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The Tax Cuts and Jobs Act (TCJA) has significantly lowered tax rates for businesses and changed many deductions.  One of the biggest and most important changes is the deductibility of business interest expense, which is creating complexity and confusion.  This provision is expected to raise $250 billion in taxes over the next ten years.

In the past, business interest expense has been generally deductible, but with some limitations.

For tax years beginning after December 31, 2017 and before January 1, 2022, deductible business interest expense is limited to:

  • 30% of adjusted taxable income before depreciation, amortization and depletion
  • plus business interest income and floor plan financing interest

Starting in 2022, deductible business interest expense will be limited to:

  • 30% of taxable income only
  • plus business interest income and floor plan financing interest

Business interest expense does not include investment interest expense or floor plan financing interest (secured motor vehicle inventory).  Any business interest expense that is not deductible is carried forward indefinitely.  Special rules for the carryover interest will apply to partnerships.

Adjusted taxable income is taxable income before interest expense, interest income, net operating loss and the 20% qualified business income deduction (Section 199A).  The 30% of adjusted taxable income cannot be less than zero.

Small businesses (those with average gross receipts of $25 million or less for the three prior years) other than tax shelters are not subject to this business interest expense limitation.  The aggregation rules apply to related businesses.

Real property trades/businesses and farm businesses can elect out of this interest limitation if they do not claim bonus depreciation and use the alternative depreciation system (ADS) to depreciate applicable real property and farm property (for assets with a useful life longer than 10 years).  Once the election is made, it’s irrevocable.

For partnerships and S corporations, the business interest limitation is applied at the entity level to ordinary business income or loss.  It does not include any separately stated items of income or loss.  There are special rules to eliminate double counting of income and to utilize excess taxable income.

What actions should businesses take?

The intent is for businesses to become less leveraged and more stable, which should create a more stable economy.  For the next several years, highly leveraged or less profitable companies may start to feel the effects of this new business interest expense limitation.  It can make financing more expensive.  Starting in 2022, this limitation will affect many businesses.

Now is the time to plan for how and when the business interest expense limitation will affect your business.  Businesses should consider doing the following:

  • Determine if the business meets the small business exception (≤$25 million) and for how long?
  • Prepare projections of income, fixed asset acquisitions, debt levels and interest rates for the future.
  • Determine if an election is appropriate for real property trades/businesses and farm businesses.

The results could be higher taxes or a change in the debt and equity structure of the business.  It could affect how you do business today and in the future.

Please contact your Clark Nuber professional or Rene Schaefer to understand this new tax provision and how it affects your business.

© Clark Nuber PS and Developing News, 2018. Unauthorized use and/or duplication of this material without express and written permission from this blog’s author and/or owner is strictly prohibited. Excerpts and links may be used, provided that full and clear credit is given to Clark Nuber PS and Developing News with appropriate and specific direction to the original content.

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Revenue Recognition for Privately Held Manufacturers

As a quick recap, the new revenue recognition standard (ASU 2014-09, also known as ASC 606) provides new requirements for recognition of revenue arising from contracts with customers, except in cases where contracts are within the scope of other U.S. GAAP requirements (such as the leasing standards). The standard impacts businesses in all industries and will become effective January 1, 2019 for non-public companies. Companies may elect one of two methods for implementation: (1) the modified retrospective approach or (2) a full restatement. Revenue amounts and timing may not ultimately change, but disclosure requirements likely will change. Furthermore, tax treatment will generally need to follow GAAP and considerations will need to be made relative to tax filings as well.

One Size Does Not Fit All

Each provision of ASU 2014-09 will not apply to every company. For example, two manufacturing companies competing in the same marketplace could face different issues, depending on what terms are negotiated in their customers’ contracts. It is important to understand the guidance as it relates specifically to each individual business. The following is a summary of the five-step process model that companies will need to work through to determine revenue recognition under the new standard. For the purposes of this article, I have added a few areas of interest for manufacturers.

