is Key
The ability to add back depreciation expense in computing adjusted taxable income could have a dramatic impact on the business interest limitation for manufacturing businesses, especially as the result of full expensing of equipment purchases; it may result in the effective cost of new equipment purchases being increased since the potential of business interest expense being limited as a deduction will be higher. Manufacturers with a significant portion of their depreciation expense in COGS should monitor further guidance from the IRS on their ability to add back this depreciation for tax years prior to 2022. However, beginning in 2022, no depreciation add back will be allowed for any taxpayers, which will reduce the ability of all businesses to currently deduct interest expense.
While there may be changes made to the tax law, as it stands now, to mitigate the effect of the 30 percent limitation, there can be no assurance that will happen. Therefore, current planning for anticipated longer range equipment purchases takes on a great meaning. Contact your Eide Bailly professional if you have questions on how your business may be impacted moving forward.