Understanding the Impacts of the Tax Cuts and Jobs Act on Manufacturing and Distribution
Manufacturing & Distribution
Fortunately, we’ve got two folks here at Aprio, Kerry Defler, who is a partner in our tax practice and focuses predominately on manufacturing, distribution companies, and Kristin Maeckel who is in our international practice and also focuses predominantly on manufacturing, distribution companies, that are here today to make sense of it all for you. The two of them and others throughout the firm have spent the last few weeks combing through the information and really pulling out the pieces of information that will provide the most valuable and insightful information to folks like you in the manufacturing and distribution industry.
The topics we’re going to spend a lot of time on are the corporate aspect of the new tax legislation and the international aspect. Obviously with everybody here being an individual, we’ll touch upon the individual aspects of the new legislation. Maybe at a 25,000-30,000 foot level, but enough to give you an understanding of some of the more significant things as it relates to the new individual changes in the new legislation.
Our ultimate goal today is to provide valuable information that you can take back as somebody works the manufacturing and distribution industry that you can take back and make informed decisions for your company. With that, I’m going to ask Kerry Defler to start today’s webinar.
Kerry Defler: Thank you, Adam, I appreciate that introduction. As Adam mentioned, there’s a lot to cover here today and hopefully you’ll find all of this to be beneficial. We’re going to talk about the Tax Cuts and Jobs Act. I’ve been with the firm 20 years in June. For my entire career, all you hear in the news about tax reform is how are we going to make things simpler, right? We’re going to make it where individual taxpayers can file their tax returns on a postcard.
Well, come December of last year, we really got anything but tax simplification. I’ve kind of referred to this instead of the Tax Cuts and Jobs Act, as the tax complication and job security act for tax professionals. So there’s a lot of complication in this. There are a lot of things that are new and so we appreciate you joining us this afternoon.
The goal here is certainly not to make each of you experts, but to get you to start to think about how the different changes that came about from tax reform impact your business and are specific to manufacturing and distribution. Hopefully this will be beneficial. Today, we’ll talk about tax rates.
As Adam mentioned, we will get into a little bit on the individual side. The new Section 199A deduction is a deduction for flow through entities and the ability to reduce the amount of income that is taxed at the individual level based on flow through income. There’s a lot of business deductions and loss limitations that apply various sections, and we’ll go through the most relevant of those as it pertains to manufacturing and distribution.
Again we’ll talk a little bit about some changes in accounting methods. I’ll hand it over to Kristin and let her handle the international aspects of this and then we’ll finish up with a few other things, including the state and local tax impact of all the legislation that has happened.
With that, let’s dive right in. Obviously, one of the things that got a lot of press is the C-corporation tax rate. Starting in 2018, that tax rate does go down to 21%. It has been either 34% or 35% for companies in the past, so companies that have less than $10 million of taxable income have been paying at a 34% rate. That now goes down to 21%, so significant reduction in tax rates for C-corporations.
There were also changes at the individual level, so all of the individual tax brackets have changed. We still have seven different brackets, in which your income is taxed at varying amounts. There are a couple of things to point out. The top rate of 39.6% is now 37%, so there is a reduction to the highest level of income. But frankly, all of the brackets changed, so there’s different income, and they’re certainly taxed at different levels. For most taxpayers, this will mean less tax paid. At least less tax paid based on just purely looking at the tax rate.
Now there’s a lot of give and take. That’s what we’ll get into. If you had $400,000 of taxable income in the prior year, your tax rate on $400,000, a taxable income in 2018 is likely going to be less. The problem is, with some of the takeaways that happen, you may actually pay tax on $450,000 of taxable income. That’s where we have to get into, all of the various changes to really understand what the impact was for each individual and certainly each business.
A quick example on the individuals and just how much the tax rates have decreased on a married filing jointly return. If you had $600,000 of taxable income in 2017, you would pay $180,000, roughly $183,000 of tax. Well in 2018, that amount is down to $161,000 in tax. Again, purely based off of $600,000 of taxable income. So, very favorable from a right perspective, in terms of just overall reducing the amount of tax due.
Same scenario on $300,000 of taxable income, again on a married filing jointly return, and see there’s about a $14,000 reduction in tax liability. Again, all very positive, but again as you kind of say, they’re in the orange bullet there, the orange highlight. There’s many other provisions that impact the calculation of taxable income and ultimately, the amount of tax due at the individual level. You really have to understand all of those implications to understand what your individual tax liability will be going forward.
We will spend, as Adam mentioned, a few minutes on the individual provisions. Each of you are individuals, and the reality is that many manufacturing and distribution companies are flow-through entities, whether test corporations or partnerships, LLCs. At the end of the day, in those cases the income from those businesses flows through to the individual and is taxed at the individual, at the individual’s rate. These other things that maybe are not business related, they do have an impact on the amount of tax that is paid at the individual level when you flow through the business income.
Standard deduction. When you’re filing your return on schedule, you either itemize your deductions on Schedule A and take the itemized deduction, or you take the standard deduction, whichever is typically higher. In this case, the standard deduction amount has doubled from last year so the standard deduction that a married filing jointly return will show as $24,000. Ultimately, this means that we would expect many individuals who have itemized in the past, the standard deduction may be more applicable to those.
If you had $18,000 of itemized deductions in prior years, now it would seem to make more sense to take the standard deduction. We will talk a little bit at the end about state tax implications and how the example I just gave you may not be the best scenario to take the standard deduction instead of itemizing. But again, you’d have to kind of look at it on a specific individual basis and see what’s the most beneficial.
In the past, the government also has given us a personal exemption, somewhere around $4,000. I think it was a little higher than that maybe for 2017. Personal exemptions are going away. In the past, those have been relatively limited. As higher earning taxpayers, you were not getting any benefit. If you weren’t getting any benefit before, well, it’s now taken away so you’re not really losing anything.
This actually seems to harm some of the lower income and middle income tax payers that may have been taking advantage of that in the past. The government’s reasoning on that is to increase the standard deduction, which is more than a make up for that.
Home mortgage interest. The rules related to the deductibility of home mortgage interest have changed. What we’ve been dealing with is you can deduct interest on mortgages up to $1 million and also then be able to deduct home equity line of interest as well. That is being changed for mortgages that are incurred after December 15th of 2017. Any mortgages after that date, you can only deduct interest on up to $750,000 of principle.
Just to be to be clear, if you have an existing mortgage that’s $900,000 and you don’t make any changes to it, then you’re fine. You can still continue to deduct all of the interest on that $900,000 mortgage. If you were to decide in 2018 that it makes sense to refinance that mortgage and you do so, and you have a new $900,000 mortgage, then you will be limited and only be able to deduct interest on the first $750,000 of that interest. The other interest does not carry forward. It’s purely just a personal interest that is not deductible.
I think I mentioned before, but another caveat again is the home equity line of interest. You can no longer deduct that in the years 2018 through 2025. You’ll see as we go throughout this presentation that for many of these provisions, their sunset is 2025, and so some of these provisions go back into 2017. Most of them are effective for 2018. Some of them end up being indefinite, some of them end up being with some type of sunset. We’ll try to go through and touch on each of those as we go through.
