June 14, 2024 U.S. Manufacturing Hurt by Congress’ Inaction

Manufacturers are facing an unprecedented constraint on their R&D efforts because of Congress’ inability to pass informed tax legislation.

Manufacturing is the backbone of the United States and has fueled our domestic economy for over a century. Not only does the manufacturing industry spur job creation, but it is also the reason why the U.S. continues to be the global leader of innovation in the aerospace, pharmaceutical, engineering, automotive, and technology industries. However, U.S.-based manufacturers are facing an unprecedented constraint on their research and development efforts because of Congress’ inability to pass informed tax legislation. As a result, we are concerned that domestic manufacturers may pull back on research and development investments. To remain globally competitive, the manufacturing industry must demand reforms from Congress but prepare themselves for additional tax burdens.

Prior to the 2017 Tax Cuts and Jobs Act (TCJA), manufacturers had the option to either deduct their research and development costs in the year they were paid or incurred or capitalize and amortize them over a period of at least 60 months. This provided flexibility and tax benefits, as businesses could choose the method that was best suited for cash flow and profitability. Additionally, businesses that deducted research and development costs could also claim the R&D tax credit under Section 41 of the tax code, which provided an incentive for investing in qualified research activities. The deductibility provided an incentive to stay competitive with foreign manufacturers.

The tax treatment of research and development costs has changed significantly due to the TCJA, which affected how businesses account for and deduct these costs. Specifically, as of January 1, 2022, manufacturers were no longer allowed to deduct R&D Section 174 expenses in the year incurred. Businesses were required to capitalize R&D costs for tax purposes as an intangible asset and amortize over a 5 or 15-year period depending on associated location of where the research was performed. The expenses associated with research conducted in the United States is now amortized over a 5-year period as opposed to research outside the United States is amortized over 15-years. No immediate deduction is allowed for retired, abandoned, or disposed property for which specified research or experimental expenditures are paid or incurred, thereby denying basis recovery in the case of retirement, abandonment, or disposal under Sec. 174(d). Amortization will not terminate in the year of abandonment but will continue through the 5 or 15-year period.

Likewise, another tax concern for manufacturers arose under the TCJA as well.  Manufacturers are asset intensive organizations and require significant capital for their production needs. Under TCJA, Congress established limitations on interest deductions when Section 163j was enacted. Section 163j limits a manufacturers tax position by disallowing interest expense based on a formula, which approximates EBITDA. In the United States, our tax policy has always supported the use of debt to fund growth and expansion by making interest deductible. As a result, manufacturers were able to more closely manage their tax burdens with their cash flow. With limitations on interest expenses, manufacturers now face an additional tax burden.  Members of Congress have recognized this unfair burden and while it seems unlikely to repeal Section 163j, legislation has been proposed to reduce the impact of the limitation.

While it is true that tax rates were reduced with TCJA, the capitalization requirements were an unintended consequence to manufacturing businesses compared to other forms of business. Organizations like the National Association of Manufacturers recognize that this legislation is not great for businesses and along with many other organizations have been asking Congress to revisit the current policy. Earlier this year, the House passed the Tax Relief for American Families and Workers Act of 2024 (H.R.7024) which would reform these research and development tax laws. However, the legislation has stalled in the Senate because many see H.R. 7024 as merely delaying the tax burden rather than solving it outright. Additionally, the upcoming Federal elections mean that there is little time left to draft and pass any meaningful legislation. Congress understands the importance of manufacturing in the United States economy but has not provided good supporting tax policy.

As a result, manufacturers are between a rock and a hard place now and it is leading many to have unfair cash flow concerns by limiting the deductibility of their R&D and interest costs. Manufacturers should continue to reach out to Congress for relief and to consider other tax planning opportunities.

Gary G. Wallace, CPA is the Managing Partner at Richmond, Virginia-based Keiter, P.C. He  provides tax services to public and private entities and their owners in a variety of industry segments, including manufacturing, retail, real estate, and financial services. Gary has significant knowledge and experience in individual taxation, business taxation, including C and S corporations and partnerships. He advises clients on all aspects of tax matters, including tax accounting methods, multi-state tax, mergers and acquisitions, income tax accounting and representation with tax authorities.

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