Revenue Recognition Model – Five-Step Process

1. Identify the contract. All businesses have agreements with their customers. A contract is anything that creates enforceable rights or obligations (contract, purchase order or change order). Approval and commitment of a contract can be in writing, orally or in accordance with customary business practices. The contract needs to also have commercial substance, as defined, have identifiable payments terms, and collection needs to be probable.
Shipping and Handling - Shipping and handling that occurs before a customer obtains control of a product is considered a fulfillment activity.  Shipping and handling that occurs after a customer obtains control of a product is considered a promised service. An accounting policy election can be made to treat promised services as fulfillment.
2. Identify the performance obligations in the contract. Distinct goods or services that have their own value should be separately identifiable from other promises in the contract (that is, explicit and implicit).
Warranty -  If a warranty is not separately priced, revenue is recognized in full at the time of delivery and the related cost is accrued. Extended warranties and warranties that provide services other than assurance that a product complies with its specifications, are accounted for as separate performance obligations within a contract.
3. Determine the contract price. This includes fixed cash consideration, variable consideration, financing components, consideration payable to the customer, and non-cash consideration.
Variable Consideration - Can include bonuses, price concessions, refunds, milestone payments, penalties, discounts, returns, volume rebates, etc. Out-of-pocket costs may also potentially be viewed as variable consideration. The new standard tasks each business with valuing contracts based on a variety of methods, with further guidance included within the standard.
Returns - Revenue is not recorded for refunds expected to be paid to customers. Rather, a refund liability is recorded with a corresponding asset (adjustment to COGS) representing the right to recover products from customers of settling the refund liability.
Gross Versus Net Revenue - The transaction price is the amount of consideration for which the company expects to be entitled (net of discounts or rebates). Companies make an accounting policy election to exclude from the transaction price certain types of taxes collected from customers.
4. Allocate the contract price to performance obligations. First, allocate transaction price using standalone selling prices for identified performance obligations. If standalone selling prices are not available for certain performance obligations, a company may use available market data. A residual approach may be used for any remainder. 5. Recognize revenue as the performance obligation is satisfied. Each performance obligation is recognized at a point in time or over a period of time. Over time, recognition is only allowed if any of the following are met:
  • Customer simultaneously receives and consumes the benefit.
  • Services rendered create or enhance an asset that the customer controls.
  • Services do not create an asset with an alternative use to the service provider and the service provider has an enforceable right to payment at all times during the term of the contract.
Milestones - Contractual billing milestones may not be considered performance obligations and are not necessarily indicative of “point in time” recognition.
Short Cycle Manufacturing - Companies may have an enforceable right to payment and under the principal of the new standard would need to recognize revenue. The FASB is already deliberating on an exception for this one, so stay tuned.
Bill and Hold - The new standard provides explicit guidance that is essentially the same guidance in the SEC’s interpretive guidance. Many private companies were already following it; therefore, no change is likely. However, companies may want to revisit the four criteria that must be met for recognition:
  • The reason is substantive.
  • The product is separately identified.
  • The product is ready for physical transfer.
  • The company cannot be able to use or redirect the product.

Other Considerations for Manufacturers

In addition to the changes in ASC 606, there are other changes to costs (ASC 340) that are not covered in the five-step model. Those who are responsible for implementing revenue recognition should also take note of the following considerations.
  • Costs of obtaining the contract - These are incremental costs incurred as a result of a contract being obtained. Costs are deferred and amortized over the life of the contract (including considerations for renewal), as long as costs are expected to be covered. This includes sales commissions but does not include legal and credit evaluations.
  • Contract Fulfillment - The costs of fulfilling a contract should be accounted for under other GAAP standards. Any deferred costs are amortized over the life of the contract (including considerations for renewal) in the same pattern as revenue is recognized. Costs included are equipment recalibration and design costs required to fulfill a contract.
The new model focuses on recognition of revenue and not margin and costs. FASB did not include guidance for abnormal or wasted materials. Use your judgement to adjust for costs that do not contribute to contract progress.

