Harmful Tax Changes You May Have Overlooked
To properly plan for your manufacturing business, you need to know the items that will affect not only your operations but the results that the taxation of your profits will have on your net after-tax income to the business or the owners. Here are three often overlooked items that could be very costly not to consider before the tax bill arrives.
1) Are you aware of the current limitations on deductible net operating losses?
On December 20, 2017, the Tax Cuts and Jobs Act (TCJA) was passed, imposing several key limitations for taxpayers. One limitation included significant changes to the historic treatment of net operating losses (NOLs) for federal income tax purposes. The TCJA included a provision limiting the NOL deduction to 80% of the current year’s taxable income for tax years beginning after December 31, 2017. The provision also changed the way excess NOLs could be treated. The TCJA eliminated the ability for NOLs to be carried back to a prior tax year and, instead, enabled NOLs to only be carried forward indefinitely. However, the significance of this law change would not be felt until tax years beginning after December 31, 2020, due to the passage of the Coronavirus Aid, Relief, and Economic Security (CARES) Act. The CARES Act placed a temporary pause on the detrimental TCJA NOL changes, in an attempt to provide economic relief during the pandemic. It is also important to note that New York State did not conform to the CARES Act regarding NOLs and therefore New York State taxpayers are required to conform to the pre-CARES, TCJA rules regarding NOL limitations and carryovers.
Under current tax law, Internal Revenue Code Section 172(a)(2), a net operating loss deduction is limited to 80% of the excess of taxable income, prior to the qualified business income (QBI) deduction, or the net operating loss.
For example, let’s assume that a corporate manufacturing company incurs a 2021 NOL of $3,000,000. The $3,000,000 NOL is carried forward indefinitely. In 2022, the taxpayer has taxable income prior to a net operating loss deduction of $1,000,000. As a result, the taxpayer’s 2022 net operating loss deduction is limited to $800,000 ($1.000,000 x 80%), resulting in taxable income of $200,000 and a new NOL carryforward of $2,200,000.
For many companies, this will come as a surprise as they thought the entire income would be eliminated.
2) Are you informed of the excess business loss limitations?
An additional limitation imposed on non-corporate taxpayers (individuals who are S corporation owners or partners in an LLC) by the TCJA includes the excess business loss (EBL) limitation. Internal Revenue Code Section 461(l) placed a dollar limit on overall net business losses for non-corporate taxpayers. The CARES Act retroactively postponed this limitation and modified the applicable tax years for the limitation to tax years beginning after December 31, 2020, through December 31, 2028. Furthermore, New York State did not conform to the CARES Act regarding excess business losses and therefore requires New York State taxpayers to conform to the pre-CARES, TCJA rules regarding excess business loss limitations and their corresponding carryovers.
An excess business loss is defined as the taxpayer’s aggregate deductions for the tax year attributable to trades or businesses, without regard to any deduction for QBI or NOLs, over the taxpayer’s aggregate gross income for the tax year attributable to trades or businesses, plus $250,000 for single filers or $500,000 for joint filers. The limitation is adjusted for inflation annually, placing 2023 limits at $289,000 and $578,000 respectively. The disallowed loss is treated as a net operating loss for future tax years.
For example, let’s assume that X is a single taxpayer and a 100% shareholder of Y, an S corporation. In 2023, X has wages of $150,000 and receives a corresponding K-1 from Y, reporting a business loss of $500,000. Based on the above, X will have an excess business loss of $211,000. X is unable to utilize the business loss to offset his taxable wages.
Code Section 461(l) limits the ability of non-corporate taxpayers to utilize trade or business losses against other sources of income.
3) Are you familiar with the new tax treatment of research and development expenditures?
One final limitation imposed by the TCJA is the elimination of deductions relating to research and experimental (R&E) expenditures under Internal Revenue Code Section 174. Historically, taxpayers incurring R&E expenditures were allowed to deduct the expenses under Code Section 174(a), capitalize and amortize the costs over a period of not less than 60 months under Code Section 174(b) or capitalized and amortized over 10 years under Code Section 59(e).
For tax years beginning after December 31, 2021, taxpayers are now required to capitalize and amortize R&E costs over five years for domestic expenses and 15 years for foreign expenses. For capitalized costs, the amortization period begins with the mid-point of the tax year in which the expenditures are paid or incurred, meaning that taxpayers are limited to only a half-year of amortization in the first year. Additionally, taxpayers must continue to amortize these capitalized costs even if the underlying property is disposed of, retired or abandoned during the amortization period.
For example, let’s assume that a manufacturer had a taxable income of $750,000 and domestic qualified R&E expenditures of $1,000,000. In 2021, the taxpayer would be eligible for a 100% expense deduction of the R&E costs, resulting in a taxable loss of $250,000. In 2022, the taxpayer would be required to amortize these costs over five years, resulting in a current-year deduction of $100,000 and taxable income of $650,000.
While several taxpayers may have felt the ramification of the NOL and excess business loss changes in 2021, it will be important to note these limitations going forward, as well as the reduced expenses relating to R&E. If you have concerns regarding these limitations and your business or personal income tax situation, we strongly encourage you to plan now and discuss these matters with your current tax advisor, or feel free to reach out to any of the professionals at Dannible and McKee, LLP.
Contributing author: Kaitlyn L. Mariano, CPA is a senior tax manager at Dannible & McKee, LLP. Kaitlyn has over 11 years of experience overseeing tax engagements for a variety of the firm’s clientele, with a large focus on manufacturers, contractors, multi-state taxation and high-net-worth individuals. For more information on this topic, you may contact Kaitlyn at email@example.com or (315) 472-9127.