Acuity Advisors

Your 2017 tax return may be your last chance to take the “manufacturers’ deduction”

While many provisions of the Tax Cuts and Jobs Act (TCJA) will save businesses tax, the new law also reduces or eliminates some tax breaks for businesses. One break it eliminates is the Section 199 deduction, commonly referred to as the “manufacturers’ deduction.” When it’s available, this potentially valuable tax break can be claimed by many types of businesses beyond just manufacturing companies. Under the TCJA, 2017 is the last tax year noncorporate taxpayers can take the deduction (2018 for C corporation taxpayers).

The basics

The Sec. 199 deduction, also called the “domestic production activities deduction,” is 9% of the lesser of qualified production activities income or taxable income. The deduction is also limited to 50% of W-2 wages paid by the taxpayer that are allocable to domestic production gross receipts (DPGR).

Yes, the deduction is available to traditional manufacturers. But businesses engaged in activities such as construction, engineering, architecture, computer software production and agricultural processing also may be eligible.

The deduction isn’t allowed in determining net self-employment earnings and generally can’t reduce net income below zero. But it can be used against the alternative minimum tax.

Calculating DPGR

To determine a company’s Sec. 199 deduction, its qualified production activities income must be calculated. This is the amount of DPGR exceeding the cost of goods sold and other expenses allocable to that DPGR. Most companies will need to allocate receipts between those that qualify as DPGR and those that don’t • unless less than 5% of receipts aren’t attributable to DPGR.

DPGR can come from a number of activities, including the construction of real property in the United States, as well as engineering or architectural services performed stateside to construct real property. It also can result from the lease, rental, licensing or sale of qualifying production property, such as tangible personal property (for example, machinery and office equipment), computer software, and master copies of sound recordings.

The property must have been manufactured, produced, grown or extracted in whole or “significantly” within the United States. While each situation is assessed on its merits, the IRS has said that, if the labor and overhead incurred in the United States accounted for at least 20% of the total cost of goods sold, the activity typically qualifies.

Learn more

Contact us to learn whether this potentially powerful deduction could reduce your business’s tax liability when you file your 2017 return. We can also help address any questions you may have about other business tax breaks that have been reduced or eliminated by the TCJA.

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How financial statements can be used to value private businesses ……

Owners of private businesses often wonder: How much is my business interest worth? Financial statements are a logical starting point for answering this question. Here’s an overview of how financial statements can serve as the basis for value under the cost, income and market approaches.

Cost approach

Because the balance sheet identifies a company’s assets and liabilities, it can be a good place to start the valuation process, especially for companies that rely heavily on tangible assets (such as manufacturers and real estate holding companies). Under U.S. Generally Accepted Accounting Principles (GAAP), assets are recorded at the lower of cost or market value. So, adjustments may be needed to align an item’s book value with its fair market value.

For example, receivables may need to be adjusted for bad debts. Inventory may include obsolete or unsalable items. And contingent liabilities — such as pending lawsuits, environmental obligations and warranties — also must be accounted for.

Some items may be specifically excluded from a GAAP balance sheet, such as internally developed patents, brands and goodwill. Value derived under the cost approach generally omits intangible value, so this estimate can serve as a useful “floor” for a company’s value. Appraisers typically use another technique to arrive at an appraisal that’s inclusive of these intangibles.

Income approach

The income statement and statement of cash flows can provide additional insight into a company’s value (including its intangibles). Under the income approach, expected future cash flows are converted to present value to determine how much investors will pay for a business interest.

Reported earnings may need to be adjusted for a variety of items. Examples of items that may require adjustments include depreciation rates, market-rate rents and discretionary spending, such as below-market owners’ compensation or nonessential travel expenses.

A key ingredient under the income approach is the discount rate used to convert future cash flows to their net present value. Discount rates vary depending on an investment’s perceived risk in the marketplace. Financial statement footnotes can help evaluate a company’s risks.

Market approach

The market approach derives value primarily from information taken from a company’s income statement and statement of cash flow. Here, pricing multiples (such as price to operating cash flow or price to net income) are calculated based on sales of comparable public stocks or private companies.

When looking for comparables, it’s essential to filter deals using relevant criteria, such as industrial classification codes, size and location. Adjustments may be required to account for differences in financial performance and to arrive at a cash-equivalent value, if comparable transactions include noncash terms and future payouts, such as earnouts or installment payments.

Independence and experience count

Business value is a critical metric, whether it’s used for financial reporting, M&A, tax planning or litigation purposes. But never base a major decision on a do-it-yourself appraisal. Contact us for help calculating an estimate of value that you can count on.

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New tax law gives pass-through businesses a valuable deduction ……

Although the drop of the corporate tax rate from a top rate of 35% to a flat rate of 21% may be one of the most talked about provisions of the Tax Cuts and Jobs Act (TCJA), C corporations aren’t the only type of entity significantly benefiting from the new law. Owners of noncorporate “pass-through” entities may see some major — albeit temporary — relief in the form of a new deduction for a portion of qualified business income (QBI).

A 20% deduction

For tax years beginning after December 31, 2017, and before January 1, 2026, the new deduction is available to individuals, estates and trusts that own interests in pass-through business entities. Such entities include sole proprietorships, partnerships, S corporations and, typically, limited liability companies (LLCs). The deduction generally equals 20% of QBI, subject to restrictions that can apply if taxable income exceeds the applicable threshold — $157,500 or, if married filing jointly,　$315,000.

QBI is generally defined as the net amount of qualified items of income, gain, deduction and loss from any qualified business of the noncorporate owner. For this purpose, qualified items are income, gain, deduction and loss that are effectively connected with the conduct of a U.S. business. QBI doesn’t include certain investment items, reasonable compensation paid to an owner for services rendered to the business or any guaranteed payments to a partner or LLC member treated as a partner for services rendered to the partnership or LLC.

