New tax law opens opportunities for metal fabricators

Editor’s Note: The following is based on information from Wipfli LLP, www.wipfli.com, a CPA and consulting firm based in Milwaukee, Wis. The editors thank Wipfli Tax Partner Samantha Wimmer for her review.

An $18 million fabricator has a strong balance sheet; however, cash flow is tied up in non-cash current assets, the fabricator is having a rough year getting paid, and taxable income is anticipated to be $2 million. The fabricator learns that it can file its taxes and take advantage of a $1 million deduction for the difference between its $5 million accounts receivable and $4 million accounts payable, saving hundreds of thousands of dollars. As a result, the $2 million of taxable income is now only $1 million. Thanks to the new U.S. tax law, this is in the realm of possibility.

Although there has been lots of commentary about reduced corporate tax rates, there has been less focused discussion (likely due to delays in IRS guidance) on strategies related to minimizing taxable income, saving taxes, and the effects of both on conserving cash flow.

First though, a disclaimer. All this is for informational purposes only; there are details and limitations in each of the areas discussed that are outside the scope of this article. This article is no substitute for one-on-one tax advice, nor does it represent official interpretations of IRS regulations. The tax regulations based on the new law are still being written, and clarifications are still being issued. For further details and clarifications, seek out a tax professional.

Regardless, preliminary guidance demonstrates that many of the new tax provisions provide opportunities to save taxes and help companies focus on cash.

Cash versus Accrual Method of Accounting

For tax years beginning before Jan. 1, 2018, most U.S. metal fabricators were required to use the accrual method of accounting for tax purposes. Why? For decades, tax guidance has required the accrual method for those maintaining inventory. Since most fabricators have inventory, the default accounting method has been the accrual method. Under those provisions, fabricators would record revenue and expenses when incurred, not when cash was received or paid.

For many fabricators, this creates a challenge for cash flow and related planning. For example, a fab shop that concentrates on large industrial projects may enjoy healthy margins, but the payments for those long projects come infrequently. Another fabricator may find itself playing “banker” as it deals with slow-paying customers and accounts receivable (AR) with a growing number of days outstanding. Although the accrual method may show a healthy business, it can present challenges given that taxes may be due on income earned but still represented by outstanding AR.

As part of the tax reform, the cash method of accounting has been modified such that many businesses previously ineligible for the cash method are now eligible. Under the revisions, businesses can adopt the cash method regardless of whether they are required to maintain inventories, provided revenues do not exceed a $25 million threshold. Specifically, that $25 million threshold is calculated based upon average annual gross receipts (AAGR) over the prior three tax years. For example, if a fabricator had gross receipts of $24 million in the third preceding year, $26 million in the second, and $22 million in the first, its AAGR would be $24 million. Since this is less than $25 million, the fabricator would qualify for the cash method.

There are certain exceptions to this, of course. When it comes to taxes, there always are. Regardless, most U.S. fabricators would certainly fall under the $25 million threshold. Once AAGR exceed the $25 million threshold, the fabricator would need to follow procedural guidance and convert back to the accrual method.

Both accrual and cash accounting methods have their merits, and which method is most advantageous depends upon each taxpayer’s unique facts and circumstances. However, with the new tax environment, most businesses with sizeable AR in excess of AP, and gross receipts below the $25 million threshold, are likely to realize a significant tax benefit from changing to the cash method.

If fabricators average between, say, $5 million and $15 million in annual gross receipts, it could be a long time before they approach the $25 million threshold. Thus, they may qualify as cash method taxpayers for an extended period, which over time can yield significant tax savings on a present value basis.

Even if a fabricator switches to the cash method for tax purposes, the fabricator can still use the accrual method for financial accounting purposes. In fact, some companies may prefer keeping both, effectively achieving the best of both worlds–better income results under the accrual method to strengthen the financial position reported to bankers and investors, and reduced taxable income under the cash method, thereby minimizing taxes.

Treatment of Inventories

The $25 million threshold for average annual gross receipts also applies to a provision related to inventories. Businesses below this revenue threshold are now exempt from the requirement to maintain inventories. Pursuant to the tax reform, these businesses can elect to treat inventories as nonincidental materials and supplies, or in conformity with their financial statements.

In addition to the new exemption for inventories, businesses below the $25 million threshold are no longer subject to the uniform capitalization (UNICAP) rules that have required manufacturers to capitalize additional costs into inventory for tax purposes. Capitalizing those costs meant higher inventory levels and fewer tax deductions until the manufactured goods were sold.

Suppose a fabricator has $100,000 of cumulative UNICAP costs capitalized into inventory for tax purposes that hasn’t yet been sold. Now that fabricator doesn’t have to apply UNICAP, and as a result, an immediate tax deduction for the $100,000 of previous capitalized UNICAP costs awaits.

Please note that the IRS does have procedural requirements (some of which are currently pending) that must be followed for businesses to adopt these changes. Therefore, fabricators that wish to change to the cash method, or change the treatment of their inventories or UNICAP costs, should consult their tax advisor before making any changes in their filing positions.

Bonus Depreciation and Section 179

The tax reform also expanded the accelerated depreciation available on property additions. Bonus depreciation has increased from 50 percent to 100 percent, and eligible property is expanded to include not only new property but used property as well. Bonus depreciation is not limited to a maximum dollar amount and is not limited by the taxpayer’s business income. The 100-percent bonus depreciation also is retroactive; it applies to eligible property acquired and placed in service after Sept. 27, 2017.

Section 179 provides another alternative for immediate expensing of eligible property. However, Section 179 has some limitations, including a maximum deduction of $1 million for 2018, a dollar-for-dollar phase out of the deduction as eligible property purchases exceed $2.5 million, and a limitation based upon the taxpayer’s business income.

Let’s consider an example of a fab shop acquiring and placing in service $2.6 million of eligible property. Due to the Section 179 phase-out limitation, the $1 million deduction is reduced to $900,000. At $3.5 million of eligible property, Section 179 would be fully phased out, resulting in no Section 179 deduction to the shop for that year.

As a fabricator, you may be wondering—what is the benefit of bonus depreciation versus Section 179? Looking at this example, if a fab shop faced the phase-out for Section 179, 100-percent bonus depreciation provides a suitable replacement. And although an immediate federal deduction may be available under either, there could be differences in the way states treat these two provisions. There have been differences in the federal and state treatment of depreciation provisions for years. For example, a state may follow the federal Section 179 rules, but not fully follow the federal bonus depreciation rules. If that is the case, choosing Section 179 provides a better answer as it maximizes both current federal and state tax savings.

The Necessity for Tax Planning

Should a fabricator take bonus depreciation, Section 179, or perhaps some combination of both? Should it switch to the cash method of accounting? What about changing inventory methods for tax purposes? The answer depends on the circumstances, and all of these considerations take serious planning, including how each strategy may interplay with the other.

For instance, say a fabricator buys a large machine and chooses to depreciate it fully during the first year. This decreases the shop’s reported taxable income substantially, reducing it to a lower tax bracket.

Because accelerated depreciation is already reducing 2018 taxable income to a lower tax bracket, other changes, such as the cash method, might be best implemented in 2019 or after, when the benefit of additional deductions could be better realized to offset income in a higher tax bracket.

Reliable forecasting is now more valuable than ever. Nobody has a crystal ball, but any fabricator that wants to implement the best tax strategies, and at the proper time, needs to know where its business is headed. With all the new options the tax law provides, a fabricator with the right tax strategy can have a competitive advantage.

Wipfli LLP, www.wipfli.com