Next Steps

The five-step revenue recognition model may appear straightforward, but it provides a simplified, high-level overview. Most companies will likely have more than one contract that needs to be evaluated. It will take time to capture the information needed to support compliance. If you don’t have one yet, create an implementation team and set up a road map to assess the impact of the new standard. Public companies were required to adopt the standard in 2018, so private companies will have a window into its impact. Implementation teams should consider evaluating the footnote disclosures of public companies as noted in their quarterly filings and compare to others in the industry as they begin to evaluate how the standard will affect their company. A CPA firm can help you with this process, and the time to start is now. For more information about implementing revenue recognition standards for manufacturers, please contact Hillary Parker. © Clark Nuber PS, 2018. All Rights Reserved

U.S. Supreme Court Overturns Quill, Opens Door for States to Require Sales Tax Collection by Virtually All Remote Sellers

Although the Court’s choice to overturn 51 years of precedent was not altogether unexpected, it will nonetheless require businesses that sell on a multistate basis to make some impactful and immediate decisions on how to operate in the post-Quill world. A few thoughts on the Court’s June 21, 2018 decision in South Dakota v. Wayfair, and its impact (short-term and longer-term) on both remote sellers and consumers:

The Court threw out the old rule, but didn’t provide clear guidance on exactly when a seller must collect tax on remote sales.

The Court’s majority opinion held that its earlier decisions in National Bellas Hess v. Illinois (1967) and Quill v. North Dakota (1992) were wrongly decided, insofar as they provided that physical presence was a prerequisite for substantial nexus under the dormant Commerce Clause of the U.S. Constitution.  The Court found that these earlier decisions had resulted in an “online sales tax loophole” or “judicially created tax shelter” for remote sellers, which “creates rather than resolves market distortions.” Holding that “the physical presence rule is artificial in its entirety,” the Court had no trouble overturning it.  However, the decision provides no real guidance on what minimum level of activity or sales into a state would be sufficient to create substantial nexus and an obligation to collect tax post-Quill. The Court remanded the case to the South Dakota Supreme Court to determine whether the state’s law meets other constitutional requirements.  In remanding the case, the Court noted favorably that other constitutional concerns may be satisfied by the law’s sales and transaction thresholds, the bar on retroactive enforcement, and the adoption by South Dakota of certain uniformity and simplification provisions of the Streamlined Sales and Use Tax Agreement.

Congress could provide a new set of rules - but will it? 

Both the Court’s majority and dissenting opinions stress that Congress could create a new set of rules for sales tax collection on remote sales, if it chooses to act.  Acknowledging that its decision may create significant new compliance burdens on remote sellers, the majority points out that “Congress may legislate to address these problems if it deems it necessary and fit to do so.” The dissent is more pointed – although agreeing that Bellas Hess was wrongly decided, it argues that “Any alteration to [the physical presence rule] with the potential to disrupt the development of such a critical segment of the economy should be undertaken by Congress.”  It remains to be seen whether and when Congress will act.

How will the states react?

A number of states have enacted laws in the past several years similar to the South Dakota law at issue in Wayfair, which requires sellers to collect tax if they make more than $100,000 of sales or have more than 200 sales transactions per year with customers there.  Although the South Dakota law bars retroactive assessments of uncollected sales tax, some of the similar laws in other states do not.  However, states will face their own administrative burdens in bringing a raft of remote sellers into their taxing systems rather quickly. Given the Court’s approving statements regarding the South Dakota law’s bar on retroactive enforcement, one would hope that most states will focus on getting remote sellers to collect and remit tax going forward rather than assessing uncollected tax for past periods.  Many of the states that have not yet enacted South Dakota-style laws will likely rush to do so; but, here again one hopes that the states will set a specific date on which remote sellers must begin to collect tax, rather than imposing retroactive liability for uncollected taxes.  It is important to note that there is nothing to prevent states from assessing tax for prior periods on sellers who had a physical presence inside their borders prior to the Wayfair decision.

How should remote sellers react?

