The Sound of Automation
In this episode, Clayton & McKervey Shareholder and Tax practice leader Sarah Russell provides insights on the current tax landscape. Listen in to learn about the anticipated tax changes and what the lack of legislative movement could mean for your business. Even though the Build Back Better Act is on the backburner, there are some important considerations regarding R&D tax credits and SALT workarounds.
Podcast Transcript:
Announcer:
Welcome to the Sound of Automation, brought to you by Clayton & McKervey, CPAs for growth driven businesses.
Denise Asker, Director of Mkt. & Practice Growth:
Happy new year, Brian. Good to see you.
Bryan Powrozek, Sr. Manager Industrial Automation:
Good to see you, Denise, although I don’t have you here with me today. You’re calling in from your home.
Denise Asker:
I am. So with the power of technology, I’m safely at home and watching you and Sarah there. Sounds like you’re going to have a good conversation about all of our favorite topic of taxes.
Bryan Powrozek:
Exactly. Every business owner’s favorite subject. We got one owner in particular. He knows every time we come out to visit him, it’s going to be the best day of his week because he gets to talk about accounting and tax.
Denise Asker:
Okay. So what’s on your mind? What are you and Sarah going to be focusing on?
Bryan Powrozek:
Well, in planning for this episode, we were thinking that there’d be a lot more to talk about in the tax arena than actually materialized. There was a lot of build up to the Build Back Better Act that then fell short. So really just talking about how the fact that the tax changes we were anticipating as part of that act, now that they’re not happening, or at least not happening right away, what business owners should think about. There was a big change to the R&D credit that was included in there that now isn’t happening, at least right away. So really just trying to address a couple of the bigger aspects of the Build Back Better Act that would’ve impacted business owners that now are not impacting business owners.
Denise Asker:
Sounds good. I know this podcast is dropping January 22. Hopefully there’s not a whole lot that changes between today and when that takes place. For our listeners, claytonmckervey.com is the place to sign up for our newsletter and to hear from tax leader Sarah Russell on a regular basis, and look forward to hearing what she has to say.
Bryan Powrozek:
Excellent. Thanks Denise.
Denise Asker:
Thank you.
Bryan Powrozek:
Yep. Hello and welcome to the Sound of Automation. Joining me today is Sarah Russell, the leader of our tax department here at Clayton & McKervey. Sarah, how are you doing?
Sarah Russell, Shareholder – Tax:
I’m good. Thanks, Brian. How are you?
Bryan Powrozek:
I’m doing okay. So today we get to talk about everyone’s favorite subject, taxes, and I think coming into this year, there were a lot of expectations around the Build Back Better Act going through, and there were a lot of changes to the tax code that were built into that act. So now, I guess, do you want to just give us a quick update on where that stands?
Sarah Russell:
Sure. So currently the Build Back Better Act is on the back burner. Senator Joe Manchin out of West Virginia continues to withhold his vote, which is needed for anything to pass in the Senate. The Senate is evenly divided, 50/50, and they’re trying to pass legislation through what’s known as the reconciliation process, which is going to require a full 50 votes out of the Democratic Party in the Senate. They can’t lose one. So if Senator Joe Manchin withholds his vote, the legislation won’t pass. Originally Senate majority leader Chuck Schumer said that he was going to bring the bill to a vote anyways, when they got back from recess after the holidays. However, when they came back from recess, the letter he wrote to the Senate indicated that he’s pivoting his attention and he’s now focusing immediately on voting rights and election reform.
Sarah Russell:
So while I anticipate we’re not done with the Build Back Better Act. Build Back Better Act. I think it’ll be a little while before we hear about it again. It’ll probably be a few weeks. I think they’re having some struggles right now getting the votes for the voting reform and election reform that they want to do. But they’re in the midst of talking about it right now. I would say all indications are that there’s still discussion happening in the background on the act, and I think it’s probably going to end up… Something’s going to happen, right? It’s either going to be, Congress is going to negotiate a much smaller bill, meaning lessen scope, focus on a few priorities rather than all of the priorities that they currently have in that act.
Sarah Russell:
Because that act is made up of several different things, right? There is some social spending that’s included in there. There’s climate change included in there. And then there’s the tax changes, which are built into the bill to pay for all of the things that the Democratic Party wants to do. So what Joe maned has not appreciated is that they’ve built in a lot of social spending policies that expire. He has indicated since the beginning that he would rather focus on a couple of items and make them permanent, rather than every policy that’s on everybody’s agenda and make them temporary. And the way that they drafted the legislation, they think that it’s really not… The cost that they’re saying it is isn’t really the true cost because the plan is that they hope to just continue to extend those social policies, so really the true cost of the legislation is much more than what they’re publicizing.