Another one of the areas of contention in Washington and across the country is the state and local tax deduction. Individuals that are itemizing deductions have been able to deduct all of their state taxes. Now they’re subject to certain limitations and alternative minimum tax that we’ll get into in a few minutes, potentially limiting individuals to deduct their state taxes.
Now what has happened for years after 2017 is the state taxes are capped at $10,000. That includes not only your state income taxes, but also includes real estate taxes that you would pay on your home and personal property taxes that you would pay on the car. Most taxpayers will see, at least anyone’s that had a substantial amount of real estate taxes or state and local taxes, that they’re going to lose the benefit of some, if not all of those deductions on a on a go forward basis. This is obviously one of the negative provisions that are out there.
One of the things that people started to look at, even some of the states started to try to solicit was “Oh, well, yeah go ahead and pay me your 2018 taxes at December 31st of 2017, that way you can deduct them.” The legislation specifically prohibits the ability to do that, so the taxes had to have been assessed and paid before December 31st 2017 to be deductible in 2017.
Another takeaway under the new legislation is the deductions for certain things that are subject to 2% of AGI limitation. If you were an individual and you had $100,000 of adjusted gross income and then the 2% limitation is $2,000, then certain deductions that you may have had that exceeded $2,000 would have been deductible. That includes things such as tax preparation fees and investment fees on brokerage accounts and unreimbursed employee business expenses.
If you had $5,000 of those types of expenses and the first $2,000 were not deductible, at least you did get benefit for the $3,000 and it was an excess of that 2% limitation. Going forward in 2018, the ability to deduct those expenses is no longer, so that deduction is gone.
Charitable contributions, the value of those has gone up. Typically, you donate to a 501(c)(3) type organization, and it’s fully deductible up to 50% of your adjusted gross income. That now goes up to 60%. It won’t impact a lot of taxpayers, but certainly in the right situation it could have an impact.
One of the interesting things, and certainly it was talked about, is if you have season tickets to college football. For example, if you have University of Georgia season tickets. You buy season tickets, but universities in pretty much all cases require you to make a donation to have a right to buy those seats. Now the charitable deduction that you make to the university in order to have that right is no longer deductible, so that is another little takeaway that may be a little aggravating for some people.
A little bit on divorce planning. Obviously we don’t want anybody to get divorced, but I thought this was interesting, and certainly we should include it. Currently, if someone is paying alimony, that alimony is tax deductible and the recipient of the alimony picks that up as taxable income. That will continue through this year. But starting in 2019, alimony will no longer be deductible by the person paying it and will no longer be income for the individual receiving it.
We joked in the morning session that if you’re going to get divorced and you’re paying alimony, 2018 might be the year to do it. Hopefully that doesn’t happen, but certainly for those in divorce situation, that’s a significant change in how the law works.
Child tax credit is going up. This is a positive, doubling the child tax credit from $1,000 to $2,000. More important is the increase in the phase out for higher income earners. The $1,000 child tax credit that we’ve had phased out at a pretty low income level in the past. Going forward, not only do we get more credit, a $2,000 credit, but we also get higher thresholds before that phase out. At a married filing jointly return at $400,000 of adjusted gross income, you can still get the full amount of that child tax credit. So we’ll see the baby on the screen is obviously very happy about it, and that a lot more taxpayers will be able to take advantage of that.
Education savings rules, 529 plans in particular. Obviously if you’ve been able to contribute to 529 plans in the past, those accounts have been used to pay college education. In that case, the earnings on those accounts is exempt from tax. Going forward, up to $10,000 per year can actually be used for elementary and secondary school education, so it just expands the definition to allow some of the money to be used on something other than other than college.
There is a change related to the Affordable Care Act. We’ve had this shared responsibility payment, often referred to as the individual mandate, which just says if you’re an individual, you’re required to have health insurance. If you do not have health insurance, then you’re going to pay a penalty and that penalty is calculated on your individual tax return. After 2018, that individual mandate and that penalty in essence goes away. It will still apply for 2017 returns that are being filed or will be filed this year, and then will continue for this year’s 2018 returns, but then going forward it will go away.
Another positive outcome of the new legislation is related to the alternative minimum tax. This has always been the government’s way of making sure that everyone pays their fair share of taxes. You calculate the regular tax and then you calculate your tax under the alternative minimum tax, which in essence is recalculating but taking certain things away, such as the deduction for state income taxes. If AMT ends up higher, you pay the AMT tax.
Historically, there’s a variety of reasons people could be an AMT. Certainly being in high state tax jurisdictions can impact you. But you end up with a lot of people in the $300,000, $400,000, $500,000, $600,000 range of income that end up paying AMT just because of the way the brackets are done and the way the phase out has been done on the exemption. There is an exemption, an amount of income that is not subject to alternative minimum tax. Those amounts have gone up quite a bit, so for a person married filing jointly return, that’s $109,400.
The problem in the past is the phase out of that exemption, which was somewhere around maybe $70,000 something last year was that really low number. So as you got into the $300,000, $400,000 of income, you were completely phased out and it just meant that all of your income was subject to AMT.
But what has happened now is the phase out. You don’t start to lose the ability to exclude that $109,000 on a married filing jointly return until your income exceeds $1 million on a married filing jointly tax return. Ultimately, it’s going to drastically reduce the number of taxpayers that will be subject to AMT. AMT survives, but a lot of people will no longer be subject to it.
Something for certain business owners and high net worth individuals to consider is some of the changes to the estate and gift tax exemption. In essence, that amount has doubled for 2018, allowing an individual to exclude from estate and gift tax $11.2 million over their lifetime, or a married couple $22.4 million. This is effective for tax years 2018 through 2025. Ironically enough in 2026, we revert back to the current $5 million amount, just indexed a little bit for inflation, so who knows? 2025 is an eternity away.
A lot can happen between now and then, but certainly as business owners that are looking especially to transition business to a future generation, there’s a really good opportunity to use some of the gifting rules to make that transfer happen. If that’s your situation, we want to make sure we’re sitting down and talking to you and going through it, helping you transition that business in the most effective manner.
Next is Section 199A. We talked about the reduction in the corporate rate from about 34% down to 21%. Well, remember the individual rate that we talked about earlier. The top rate is 37%. So a flow through entity that has income flowing through from an S-Corp that’s paid at the individual level, that’s going to be taxed and will continue to be taxed at 37%.
Obviously, Congress looked at this and said “Okay, we’re going to go to a corporate rate of 21%. We have a flow through rate of 37%. We need to reconcile that a little bit. We need to make this a little bit better.” They certainly wanted to make it where individuals, owners of flow through businesses, received some benefit for that and didn’t pay quite as much tax at 37%, causing such a disparity between that and a C-Corp rate.
The rules related to this deduction are complicated. Not every business and type of business qualifies. As manufacturers and distributors, you do qualify. There are typically some service companies that are disallowed and I’ll show you a slide in a few minutes on that. Know that just manufacturers and distributors do qualify for this exemption, and that it applies for tax years after 2017. So we’re talking about 2018 tax return. It’s kind of the government’s way of leveling the playing field between the flow through entities and the C-corporations.