This will obviously depend on many factors, including whether the seller has had any physical presence in states where it has not collected tax, what its sales volumes are in the various states, whether its products and services are even subject to sales tax in the states where its customers are located, and more.  Some remote sellers may want to consider registering and collecting tax in all states in which they make sales.  For others, a more cautious approach may be justified. Careful consideration should be given to whether liability exists for uncollected tax resulting from past in-state activities.  It is probably not advisable to register and begin collecting tax prospectively as prior periods will remain open for assessment.  Voluntary disclosure programs where the look-back period for uncollected tax is limited and penalties are waived are available in every state to address past exposure. The best strategy for coming into compliance may vary significantly from company to company based on the specific facts involved.  For those sellers that wish to register and begin collecting tax, consideration should be given to the cost of compliance.  Sales tax compliance software is available and may provide a cost-effective way to manage tax collection and filing returns.

How will consumers be impacted?

The immediate impact may be minimal.  Some of the largest remote sellers already collect tax in all or virtually all the states where they have customers.  And, as discussed above, it will likely take some time for the states to bring other remote sellers into compliance, and for those sellers to implement broad-based sales tax collection. In the long run, however, it is likely that consumers will be paying sales tax on most remote purchases that currently go untaxed. Although there may still be small seller exceptions and other provisions that allow some sales to escape taxation, the likelihood is that absent action by Congress to limit their authority, states will act aggressively to require tax collection on remote sales and sellers will eventually be brought into compliance.  The days of widespread tax-free buying from internet and catalog vendors are almost certainly a thing of the past. For more information on how the Wayfair decision may apply to your specific facts, contact any member of the Clark Nuber state and local tax team, or your own tax advisors. © Clark Nuber PS, 2018. All Rights Reserved

Three Key Tax Incentives for Manufacturers and Distributors under the Tax Cuts and Jobs Act

The three incentives that the TCJA allows for these types of companies are: using the cash method for tax purposes, treating inventory costs as non-incidental materials, and exempting them from the new interest expense limitation.

Using the Cash Method

Businesses may use the cash method for tax purposes, even though the business keeps its books and records on the accrual basis. Previously, businesses could not use the cash method if they had gross receipts over $10 million, maintained inventories, or were a C corporation or had a C corporation partner with gross receipts over $5 million. When using the cash method for tax purposes, income is recognized when the cash is received and expenses are deductible when they are paid.  The cash method provides a better matching of cash flow with taxes paid and more flexibility in tax planning. In the year the change is made, there is usually significant tax savings.  C corporations have the flat tax rate of 21%, so there may be some planning needed if the cash method creates a loss.  For S corporations, partnerships, and sole proprietorships, strategic planning can spread out the tax savings over two years by taking advantage of reducing taxes at higher tax rates.  As a business grows, the tax savings increase.  Changing to the cash method requires an Accounting Method Change (Form 3115).

Treating Inventories as Non-Incidental Materials

Businesses may treat inventories as non-incidental materials and supplies or conform to the method the business uses for financial statements or its books and records.  Under the previous law, businesses were required to capitalize materials, labor, overhead, and related general and administrative expenses (uniform capitalization) for tax purposes.  This change also requires an Accounting Method Change (Form 3115).

Exemption From the New Interest Expense Limitation

The TCJA added a new provision that limits the interest expense a business can deduct.  For 2018 through 2021, interest expense is deductible to the extent it is less than 30% of taxable income plus interest expense, depreciation, and amortization.  After 2021, interest expense is deductible to the extent it is less than 30% of taxable income plus interest expense only.  This interest expense limitation does not apply to small businesses. There are many other tax incentives available to manufacturers, distributors, and retailers, such as the Section 179 expense election up to $1 million and 100% bonus depreciation.  It is also important to consider what type of entity the business should use for tax purposes (C corporation, S corporation, LLC) with the different rate structures and limitations under the new tax law. Businesses should give careful consideration to planning with the TCJA.  There are many incentives that can result in significant tax savings.  Please contact your Clark Nuber professional or Rene Schaefer to understand how this new tax law can help you. © Clark Nuber PS, 2018. All Rights Reserved

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