Sarah Russell:
So I think they could break it down into smaller packages. It’s a little bit difficult for them to do that because they will not get Republican votes on any of the items on their agenda. So to use the reconciliation process takes a lot of time, and I don’t think they would be able to get through several different bills under the reconciliation package before the midterm elections. That’s one thing that could happen. They could scrap the Build Back Better Act and start from scratch, which is what Joe Manchin said he would like to see happen before the holidays, right after he vetoed the bill and said, “You won’t get my support. I’m done negotiating. There could be no deal.” So I think at time will tell, we’ll see where we end up, but I’m not disappointed that we didn’t get something before the year end. It makes coming into tax season a little bit easier this year. We’ll see where we end up.
Bryan Powrozek:
Exactly. I think that’s the hard part that we often find is that clients come to us asking for clarity and answers, and when these things happen, you really don’t have much that you can turn to, because you’re not sure what direction it’s going to go. I think the prevailing opinion is taxes will probably go up, but how much, what areas, et cetera.
Sarah Russell:
Yeah, the prevailing opinion is taxes are going to go up. However, Kyrsten Sinema out of Arizona has vehemently said that she will not vote for a bill that includes tax rate increases. Now she did support some other things that are really tax rate increases without increasing the individual tax rates. So we think tax rates will go up in some form or fashion. It’s just a matter of what that looks like. And if they can actually come together and come compromise on a bill that the entire Democratic caucus can support.
Bryan Powrozek:
And I think that that was always the thing that people said to look out for, is can they keep this group together that was able to win all these seats and win the presidency, when now it comes time to actually start paying on those promises you made during the election cycle. And a lot of those things are in conflict. So I think we’re seeing it play out, I think the way a lot of people might have thought it would with competing priorities within the Democratic Party and not being able to satisfy everybody.
Sarah Russell:
Yeah. I will say that the progressives in the party are now starting to publicly come out and say, “Well, a smaller bill is better than no bill. Let’s try to get something passed.” So while last summer the progressives didn’t really want to compromise, they didn’t want to scale back their priorities, there’s a little bit of coming to the table, saying, we really got to get something past because if we get nothing past, the likelihood of us winning midterm elections goes down and it’s already looking pretty unlikely that they’re going to maintain all the seats, so they’re going to have to do something, I think, just to save their political careers, maybe.
Bryan Powrozek:
Exactly. Exactly. And there were a couple aspects that were built into the Build Back Better bill… As you mentioned, there are a lot of different things that got plugged into it, but two in particular that I think really had an impact for business owners, integrators in particular, and in the first of those was the R&D tax credit. Most companies claiming the R&D tax credit have probably heard by now, but there was a change made under the Tax Cut and Jobs Act that was now corrected or at least adjusted in the Build Back Better Act, I guess. Can you give a little background on that and talk about the current status?
Sarah Russell:
Yep, sure. So the tax cuts and jobs act from 2017, one of the provisions that was included in there was that research and development costs, as defined under section 174, would have to be capitalized and amortized beginning January 1st, 2022. So here we are today, beginning now. And in the Build Back Better Act… So there’s been several proposed legislation to try to fix this, because this is a pretty big deal for a lot of companies. And those bills haven’t really gone anywhere, but the Build Back Better Act extended it, so that that provision didn’t go into effect until 2026. So it’s four years down the road, figuring we’ll kick this can a little further down the road and then we’ll see what happens. But since we didn’t get anything past, that provision is currently now in effect. It’s certainly quite possible that there will be an extender provision that comes out standalone basis, because this is one item that’s probably bipartisan. May be a little bit easier to get through if they can’t get it into another piece of legislation.
Sarah Russell:
But when you look at the automation industry, we have a lot of clients that take the research and development credit. And in order to take the research and development credit, you have to have qualifying expenditures as defined under section 174. And what you see a lot in the automation industry is that what might typically be considered cost of goods sold type costs are qualified under section 174. So you’re sort of recharacterizing them as 174 costs instead of cost of goods sold. But to take the credit, it has to be section 174 cost. So you’re in this situation now where you could have… I’ll just give an example, a taxpayer that has a million dollars of qualified research expenditures for purposes of the credit would typically generate about a $65,000 credit. Say that tax payer in 2021, before this new provision goes into effect, had taxable income of $300,000.