Last point there, subject to certain limitations, which we will get into, individual taxpayers may deduct 20% of qualified business income from a partnership as corporation or sole proprietorship. So, simple example, no limitations. There are limitations that we’ll get into. But at a high level, under old law, if you had $1 million of flow through income, and let’s assume the maximum rate, you probably wouldn’t pay $396,000 because some of that income is taxed at lower rates. We just assume the top rates for a minute just to show how this works. On $1 million and 39.6% top individual rate, you would have paid $396,000.
Under the new law, we’ve got $1 million of flow through income. We receive a 20% deduction of that income, so we’re only taxed on $800,000. Now the new top rate is 37%, so when you do the math, that’s $296,000 compared to $396,000 under the old rules. At the end of the day, we’re looking at a 10% rate reduction for flow through entities. That is obviously very positive, and that individual’s now paying 29.6% on their flow through income.
Now that compares to the corporate rate of 21%. We’re not going to get into a lot of should I convert, should I not convert. For that, each specific case needs to be addressed. Certainly, those of you that are our clients, we’re going to be sitting down with you walking you through all the complications of this tax reform, making sure that you understand the impact that it has on your business. If you’re in those relevant situations, we’ll be having conversations about if it makes sense if you’re a flow through entity to convert to a C-Corp and vice versa.
I will say as a general rule, in many cases, it’s not going to make sense if you’re a flow through entity to convert to a C-Corp. But again, it’s very fact specific, dependent on what the future plans of a business are, if you’re planning to sell or whatever. Again, we’ll be addressing those questions one on one basis with each of our clients.
If we could just take 20% of our qualified business income, then this rule wouldn’t be that bad. The deduction is actually the lesser of the 20% of qualified business income that we talked about, or a limitation that’s based on W2 wages and capital. If you look at the limitation based on W2 wages and capital, it’s actually the greater of 50% of the W2 wages from the business or the sum of 20% of the W2 wages from the business plus 2.5% of the cost of depreciable tangible property. Again, lots of complication, but let’s look at a couple of examples to maybe simplify this a little bit.
Let’s suppose in example one there is a simple little operating company. It’s an S-Corp at $800,000 of qualified business income. The company pays $100,000 in wages and this particular company doesn’t have any property. So, our deduction is the lesser of 20% of the qualified business income, $160,000, which is 20% of the $800,000 or 50% of our W2 wages in this case, which is $50,000, so we get the lesser of those two. In this case, in our deduction we don’t get the full benefit of the 20% of the qualified business income and we’re limited based on the fact that we have a small amount of W2 wages.
This is something that from a planning standpoint we’ll be getting out in front of, we’ll be getting with our clients and looking at, and we want to make sure you understand how this impacts you, what benefit you can and to the extent that we can plan around it. Potentially, we could have had this company paying a little bit more in W2 wages, maybe take a bonus, and then match them to increase that deduction.
Example two we see a lot in manufacturing and distribution. This is kind of example of a real estate holding company where the owner of the manufacturing company also owns the building, and we’re paying rent back and forth. Let’s say we have an LLC, got $1 million of qualified business income, those entities typically don’t have any wages, but let’s say in this case we have a $10 million building.
As you see, there’s a $10 million cost of depreciable property. I think it’s important to note that we are talking about the original cost of the goods and not fair market value or tax basis. In this case, our deduction is again the lesser of 20% of the qualified business income, which is $200,000, or 25% of our W2 wages. We don’t have any but we add 2.5% of depreciable property, which is $250,000. Again, it’s the lesser of those two amounts, in which case, this is $200,000, and the individual return would then shell $1 million dollars of income from the real estate holding company. Then the individual would be entitled to a $200,000 deduction and ultimately only tax on $800,000.
A little bit more complication when you put it all together and show both limitations at one time, S-corporation and $1 million of qualified business income. They have $100,000 in wages, same $10 million in property. First of all, we need to look at our W2 wage limitation, our capital limitation, and we get the greater of those two. So 50% of our W2 wages is $50,000, plus the other limitation, 25% of the W2 wages is $25,000 plus 2.5% of our depreciable property puts that limit at $275,000. It’s the greater of those two so we get the $275,000 in this case, but now we have to take and compare the $275,000 with the 20% of our qualified business income and we get the lesser of those two so we end up with a $200,000 deduction.
Again, lots of complication, lots of mathematics, but there are certainly some planning opportunities around this as it relates to W2 wages and various things, so it’s something to be aware of. Again, this is out here to level the playing field. I mentioned earlier, not everybody qualifies for this. In essence again, manufacturers and distributors do qualify for it. Typically, these types of service businesses listed here on the screen do not. Our accounting profession is certainly excluded, so we do not get any benefit from this deduction. Ironically, the engineers were specifically written in and they do qualify. The way I look at that is, the engineers have better lobbyists within Congress than we do, so good for them, I guess.
Adding a little bit more complication to all of this, I mentioned certain businesses don’t qualify. If your income’s low enough, you do qualify. If your income is less than $315,000 on a joint individual tax return, that’s taxable income. Then, you actually can take it so some individuals in the accounting profession and some other service professionals would qualify. But as your income goes from $315,000 to $415,000, you start to phase out on that exemption.
We’re going to change the presentation of individual returns, or entity level returns. There’s more information that will have to be disclosed on those returns. We’re going to have to be providing W2 information, wage information, total wages, as well as cost basis of the property to enable shareholders and partners to figure out what that deduction is going to be.
Now we’ll get into some of the business deductions and some of the winners and losers in terms of good things and bad things that happen and how it impacts manufacturing and distribution. Section 179 is one of the positives. In the most recent years, we’ve been able to just write off $500,000 of equipment purchases.
Under the new Section 179 rules, that actually goes up to $1 million starting in 2018. There’s always been a phase out on that as it does not allow some of the larger corporate taxpayers to take advantage of it. That phase out starts at $2.5 million and phases out dollar for dollar, so anyone that is putting in service less than $2.5 million dollars, we’re going to be able to write off at least $1 million of those assets up front. That’s very positive for manufacturers, especially those that are capital intensive and constantly buying new assets.
A few things that now actually qualify for Section 179 that historically have not are roofs and HVAC systems. There typically has been no ability to write those off. Now we can actually write those off under the Section 179 rules, so that’s again very positive for those that own buildings that are used for manufacturing.
Now onto used assets and/or bonus depreciation. Bonus depreciation has been around in various forms since 2001. With the most recent returns, we’ve been allowed to take 50% bonus depreciation. So if you bought $100,000 asset, we can write off $50,000 of it immediately and then take the regular depreciation on the remaining $50,000. One of the caveats to that rule has always been that it only applies to original use property, so in that sense, you have to be the first taxpayer to use that. If you bought a used piece of machinery, it didn’t qualify for bonus.