The QBI deduction isn’t allowed in calculating the owner’s adjusted gross income (AGI), but it reduces taxable income. In effect, it’s treated the same as an allowable itemized deduction.

The limitations

For pass-through entities other than sole proprietorships, the QBI deduction generally can’t exceed the greater of the owner’s share of:

50% of the amount of W-2 wages paid to employees by the qualified business during the tax year, or
The sum of 25% of W-2 wages plus 2.5% of the cost of qualified property.

Qualified property is the depreciable tangible property (including real estate) owned by a qualified business as of year end and used by the business at any point during the tax year for the production of qualified business income.

Another restriction is that the QBI deduction generally isn’t available for income from specified service businesses. Examples include businesses that involve investment-type services and most professional practices (other than engineering and architecture).

The W-2 wage limitation and the service business limitation don’t apply as long as your taxable income is under the applicable threshold. In that case, you should qualify for the full 20% QBI deduction.

Careful planning required

Additional rules and limits apply to the QBI deduction, and careful planning will be necessary to gain maximum benefit. Please contact us for more details.

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Income statement items warrant your auditor’s attention……

Today’s auditors spend significant time determining whether amounts claimed on the income statement capture the company’s financial performance during the reporting period. Here are some income statement categories that auditors focus on.

Revenue

Revenue recognition can be complex. Under current accounting rules, companies follow a patchwork of industry-specific guidance. So, companies in different industries may record revenue for similar transactions differently.

However, more than 180 industry-specific revenue recognition rules will soon be replaced by Accounting Standards Update (ASU) No. 2014-09, Revenue from Contracts with Customers. The new standard goes into effect in 2018 for public companies and 2019 for private companies and not-for-profit entities. It calls for a single principles-based approach for recognizing revenues from long-term contracts.

As you implement the updated guidance, expect your auditor to give more attention to how you report revenue than in previous years. For example, your auditor might analyze revenue-related balance sheet accounts (such as accounts receivable) to uncover over- or understatement of revenue. Your auditor might also conduct tests to verify the legitimacy of accounts receivable balances recognized as revenue during the reporting period.

In the case of complex contract sales, testing includes reading the contract and verifying that the company earned the right to recognize revenue. For simpler transactions, a review of relevant documents such as invoices, bills of lading and payment information may suffice.

Cost of goods sold (COGS)

There are three components of COGS: raw materials, labor and overhead costs. COGS is a major line item for many companies, so auditors spend significant time verifying these costs.

They may review purchase orders, shipping documents and employee time records to verify specific amounts claimed for labor and materials. In addition, these costs tend to change in tandem with revenue. So, if labor as a percentage of revenue changes over time, it’s likely to raise a red flag during your audit.

Calculating and allocating overhead costs calls for a high degree of subjectivity. Auditors often turn to analytical procedures to test COGS. For example, they may use the inventory balance to help confirm the amount and cost of inventory consumed during the reporting period.

Operating expenses

Companies incur various expenses — such as sales commissions, office supplies, rent and utilities — to support their general business operations. Auditors typically review vendor acceptance and payment approval processes to determine whether the amounts reported appear reasonable and timely. To uncover anomalies, auditors also analyze operating expenses over time and against other line items.

Operating expenses for services, such as advertising and professional fees, can be an easy place for dishonest employees to hide fraud. So, auditors tend to scrutinize these accounts. For example, they’re likely to review invoices and inquire about prepaid retainers. Auditors also send letters to their clients’ attorneys to assess the risk of pending litigation that may need to be reported as a liability on the balance sheet.

A balanced approach

During an audit, income statement items warrant close attention due to their complexity, possible effects on balance sheet items and the potential for manipulation. Contact us for more information about what to expect as auditors review your revenues and expenses this audit season.

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The TCJA temporarily expands bonus depreciation ……..

The Tax Cuts and Jobs Act (TCJA) enhances some tax breaks for businesses while reducing or eliminating others. One break it enhances — temporarily — is bonus depreciation. While most TCJA provisions go into effect for the 2018 tax year, you might be able to benefit from the bonus depreciation enhancements when you file your 2017 tax return.

Pre-TCJA bonus depreciation

Under pre-TCJA law, for qualified new assets that your business placed in service in 2017, you can claim a 50% first-year bonus depreciation deduction. Used assets don’t qualify. This tax break is available for the cost of new computer systems, purchased software, vehicles, machinery, equipment, office furniture, etc.

In addition, 50% bonus depreciation can be claimed for qualified improvement property, which means any qualified improvement to the interior portion of a nonresidential building if the improvement is placed in service after the date the building is placed in service. But qualified improvement costs don’t include expenditures for the enlargement of a building, an elevator or escalator, or the internal structural framework of a building.

TCJA expansion

The TCJA significantly expands bonus depreciation: For qualified property placed in service between September 28, 2017, and December 31, 2022 (or by December 31, 2023, for certain property with longer production periods), the first-year bonus depreciation percentage increases to 100%. In addition, the 100% deduction is allowed for not just new but also used qualifying property.

The new law also allows 100% bonus depreciation for qualified film, television and live theatrical productions placed in service on or after September 28, 2017. Productions are considered placed in service at the time of the initial release, broadcast or live commercial performance.

Beginning in 2023, bonus depreciation is scheduled to be reduced 20 percentage points each year. So, for example, it would be 80% for property placed in service in 2023, 60% in 2024, etc., until it would be fully eliminated in 2027.

For certain property with longer production periods, the reductions are delayed by one year. For example, 80% bonus depreciation would apply to long-production-period property placed in service in 2024.

Bonus depreciation is only one of the business tax breaks that have changed under the TCJA. Contact us for more information on this and other changes that will impact your business.

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