Sarah Russell:
When you do the math, in general, after you take the credit, the tax liability that the… If this is a pass through company, that the owners would end up paying would be about $25,000 because that research and development credit’s going to reduce your tax bill significantly, and you’re not going to have a lot of tax left to pay. Well, flash forward to 2022, say that fact pattern is the same, that tax payer now, instead of $300,000 of taxable income, is going to have about 1.1 million of taxable income, because you’ll have to add back the research costs, the million dollars, but then you’ll get to take some amortization expense against it. So the significant difference in that scenario, you’re still generating the same amount of credit, $65,000, but now you’re tax bill is significantly more because you’re paying tax on 1.1 million instead of 300,000, and you end up paying about $260,000 of taxes.
Sarah Russell:
So while it’s a temporary difference, because you’re capitalizing the cost, but then you get to take amortization over five years in general, it’s still huge cash flow impact in the current year. So I have some hope, I think a lot of people in the in practitioner industry doing research credit analysis have some hope that they may fix this. I think that you can’t plan for it to be fixed until it’s actually fixed. And oftentimes these types of fixes don’t come out until the end of the year. So unless we get another, a piece of legislation that gets passed that includes this, you can’t count on it for estimated tax purposes for the current year certainly, I think.
Bryan Powrozek:
And that’s the interesting part, is this was one of those things done at the end to get the Tax Cut and Jobs Act through with everyone saying, “Oh, we’ll fix that down the road.” And in typical fashion, it’s now got to the 11th hour and it’s like…
Sarah Russell:
Absolutely. Because the Tax Cuts and Jobs Act was also passed under the budget reconciliation process, and that process requires… You can only create so much deficit under that process. So you have to have these revenue generators, and this was one of those revenue generators that helped to balance that bill, that everybody thought we’ll just fix this later. Well, later here we are and it’s still not fixed.
Bryan Powrozek:
Exactly. So hopefully the listeners out there who, if you’re a business owner and you do claim the credit, hopefully whoever advises you on that has already talked to you about this, but it’s almost more of a kind of watch this space, wait for the developments and see what happens. Hopefully if, as you mentioned, if a standalone piece of legislation goes through or an extender goes through, you can use the credit as part of your tax planning strategy for this year, if not plan for it not being there, and more than likely it gets fixed in time for the 2022 filing season, as opposed to this season.
Sarah Russell:
Yeah, hopefully it gets fixed before 2022 filing season, which is a year away. I don’t think it’ll be fixed before first quarter. So when you’re paying your first quarter estimates, you may not be able to count on having the value of the research credit, because one thing that I will say is you don’t have to take the credit. So if you don’t have to take the credit, it may not be beneficial to classify these costs that are typically cost of goods sold as 174 costs, because then you still get to take the deduction. So you’d still only have the $300,000 of taxable income in the example that I gave, but you just won’t have that $65,000 credit. So your tax bill would be 90 instead of the 25.
Bryan Powrozek:
And even this just popped into my head as we’re talking here, but with the memo that the IRS released last October further complicates this because now if you’re going to go back and amend, once they do fix this, there’s additional reporting requirements on the amended returns. So it’s definitely something to review with your advisor to make sure the best way to handle it.
Sarah Russell:
Yeah, there’s definitely a lot of activity going on in the research credit space. There’s even another broader piece of legislation meant to generate research and innovation to have the United States compete a little bit more with China and some of the developing countries. So I will say if they can’t pass a budget reconciliation bill, potentially they could slide it into that bill, because that is a bipartisan drafted piece of legislation. It hasn’t moved forward because it hasn’t been the highest priority, but there is a bipartisan piece of legislation that’s out there floating around that seems to be on the agenda for the first quarter potentially to readdress. So maybe we could get lucky there and have a little bit more clarity be for the end of the year, but who knows. Certainly since the pandemic has happened, I think one thing that’s been really true in tax is that there’s been a very big lack of clarity.
Bryan Powrozek:
Exactly. It’s definitely not an occupation for people who can’t live with the gray. It just seems to be getting more and more gray as we go along.
Sarah Russell:
That is very true. Very true.
Bryan Powrozek:
So another area that really comes into play for the business owners themselves, and was another change under the Tax Cut and Job Act that a lot of states in particular have been trying to adjust to is the limitation on the deductibility of state and local taxes. So I know that, again, within the Build Back Better bill, there were some adjustments to try and raise that limitation. But even a lot of states like Michigan, where we’re at, just made a change to it that that helps business owners work around that limitation. So I guess just some insights there on what’s going on with state and local deductions.
Sarah Russell:
Sure. So as you mentioned, the Tax Cuts and Jobs Act imposed a limitation for individuals that… It made it so that you could only deduct state and local taxes up to $10,000. And for most people, that could be just the real estate taxes. So many businesses are structured as pass through entity, and the taxes that they pay at the state level are paid at the individual level. So you could have a significant state tax liability due from your business income, and you’re not getting any deduction for it. The Build Back Better Act had proposed to raise that limitation to $80,000. So still not a lot for a lot of business owners, but it was better than 10. But what’s gone on over the course of 2021. There’s about 22 states that have passed what they call the salt work around. And really what it does is they have allowed, instead of the business owners paying the tax at the individual level, they say you could make an election to pay it at the entity level.