Those rules change starting for 2018. First and foremost, bonus depreciation goes from 50% to 100%. So we can write off all of it, very similar to the Section 179 rules, and with frankly no cap here and no phase out. The other really good thing here is that now, our used assets actually do qualify, so it doesn’t have to be the original use. This is one of those provisions that does go back into 2017 a little bit, so 100% bonus applies to assets that are acquired and placed in service after September 27th of 2017. Any assets that you bought after that date would actually qualify for 100%.
Placed in service is important. Noting the date of when you acquired it is also important. If you signed the contract to acquire an asset on August 1st and it was November 1st before you had that machine up and running, the old rules would apply on that because you actually purchased that machinery prior to the September 27th date. That’s simply important to note.
Just a chart here that I think is hopefully helpful for future reference. The bonus depreciation was going away and being phased out over the next few years, so the new rules allow that again 100% bonus depreciation to stay in effect through 2022. Then we start to wind that down after that, but again, those dates are an eternity and a lot will happen between now and then. Depreciation rules as it relates to manufacturing and distribution are very positive and certainly allow taxpayers to reduce taxable income.
Now we’re going to focus for a little while on some of the things that are not very positive, and have really a negative impact on manufacturing and distribution. The first of these is the interest limitation rules. It’s important to note that these rules only apply to companies that have average annual gross receipts over the last three years of $25 million. So again, small businesses don’t have to worry about this limitation.
For the larger ones that do, you can always deduct interest on 30% of what’s deemed to be your adjusted taxable income. The adjusted taxable income from a definitional standpoint is calculated very similar to EBITDA, and we’ll walk through an example in a minute to show that.
Any interest that you’re not able to deduct just carries forward, and would go into the pool with interest paid in the following year, and you would apply the same lifting 30% limitation to it. Any carry forwards of interest expense are treated very similar to NOLs in terms of if there’s an ownership change and we have to look at Section 382 limitations and limitations after the ownership change, those same rules would apply for interest expense carry overs as well.
Here again is this kind of a definition of how we get to adjusted taxable income, so we’re going to add things back such as the interest expense. Any NOLs, the 199A deduction that we talked about, as well as depreciation and amortization, are added back. Actually, if you look at the last bullet point there, there’s one caveat for years after January 1, 2022. The add back for depreciation and amortization actually goes away so you’ll have a smaller base upon which you would be calculating the interest limitation. That’s obviously very negative from a manufacturing and distribution standpoint as a lot of manufacturers and distributors have a significant amount of depreciation expense.
Again, an example to hopefully make this make a little bit more sense. Let’s say we have a taxpayer that has $80 million of gross receipts or gross sales. We’ve got $40 million of cost of goods sold, so $40 million gross margin. They paid $5 million of interest expense, $2.5 million of depreciation, and then another $30 million in a combination of other expenses. Ultimately, that gives us taxable income of $2.5 million.
Now we have to calculate our interest limitation, so for that, we’ll start with the $2.5 million and we’ll add back the interest expense. In this case, we’re going to add back our depreciation as well. That gives us adjusted taxable income of $10 million. The interest limitation’s 30% of that number, so in this case, we only can deduct $3 million of interest expense. We had $5 million, so we have $2 million disallowed and unfortunately, instead of paying taxes on $2.5 million of income, we have to pay tax on $4.5 million since we have to add back that $2 million of interest.
For Companies that are highly leveraged and have a lot of debt, this is going to be an extremely important calculation to be looking at to make sure that we all understand what the impact is. That limitation is actually calculated at the entity level, so it’s not for the floater entity. It’s not something that’s computed at the individual level.
The entity will compute it, so again, we’re just going to add a little bit more complication to our entity returns. This allowance will get allocated ultimately the same way that other non-separately stated items of income would be allocated. Even though it’s not deductible, your basis in the entity is actually reduced for that amount.
There has been a domestic production activities deduction that has been very positive for manufacturing. This has been eliminated with the new legislation. For companies that had this deduction in the past, it’s been an additional deduction that’s been allowed for companies such as manufacturers that are producing goods here in the U.S. That deduction has been 9% of the net income associated with that production. A 9% deduction at previous rate had the effect of really reducing the tax rate for manufacturers by about 3%. So a company that was paying a 34% tax rate, by the time you took the DPAD, you were really paying a net 31% tax rate.
Now DPAD’s gone, the new rate’s 21%. So from a manufacturer perspective, it’s not a 13% reduction or 14% if you’re in the 35% bracket. It’s actually a 10% or 11% reduction. So other taxpayers are getting more of a tax break than manufacturers on this, which is obviously a little bit unfortunate. For those that are flow through entities, again you have the same 3% benefit in the rate because of the 9% deduction. Instead of paying 39.6% in the past, that income was at 36.6%. It’s roughly what you were paying if you were in the top rate.
Well, now DPAD goes away and the new rate’s 37%, resulting in a tax increase for manufacturers before you apply the Section 199A rules that we just looked at. This would have the result of dropping the rate by another 10%. This is certainly one of the positives.
With 263A, the UNICAP rules that’s required capitalization of certain direct and indirect costs associated with inventory and that it’s saying that your storage and handling costs and some other costs couldn’t be expensed for tax purposes until you sold that inventory. It adds certainly a significant amount of complication to manufacturers and certain distributor’s tax returns. The rules for being subject to 263A have been loosened a little bit. Our small taxpayers, those with $25 million or less in average annual gross receipts, are now exempt from those rules.
If we have some capitalization amount, there’ll be an opportunity to change accounting method starting in 2018. We’ll talk a little bit in a few minutes about accounting methods about the 471 rules. Ultimately, the same provisions here are saying that manufacturers that are less than $25 million are now exempt from the section 471 rules related to accounting for inventory. At one level, you’re okay. But you do have to keep inventory.
You still have to track it. It’s just treated at the IRS as non-incidental supplies. You still can’t expense it until it’s actually been consumed, but some of the more stringent rules related to inventory and capitalizing costs have been loosened up a little bit. There was a lot of talk about repealing LIFO as legislation kind of went through Congress last year. It was not repealed, so LIFO does continue to exist. One of the more controversial topics is related to net operating loss deductions and some of the changes there.
Under prior law, you potentially had a two year carryback. If you didn’t carryback or you wanted to carry forward, you could carry losses forward for 20 years. There was really no limit in the amount of taxable income that you could offset, other than we had to apply some of the AMT provisions and potentially you would pay AMT tax. Going forward, for tax loss years beginning after 2017, carrybacks are disallowed so we can no longer carryback and get back tax dollars, but we do have an indefinite carry forward.
Now I mentioned controversial, and its maybe still questionable about how it’s being treated is going forward. We can only use NOLs to offset 80% of taxable income. What it means is if you’ve been a loss company and you’re now becoming profitable, you can’t offset all of your taxable income, even though you may have a significant amount of net operating loss carryovers.
You do the math on that. It becomes 4.2% effective rate that you would pay. Some taxpayers that were an AMT previous were paying about 2% rate. It does just mean that a lot more attention has to be paid to this, and we need to be talking with you and making sure that you’re coming out of an NOL situation profitable. We can make sure that we’re all on top of what the implications of that are, knowing that there certainly could be some tax due.
