Authored by Jacque Lee and Rob Kane
Reprinted courtesy of Beverage Master. Read the full issue.
The comprehensive tax reform legislation passed by Congress this past December is poised to significantly impact the craft brewing industry in a number of ways.
The Tax Cuts and Jobs Act (TCJA) affords craft breweries a wealth of opportunities to positively impact their bottom line, so it’s critical for brewers to develop an understanding of the new tax rules and how they can be applied effectively. With that in mind, let’s analyze some of the rules and explain how breweries can benefit from these new measures.
Cash basis method of accounting and accounting for inventories
Many craft breweries utilize the cash basis method of accounting for tax purposes. Under the previous rules, companies were generally allowed to use this method if their average annual gross receipts did not exceed certain levels (usually a maximum of $10 million). As craft breweries grew and expanded, they became limited in using the cash basis method of accounting as they exceeded the gross receipts test.
The new rules increase the gross receipts test to $25 million, widening the population of businesses that may be able to use the cash basis method of accounting. In addition, taxpayers who meet the $25 million gross receipts test do not have to account for inventory under § 471 and generally may treat inventories either as non-incidental materials and supplies, or conform to the inventory method used for financial statement purposes.
Also impacted by the increased $25 million gross receipts test are the uniform capitalization (UNICAP) rules for inventory. Both producers and resellers meeting the $25 million gross receipts test are exempt from the UNICAP rules.
The provisions above are effective for tax years beginning after Dec. 31, 2017. Application of the provisions is a change in method of accounting under § 481, requiring the consent of the IRS to make the change.
Deducting the cost of new equipment
The cost of equipment can be quite expensive for craft brewers, so receiving an immediate tax write-off for the cost of this equipment would be extremely beneficial to any brewery planning to expand its operations. Under the new law, businesses may take 100 percent bonus depreciation on new or used tangible personal property with a recovery period of 20 years or less that is both acquired and placed into service after Sept. 27, 2017 and before Jan. 1, 2023. Property acquired before Sept. 28, 2017 and placed in service after Sept. 28, 2017 remains eligible for 50 percent bonus depreciation. Bonus depreciation is phased down 20 percent each year for property acquired and placed in service after Dec. 31, 2022 and before Jan. 1, 2027. Another expensing provision that may benefit craft breweries is § 179 expensing. This allows businesses to deduct the cost of qualifying equipment and software placed in service during the tax year. The new law increases the expense limitation to $1 million and the phase-out amount to $2.5 million for property placed in service in taxable years beginning after Dec. 31, 2017.
Both bonus depreciation and § 179 expensing may result in substantial present value tax savings for breweries with plans to purchase new or used equipment.
New limitations on deducting business interest
The TCJA also added more rules related to expensing business interest. Under the new rules, most companies would not be allowed an interest expense deduction for amounts exceeding 30 percent of their adjusted taxable income.
Adjusted taxable income for years beginning before Jan. 1, 2022 is defined as taxable income calculated without regard to depreciation, amortization, business interest expense/income, net operating losses, items of income or loss not allocable to the trade or business and deductions for certain pass-through income.
For tax years beginning on or after Jan. 1, 2022, the definition of adjusted taxable income is the same as previously described other than the adjustment for depreciation and amortization.
The rule generally doesn’t apply to taxpayers who have less than $25 million of average annual gross receipts for the previous three years. For many newer craft breweries that are below the gross receipts threshold, the limitation on deducting business interest would not have any effect.
For those breweries with average annual gross receipts exceeding $25 million, potential tax planning strategies exist to help reduce the impact of the interest limitation. For example, instead of financing an expansion through additional bank debt, breweries may consider adding new equity investors instead. Adding investors would increase cash through equity contributions rather than debt.
Research and development credit opportunities
The TCJA also retained some important tax credits with the potential to favorably impact bottom lines for craft breweries, including the research and development (R&D) credit.
The R&D credit provides companies with an incentive to invest in innovation. The credit is available to companies that develop new products or new processes, or improve upon existing products or processes. Companies that qualify can claim wages, supplies and contract research costs associated with R&D projects and activities. For craft breweries, the types of activities that may qualify include developing and testing new brew recipes and ingredients, evaluating new brewing raw materials and improving bottling or packaging processes.
Certain start-up breweries may also be eligible for the R&D credit payroll offset that was enacted as part of the Protecting Americans from Tax Hikes (PATH) Act of 2015. The R&D credit payroll offset allows eligible small businesses that have little or no income tax liability to offset the R&D credit against payroll taxes instead of incomes taxes. To qualify, a business must have gross receipts of less than $5 million for the current taxable year and no gross receipts for any taxable year preceding the five-taxable-year period ending with the current taxable year. For example, to be eligible for the R&D credit payroll offset in 2017, a company must have had less than $5 million of gross receipts in 2017 and no gross receipts prior to 2013.
The election to claim the payroll tax credit must be made on a timely filed original tax return (including extensions). Up to $250,000 of annual federal R&D credits can be allocated against payroll tax liability, beginning in the first quarter after the filing of the income tax return.
Excise tax rate decrease
Both large and small craft breweries also have the potential to a see a reduction in their per-barrel excise rates. Small brewers producing less than 2 million barrels per year could see their rate go down from $7 per barrel to $3.50 per barrel for the first 60,000 barrels. The general excise tax rate will go from $18 per barrel to $16 per barrel on the first 6 million barrels, and the rate is $18 per barrel for barrels brewed or imported in excess of 6 million barrels. The new rates go into effect for beer removed after Dec. 31, 2017 and before Jan. 1, 2020.
Twenty percent deduction for certain pass-through income
The TCJA includes a rule allowing individuals, estates and trusts to claim a deduction equal to 20 percent of the domestic qualified business income from a partnership, S corporation or sole proprietorship. The deduction is generally subject to a limit based on either wages paid or wages paid plus a capital element.
This deduction will benefit many small businesses including brewers. Although the calculation appears to be relatively simple, it is an involved computation with many nuances, exceptions and areas where guidance is currently lacking and clarification is needed from Congress or the Treasury Department. As such, consult your tax advisor about how this may benefit your business.
Converting to a C corporation
With all of the new tax law changes, many companies may ask whether they should convert to a C corporation from a pass-through entity (such as a partnership or S corporation). The highest marginal rate for individuals is 37 percent under the new law, while C corporations are taxed at a flat rate of 21 percent. With the revised tax rates, C corporations seem to come out ahead, with lower tax rates than individuals. This has resulted in speculation over the benefits of switching to a different entity type. Whether or not a particular company should switch to a C corporation would depend on multiple factors, all of which should be considered carefully.
Among the factors to be considered is the general availability of the 20 percent deduction for pass-through income discussed above. Other considerations, such as the desire to pass through company losses to owners, or decisions to make frequent cash distributions, might make converting to a C corporation less advantageous. Additional factors, like continued positive taxable income and a lack of desire to make cash distributions to owners outside of tax distributions, may make converting to a C corporation more desirable. Ultimately, switching entity types is a fact-specific analysis, and any final decision is best made after engaging in discussions with a tax advisor.
There is no shortage of ways in which craft breweries can benefit from the recently passed comprehensive tax reform legislation. Possessing a knowledge of the Tax Cuts and Jobs Act and leveraging some of the new rules and measures in place can not only help a brewery reduce business complexity, but also save it valuable time and positively impact its bottom line.
For more information on these topics, or to learn how Baker Tilly craft brewery specialists can help, contact our team.