Sarah Russell:
So ABC partnership can elect to pay the taxes at the partnership level. And what that will do is reduce your federal taxable income, because you’re getting of the deduction at that federal level. And this was challenged. The IRS tried to challenge the validity of the workaround, but it’s sort of been upheld, and I think it’s pretty safe to say that you could do that. It is an election and all the states are different, as is true with general, state, and local taxes. Every state has different rules. It’s a little bit more complicated. It sounds really easy. I’m for sure going to do that. Why wouldn’t I? But there are things that you would want to think about. For instance, if you had some losses in a prior year, you may not want to pay the state and local taxes at the entity level because those losses would be coming from your personal return.
Sarah Russell:
So you really need to look at it and see what makes sense for you as the taxpayer and whether or not you make those elections. Some of the elections are permanent, some of them last couple of years, some of them are made annually. It just depends on the state. It’s not just a slam dunk tax position to take, you really need to think through it and make sure that you understand all the implication.
Bryan Powrozek:
Which is interesting. You mentioned that we looked at it for a client and the company had three owners, a majority owner and then two smaller owners, and the position was better for the one owner than the other two owners. So now it becomes a a conversation amongst the management team of which direction do we want to go with this and see if it’s better or worse?
Sarah Russell:
In some of the states, like California has very specific rules. Not every pass through entity is even qualified to make the election to pay the tax at the entity level based on who their partners are. So as with everything in tax, it’s complicated. So you really do need to sit down with your advisor and look and see whether or not it makes sense.
Bryan Powrozek:
And fortunately… Well, I guess I could see a scenario where maybe you have owners in different states. But fortunately, unlike most state and local matters, it’s your home state, so your advisor should be able to advise you on what’s going on in that particular state so you don’t have to worry about managing 50 states like some of the…
Sarah Russell:
Well, I mean there are 21 states, or 22 states, Michigan was the 22nd, that have enacted a pass through entity tax. So if you’re doing business… A lot of our clients are filing in 10, 15 states. So you really do… As practitioners, we’re really looking at all of the states to see how do these rules interact with what’s going on in the business? How material is it? Because if the income that sourced to that state is low, maybe you don’t bother. Because it is another filing. It’s another return that you didn’t have to file before, so there’s a little bit of compliance costs that are going to be associated with it. There’s a lot to sort through.
Sarah Russell:
And a lot of the states that have enacted rules enacted on towards the last minute. When it became evident that the Build Back Better Act wasn’t going to pass, draft legislation that had been floating around came up to the top and got passed through legislature in a lot of the states. So there is still not a lot of guidance either. Michigan passed it in right before the holiday, I want to say on the 22nd. They have not issued a ton of guidance yet, not surprisingly on it. So it’s still a little bit unclear on how some of the details of these pass through entity taxes are going to work.
Bryan Powrozek:
Yep. Exactly. So I guess then to just summarize, unfortunately not a lot of clarity on a lot of these things right now and just stay in touch with your advisors, ask questions, as you see things coming through, because like you said, the something that was in the Build Back Better bill may go away, but then come into another piece of legislation, and you really got to keep track on all of it for your business.
Sarah Russell:
Yeah, I would say if you’re not subscribing to our newsletter, we do… While there was a lot of activity going on in relation to the Build Back Better Act, we were issuing a weekly blog to keep you updated on what was the latest news. As things ramp back up in Congress, we’ll be… We stopped issuing it weekly because there wasn’t that much to talk about, but we’ll be issuing those blogs again as needed, as more information is coming through. So if you don’t subscribe to our newsletter, I would recommend that you maybe go out to our website and figure out how to subscribe.
Bryan Powrozek:
Excellent. And same thing, if you’re listening to this and a question comes to your mind that didn’t get addressed here on our website, you can find Sarah’s contact information and reach out to her, or really any member of our team for more information.
Sarah Russell:
Yep. We’re always happy to answer questions.
Bryan Powrozek:
Excellent. Well, Sarah, appreciate you taking the time to come in today and I guess we’re all set.
Sarah Russell:
Yeah. Thanks for having me, Brian.
Bryan Powrozek:
Thanks Sarah.
Announcer:
Thank you for tuning in. Don’t forget to like us, subscribe, and share on social. To learn more about Clayton & McKervey, visit us at claytonmckervey.com. That’s C-L-A-Y-T-O-N-M-C-K-E-R-V-E-Y dot com. We thrive on finding the solutions for you.