The little bit of unknown here is, as we’ve read the legislation and talked to some colleagues around the country and really looked what the intent of the legislation was from Congress, it seems to apply to all of your net operating losses, whether they were pre 2016 or 2017, or after the new legislation. If you had a 2016 loss and you were using that in 2019, that would still be subject to the 80% limitation.
We have seen in recent days that there are some national firms, some big four firms, that think we can take a different approach and split our NOLs into two different buckets. Those that incur on or before 2017, and those afterwards. Their thinking is that the losses that are incurred prior to the legislation years, let’s say the 2015, 2016, 2017 losses, can be used to offset 100% of taxable income. That only the new losses, those incurred in 2018 and future years, would be subject to the 80% limitation.
We don’t have any guidance from the IRS. I think in the next couple of weeks, we’ll continue to see a lot of dialogue around this. We’re obviously working on tax provisions that are coming up, and it’s something that we all have to make sure everyone in the profession is in agreement on. It should be one way or the other, and so we’re going to kind of keep our eyes and ears open to see how that transpires and certainly we’ll be putting out some information surrounding that, once there’s a little bit more clarity. At this point, I would make the assumption that all of your NOLs are subject to this 80% limitation in future years.
Now a quick little example. Here in 2018, we generate $1 million loss. We end up in 2019 with $800,000 of income. We can only use 80% of that to offset our liability, so we end up with $160,000 of taxable income. At 21%, $33,600 of tax and our NOLs just continues to carry over until we can use it in a future year.
We talked about the individual alternative minimum tax still being around with some limitations. Corporate AMT has been repealed, so that’s very positive. Companies that have AMT credit carryovers from prior years, those will be refundable in years 2018 to 2021. You can use those credits to reduce your regular tax liability in those years, and actually refund up to 50% of the excess amount in each year. Any remainder is completely refundable in 2021.
Good news on the R&D credit. R&D credit has, in essence, been saved. It didn’t go away, so we’ll continue to be able to claim R&D credits for manufacturing companies. The change with the new law is somewhat delayed. After 2021, R&D expenses are required to be capitalized. So U.S. base expenses over a five year period and any international expenses or expenses that are incurred outside of the U.S. would be required to be capitalized and amortized over a 15 year period.
There’s a lot that can happen between now and end of 2021. Hopefully that will change. But again, that is very negative, as historically, as R&D expenses have been incurred, they’ve been fully expensible for tax purposes, with the credit on top of it. Now we’ll still get the credit, but we’ll have to capitalize and amortize some of the expenses, so hopefully there will be some change in that.
For meals and entertainments, there’s a little bit of confusion some change that’s in the rules. In the past, meals and entertainment expenses have all been 50% deductible. Now with the new legislation, anything that’s considered entertainment, amusement, recreation related is now 0% deductible.
You have situations where you take a client out to lunch. If you take a client out to lunch, the purpose of that is obviously business related, but it’s a meal. That would be 50% deductible. But if you took the client out to dinner and then you went and saw a ballgame, the IRS may look at that particular instance and say the whole purpose of that meal is related to entertaining the client. Because of that, 0% of that meal portion and the cost of the tickets and concessions and everything else would be 0% deductible, so that’s obviously a negative.
Internal meals continue to follow the same rules that they have. Most of the time, you bring lunch in for employees, or you have a holiday party, those will continue to be 100% deductible. Travel meals will continue to be 50% deductible. There are some entities that have their own cafeteria for providing meals for the convenience of the employer, and those have historically been 100% deductible. Those back off now to 50% deductible, and after 2025 are 0% deductible.
Historically, both real property and personal property have qualified for like-kind exchanges. Those rules change. Personal property is no longer eligible for deferral. An example would be an automobile that may be exchanged where it’s been fully depreciated. We have a gain on the trade end. We’ve been able to defer that gain in the past by reducing the basis in the new asset. Now under the new rules, we would have to recognize that gain.
There are now depreciation limits on luxury automobiles. We see a lot of companies that have automobiles. Just wanted to include this as reference. It’s for vehicles that are less than 6,000 pounds. The IRS has historically significantly limited the amount of depreciation that can be taken on those. It’s still limited, but the appreciable amount for each year has actually gone up, and in some cases tripled.
Not going to spend a lot of time on this as it doesn’t impact a whole lot of companies, but for companies that are issuing stock options and restricted stock units to their employees, the way the rules work is, if you use the example of restricted stock as restrictions laps on those units, it becomes taxable compensation to the individual recipients. In this case, there’s new legislation that allows the deferral of that taxable income up to a five year period. That’s very positive for somebody that is receiving restricted stock units.
The unfortunate thing here is that there’s a whole bunch of exemptions, and we don’t have them all listed here, but the biggest one is that in order to take advantage of this, you actually have to be granting these units to at least 80% of your employees. That’s very uncommon from what we’ve seen in our experience. A lot of time, it’s the executive level or it’s a small group of people that are receiving these, so we don’t expect to see a lot of people taking advantage of this. But in the right situation, just know that it is out there.
Next is Employee Achievement Awards. As long as these wink of service awards or safety achievement awards have been given as part of a meaningful presentation, a lot of that could be excluded and considered tangible personal property. It could be excluded by the employee and the employee would not have to pay tax on it.
The rule that has changed here is the IRS has gone in said that tangible personal property actually excludes a whole bunch of things, including cash and vacations and sporting event tickets. You can still give a gold watch and that be nontaxable to the employee, but you can’t give cash or anything away.
Now one of my partners actually was telling me a good way to get around it. Let’s say you have a qualified plan for these type of things, and so you want to spend $1,600 on an employee. You go to a department store and you buy the ugliest thing that you could possibly think of, ugly vase or whatever, something that’s really expensive. Give it to the employee with a gift receipt and then the employee turns around and takes it back and turns it into cash. So there may still be some ways around it, but just it’s one of the changes that has happened.
Sexual harassment settlements are obviously very prevalent in the news today in terms of everything that’s going on, and they are certainly getting a lot of attention. Congress is paying attention to this as well. I know a lot of lawsuits are being paid out and what they’ve said is that if there is a non-disclosure agreement relative to one of these payouts, and I would typically think there almost always would be, then any payments related to that sexual harassment lawsuit, including attorney fees, are nondeductible.
I had to move on a little bit, and certainly want to get to the international component with Kristin, so a few more slides before I’ll turn it over to her.
The business loss limitations. Under the old law, you always have misses relative to flow through entities. You always have to look at basis limitation, risk limitations, and the passive activity loss rules in order to determine how much loss from a flow through business can be deductible at the individual level. Those rules have not changed at all.
What has changed is the ability to deduct the amount of that business loss that can be deductible. Now we’re going to look and we’re going to aggregate all of our business income together as flow through at the individual level. Now you’re limited to a $500,000 deduction from your businesses. This is extremely negative and could have a really negative impact on certain individuals that have some outside income from wages or other investment, but have heavy business losses that have been sheltering income. Now we’re going to be reduced in terms of how much of that ability there is to shelter.
Another quick example of a married filing jointly taxpayer. Say we’ve got $1.5 million of other non-business income. That could be wages, it could be investment income, and let’s say we have an $800,000 loss from an S-corporation. Now the rules say I’m limited and assuming I don’t have any problems with that risk and passive losses or anything like that or basis, I can still now only deduct $500,000 of that $800,000 loss. Instead of paying tax on $700,000, I’m actually going to pay tax on $1 million, so it’s extremely negative. If you have losses that are flowing through, it’s something that we’ve got to pay attention to, and it’s something that we’ve got to be looking at and making sure that we’re planning for properly.
For accounting methods, manufacturers in the past haven’t really been able to use the cash method of accounting. There were especially significant rules on limiting corporations to be able to use cash method of accounting. Now for tax years starting after 2018, actually for starting in 2018, we have a $25 million aggregate gross receipt limit where if you are under that amount, then you can actually use the cash method of accounting. For manufacturers now, that’s obviously very positive. It will make it good for manufacturers, especially those that have a significant amount of receivables in excess of their payables.
Let’s talk a little bit about inventory, and the same rules apply. If you’re less than $25 million, you don’t have to account for inventory. You do have, in this case, two options. We treat our inventories as materials and supplies that are non-incidental, or we follow our book accounting treatment for inventories. Ultimately, as I kind of said before, the inventory rules lack a little bit. You certainly have to keep track and keep a list of what you have. You can’t expense it until it has certainly been consumed or in the most cases would be sold.
Long term contracts. A long term contract is considered anything that doesn’t complete in the tax year that it started. Under the old rule, I don’t see this a lot in manufacturing, distribution. But under the old rule, you had to use the percentage of completion method. Now, if you’re under $25 million in gross receipts, and you expect your contract to be completed within a two year period, you can actually use a completed contract method. In the right scenario, this is obviously very favorable as well.
With that, I’m going to turn this over to Kristin and let her go through some of the really, really complicated provisions related to international tax and some of the changes that have been made there.
Kristin Maeckel: Hello, everyone. My name is Kristin Maeckel. I’m a tech partner in our international practice. I’m here today to give you an overview over how internationally transacting businesses are affected by the tax law changes. I say overview instead of providing you with details because the part I will talk about now is an area of tax reform, where we can expect many more regulations and notices to be issued to clarify matters.
There are many definitions and a lot of calculations that will go into calculating the additional income and the additional tax that may arise out of these changes. While the rules mainly affect firms which have an ownership in foreign entities, the changes that I’m going to talk about shortly do not only affect them, so please listen up when I’m talking about foreign derived intangible income or FDII.
It’s because this is a new deduction, which will probably benefit a lot of companies that may not have a foreign entity abroad, but that sell property or licenses to foreign users or foreign related parties. I’m going to talk about soon, so you may want to listen up when I talk about that.
Let me just make some general remarks on how the new tax system differs from our old law. Previously, income of foreign corporations was not taxed with some exceptions, but it was not included as taxable income on your annual tax return. It was only taxed when brought back as a dividend. Together with us having the highest tax rates in the world, this incentivized many firms to move income to foreign jurisdictions or at least not to bring it back, if not absolutely necessary. Now with this new tax law change, the goal is to incentivize firms to manufacture in the U.S., hold intangible property in the U.S. and the deferral of income.
There was a lot of talk of making the tax code easier, but I guess it’s open for judgment if that was really accomplished or how things will be more complicated going forward. These goals that Congress had are intended to be achieved by doing five different things. I mean, there’s more rules than just five different rules, but the main five changes that we’re going to talk about are used to accomplish this end of the deferral.
Number one created a quasi-territorial system with a 100% dividends received deduction for dividends from foreign entities. Now this just means whenever you bring back a dividend in the future, there will be no income tax on that dividend going forward. Then it’s not just a flip the switch type of provision. So it’s not that he who will bring back dividends is tax free in the future. You will also be taxed on the unrepatriated earnings that you currently have sitting abroad in foreign entities.
To make this happen, a onetime tax or a toll charge as we can call it, was created to tax these earnings. This toll charge is actually implemented on your 2017 tax return, which means you have to make your tax payments already in April. If you own at least 10% of a foreign entity, then this is a provision that you need to work on as soon as possible.
Number three is that the tax base will be broadened by a new taxable income stream to currently tax foreign income, which is not [inaudible 01:09:01] fixed assets. There’s a nice abbreviation for it. It will be called GILTI income, which stands for global intangible low tax income. To reduce having a current tax on a new income stream, a new deduction was introduced and that is number four. It’s called FDII, which stands for foreign derived intangible income. That is just an incentive for all of you to manufacture in the United States.
Those are the five main things that I’m going to talk about in the next few minutes. How does this end of the deferral work? As I said, the easy provision is the dividends receive deduction. All that happens is you bring back a dividend in the future, and it will be tax free. There won’t be any tax on that.
The second thing is the onetime tax, so it’s a transition tax. If you or your company own 10% of foreign entity, you may owe a onetime tax on all previously untaxed earnings accumulated since 1986, or since you have owned the company. How is the tax calculated? What we’ll do is we’ll look at your earnings and profits position, either on the November 2nd, 2017 or December 31st, 2017. Those are the two measurement dates, and we will look at how much of these foreign earnings are tied up in cash and cash equivalent assets. These are most of your short terms assets, including receivables. This amount will be taxed at 15.5%. The earnings and profits that are tied up in other assets will be taxed at 8%.
The good thing is that there’s an interest free loan from the Government, because you can actually elect to defer the payment of the tax for eight years. So in years one to five, you have to pay 8% of the tax, and then it goes up to 15%, 20% and 25% in the last year. That means you will have some ease of the burden on your cash flow layout in the next few years.
The good news is if you are owner of an S-corporation, you can defer this onetime tax until the S-corporation ceases to be an S-corporation. You liquidate it, sell assets, whatever is a triggering event to end the S-corporation. As I mentioned, this tax has to be calculated, and you’ll report it on your 2017 tax return.
We have to determine your accumulated E&P position. There is a notice expected to come out from the IRS that provides more details on how this has to happen, mostly on how to approach the E&P on November 2nd. This is one of the things that we have to do before you file the tax return, is firm up the E&P position. We also need to determine the tax pools, because this tax can be partially offset by foreign tax credits.
In determining the tax pools, we’ve shown how much tax you have paid in the past. Then, from what I’m understanding currently, the IRS will not accept just a general ledger print out, saying this is the tax that we’ve paid. They really want to see the proof of taxes paid. So as we talk about you having to pay this tax, then this is one of the things for you to look for as soon as possible, so we can prove that you actually paid the tax.
We also need to determine the cash positions that your foreign entities have at the end of three years: 2015, 2016 and 2017. Then we need to determine how much of your earnings are bound up in cash. There’s one example that we want to show with regards to that transition tax. As I mentioned, the tax will be paid on cash and cash equivalent assets, and we just want to show briefly in an easy example how that works.
We have a company, a U.S. corporation that controls a foreign corporation. Let’s assume we determine that the accumulated E&P position is $1,000. The aggregate cash and cash equivalent position is also $1,000, and there’s no tangible other assets in this entity. Now looking at the calculation, this means that $1,000 will be included in your income, $1,000 of E&P, so it’s not that we apply 15.5% tax to that. What is actually written into the law is that you subtract a participation exemption of 55.7%, to come to a net E&P inclusion of $443.
Now in this example, we assume that there’s no foreign tax credit so you don’t have to gross up your income by the cash taxes paid, so we end up having total taxable income of $443. I’ve got to pay $155 of tax at 35% because that is still the tax rate in the year 2017. That $155 is actually a tax rate of 15.5%.
In this example, for assets that are tied up in non-cash assets, the percentage of 55.71% would actually be 77.1% to come to the 8% tax rate. This is just to exemplify how the calculation actually works. We’re moving on to the number three I mentioned before, where we’re broadening the tax base through a new income stream, which we call GILTI, Global Intangible Low Taxed Income.
In any year after the onetime transition tax, so starting in 2018, the U.S. taxpayers of foreign controlled corporations will have to pay a tax on the intangible assets income of the foreign entity. This is done to discourage income shifting by subjecting the income to the current tax, so that means it will be an annual income tax accretion on the U.S. tax return. A lot of you will probably say you don’t have any intangible assets in my foreign entity, which may be right. That is correct, but it’s really not relevant for the calculation of interest income. What Congress has done, which actually makes it easier from a calculations perspective, is it introduced the new definition, and justifying intangible income as any income which is not generated through your fixed assets that you hold in all capital investments that you hold in the foreign entity.
What Congress says is okay, you own capital assets abroad. You have a normal rate of return on this, which they define as 10% of the qualifying asset base. So your tax is on the residual income. The definition of the residual income is whatever is not a normal rate on return of capital investment is intangible income.
The good news about this is that there’s a deduction allowed for corporate shareholders from this income, which is 50% of GILTI until 2025. After 2025, it’s 37.5%, so reduced income for now will just be reduced by half. The result of this is when combined with a 21% corporate tax rate, the effective U.S. tax rate on this GILTI income is 10.5% for the year 2018 to 2025, and then goes up to 13.125% starting in 2026. Again, you can also use a reduced tax credit on this.
As you see, there will be a very reduced tax rate on this income. Again, we have a short example on how this income calculation will work, in a sense. Here we have a U.S. corporation that owns two CFCs, two controlled foreign corporations. They both have some gross income. For ease of showing the calculation, we assume that they have not paid any taxes. One entity has tangible assets, which is $1,000. The other one does not.
That means that the income that we’re looking at for this income calculation is $600. The GILTI income is the $600 reduced by your normal rate of return on the capital asset, which is 10%. So, it’s reduced by $100 and our GILTI income is $500. From that, we deduct the 60% that exists right now to come to a GILTI of $250. Now since this is a tax that will affect going forward, the tax rate that you apply to that fixed income is 21%, arriving at a tax of 52.5%. You will see from that then, that the tax rate of that is 10.5% of the GILTI income of $500. This is how we get to a favorable tax rate on this.
Moving on to the number four I previously mentioned, which is actually a deduction. It’s not an additional income stream, which is now called foreign derived intangible income. It resolves directly out of the definitions of the GILTI income, but it’s actually a deduction. You will get the deduction on the FDII, which is income derived from the sale or any other kind of disposition of properties to a foreign person, and it’s important. It has to be for use in a foreign country.
It also includes a license. For example, IP to a foreign person for foreign use and services provided to a person located outside of the United States. It does not matter if the service is actually provided in the United States or abroad. This also includes sales that you make to related parties, as long as the related party actually resells the services or the products to an unrelated third party that uses the product abroad. Now that means the sale has to be done to a foreign unit or firm already. You cannot sell it to a U.S. firm that actually uses it in the United States, by example.
What it means is just as an example, is if you sell inventory parts to an affiliated party abroad and that entity actually uses it in producing something, for example a car that is going to be sold abroad, that is an income stream that qualifies. However, if you just sell a piece of equipment to a foreign company or foreign affiliate that will just stay in the company, then that would not qualify.
Nevertheless, we believe that a lot of our clients will benefit surely from this deduction. What it means though for all of us is that we need to analyze the income streams, which will be the basis for this deduction, to determine what qualifies and what does not qualify. We also have to make a reasonable allocation of expenses that qualify for that, so the tax is on the profit of that.
Moving to the last item that I mentioned previously, another measure to broaden the income tax base in the country, which we call the Base Erosion and Anti Abuse Tax or B.E.A.T. Tax, is a new minimum tax to make sure that firms do not pay more than 3% of their deductions. With deductions, we mean all payments and deductions below the cost of sales low gross profit. We want to make sure that they do not pay more than 3% of their deductions as base erosion payments, which would mean for example, insurance fees or management fees.
Now this provision only applies to firms with some U.S. connected revenue of more than $500 million. However, it does apply to an affiliated group, so that means if you have another affiliated entity here in the United States, their U.S. income would be included. Also, the U.S. connected income of foreign entities would be included, but that foreign income would not be.
That’s really brought a high limit. A lot of firms will not have to worry about this new income tax. One kind of fallout out of this BEAT Tax is that you may have it on your tax return as well. The transactions with foreign related parties are recorded on a separate form in the tax return. That has been penalized with $10,000 if you did not file that form or did not file it on time. Now this penalty has increased to $25,000, which is of course very steep.
We handle this form for all of our clients, but nevertheless, it shows there’s a lot of scrutiny on the correct recording of these transactions. We have to take this very seriously so we do not run into any penalty problems with regards to those.
That concludes the part of the international tax law that we wanted to talk about today. Let me just say two things on the transfer pricing. We have not talked about that, but we think that we need to look at it. With the lower income tax rates, we want to reevaluate your transfer pricing policies and see if there’s any changes required or recommended. That’s one thing, and then with a lower tax rate, the tax authorities will look to broaden the income tax base. We have to expect that there will be more audits where transfer pricing will be an issue, so we need to make sure that we firm up all of our transfer pricing positions.
With that, I pass it back to Kerry, who will give you another brief study on what is new for the state and local tax.
Kerry Defler: Thank you, Kristin. I know we are right at about an hour and a half, and I think that’s what we had scheduled. We are close. We’ve got a few more slides to get through, so I apologize. We are going to go over the hour and a half by a little bit. Hopefully in the next seven or eight minutes, we can wrap up, so any of you that can hang on, we certainly appreciate it.
I know certain individuals have submitted questions online. Certainly if you have additional questions, please submit those. Unfortunately based on the timing, we’re not going to be able to get to those on the phone. However, we’re committed to getting you a response back, and we will try to do that offline once we are complete. If you do have additional questions, please do not hesitate to put those through.
I wanted to just make sure from a state and local perspective that we kind of understand some of the impact there and some of the things that need to be considered. Obviously, what went through Congress and was signed by the President is federal legislation, but the reality is that the starting point for computing state tax liability is federal taxable income whether you’re looking at it from a business standpoint or an individual standpoint. So a lot of the takeaways that we talked through, whether it’s a state and local tax deduction on the individual side that is capped or going away, or this allowance of entertainment expenses for businesses, or the reduction in the amount of interest expense, all of those have an impact of increasing federal taxable income, which again is a starting point for state purposes.
What that is going to mean is that for entities, the state tax expense is expected to go up for most businesses and most individuals. States are actually starting to understand this and they’re having discussions. I saw an article yesterday regarding New York and how they started to look at some of these provisions. There were several different reasons that the amount of revenue was going to go up, I think it was over $1 billion of additional revenue for a state like New York, just because of certain things that have gone away.
States are starting to grapple with what they are going to do with that. How are we going to spend it? Are we going to spend it on roads and bridges, or education? Are we going to take that money and find ways to get it back to our taxpayers? Are we going to change our rules to allow a deduction for state taxes, even though it wasn’t disallowed?
There’s a lot of unknown, and we have gone from one legislature to now 50 other legislatures that are having to grapple with tax reform and figure out what to do. A lot of them historically have automatically conformed to the Internal Revenue Code. Well, there’s a lot of things in here that they may not want to conform to.
Historically, you’ve seen a lot that have not allowed for the increase in Section 179 or the increase in bonus depreciation, so that kind of decoupled from federal legislation as it relates to those items. It’s just going to be interesting to see what happens with the states on a go forward basis. A lot of them are in session now, and they have a short window in terms of figuring out how they want to handle this on a go forward basis.
As I mentioned, the overall effective state tax rate is going up. If you were paying a 6% state tax, you were really paying about 4% of the net of the federal benefit. Well now, in many cases that federal benefit is going away and you would be paying the full state 6% state tax. Again, that just kind of reverses a little bit of the windfall that the IRS and the federal government have given us with regard to lower federal tax rates.
One of the interesting things that’s out there from a planning perspective is the various tax credit programs. These are getting quite a bit of publicity today in the news media, and it’s very similar in Georgia. We have a student scholarship organization plan for a $58 million fund that the state has set aside and allows taxpayers to contribute to this fund. The money ends up being funneled to the private school education system, and what happens is individuals get a tax credit for the amount that they contribute, a dollar for dollar tax credit on their Georgia return.
For example, a married filing jointly return could contribute up to $2,500 to the student scholarship program. You actually get a $2,500 Georgia tax credit, so in essence you’re turning your cash into a tax credit. Ultimately, it’s a dollar for dollar return.
The benefit is that rather than paying state tax, what you’re paying is a charitable contribution to that organization. The importance of these programs going forward is that now we have a cap on the ability to deduct state income taxes. Well, if we can’t do that on our state income taxes because we were over the $10,000 threshold, we can convert some of those tax dollars into a charitable contributions that do not have a limit.
That is a win, so business owners here in Georgia can actually contribute up to $10,000. These are business owners that have businesses with income that’s flowing through. You can actually contribute up to $10,000. For a married filing jointly, it’s $2,500. I forget the single amount, but I think it’s somewhere around $1,500.
The only issue with the SSO here in Georgia is that program is very popular, and you have to actually contribute to it by the beginning of the year. The $58 million fund for 2018 has already closed out, and it was closed out by very early in January. There are two other funds that are relatively new. One is the Public Education Donation Credit, which is a $5 million fund, and the Rural Hospital Donation Credit, which is a $60 million fund. As far as I’m aware, both of those are still open at this point, and they work very similarly.
On the public education, it’s 100% credit. On the hospital donation, it’s only a 90% credit. Even though you only get a 90% credit for your donation, you do still get that federal tax deduction, and so that may still be beneficial. Certainly for individual taxpayers, they’re going to be limited under the SALT deduction. This is something to look into, and certainly is one thing to look at relatively quickly before both of those funds close out.
If you need any more information, we’re certainly here to provide that, and we can direct you on what to do there. I mentioned before the itemized standard deduction. Here’s an example where an individual taxpayer has $22,000 of itemized deductions. Well, that’s less than the standard deduction of $24,000, so on the surface, it looks like this taxpayer should itemize their deductions.
The problem is from a state standpoint is that if you take the standard deduction for federal, you also have to take the standard deduction for state. In this case, the state standard deduction is only $3,000, so the total benefit that would be received if you take the standard deduction is less than it would have been if you had sacrificed and only taken an itemized deduction at the federal level.
I know a lot of our clients that are business owners, some of them still do their individual tax returns themselves, so it is certainly something to pay attention to. Obviously, we’re always here to help the best we can, and as we’re preparing returns, we’re maximizing the benefit and making sure that we will be picking whether we take the standard deduction or the itemized deduction based on what the overall best result is.
Again, just future considerations from a state standpoint. Overall, the state tax is going to make up a higher percentage of the total tax rate on a go forward basis, so we expect the companies to want to pay a lot more attention to how we minimize our state tax liability and what the planning opportunities are around that.
We have a dedicated state and local group here that can help us get out in front of that and plan for those taxes. Looking forward, a question as to whether or not states are going to conform to the Internal Revenue Code or decouple and break away from it is certainly something to continue to pay attention to.
A couple of other considerations and we’ll wrap up. Obviously the change in tax rate is going to impact the reporting of deferred tax assets and liabilities for companies. Since the legislation was enacted in 2017, then the impact of the change in the tax rate will run through 2017 financial statements in that fourth quarter. For example, if you had a large deferred tax asset on your books that was previously valued at 34%, we’re going to write that down to 21% so that reduction in the asset is running through the P&L. What will end up happening is for financial statement purposes, they’ll have a lot more tax expense than you normally would, and your overall effective tax rate will be higher.
Lots of companies are used to their effective rate being very similar from year to year, and this will be one of those years where it will not be. It will certainly be very inconsistent and we’ll be able to help you navigate through and understand that logic. From a foreign perspective, when you have foreign owned businesses that are rolling up into larger companies and parent companies that have other brother sister companies, there will be some explaining to do in regards to that overall effective rate.
Another credit that is out there that we had mentioned is to encourage companies to pay their employees while they’re off during FMLA type events. In essence, the credit is 12.5% of the wages that are paid to the employee as long as you’re paying at least 50% of the employee’s normal wages. As that wage amount is increased above 50%, the credit increases as well.
This is a nice credit. It’s a general business credit, which means that it’s an income tax credit that will flow through the tax return, so it’s not a payroll tax. The payroll department comes into play in terms of tracking this, but in terms of claiming the actual credit, it will be done on the tax return.
From a payroll standpoint new withholding tables have just been released. The IRS wants you to be using those by the middle of February, so keep that in mind as well. Certainly we didn’t spend a lot of time on some of these things that have been disallowed, such as qualified moving expenses, which can no longer be exempt from employees’ wages. Paying attention to those such items and making sure they’re handled properly for payroll will be important.
With that, I know it says questions, but we are out of time. Again, we will respond to whatever questions that you may have submitted. We appreciate everybody’s time. There’s some good, there’s some bad, and our goal is to be sitting down with each of our clients one on one and making sure that you understand the impact of the new legislation. If you have any questions or want to reach out before we have those one on one meetings, feel free to do so. Again, we appreciate everybody’s time and have a great day.