As originally published in the Spring 2018 issue of Artisan Spirit.
On December 22, 2017, President Trump signed into law H.R. 1 — a sweeping tax reform law that changes the tax landscape for businesses (and individual taxpayers) in the United States in several significant ways. [Note: Congress initially labeled the bill the “Tax Cuts and Jobs Act” but later removed that name in order to comply with Senate rules regarding the budget reconciliation process. Because that original name stuck, however, I will use its acronym — TCJA — in this discussion.]
The TCJA is the most significant piece of tax legislation to be passed in several decades, and it accomplishes many things. A few of those accomplishments will impact smaller businesses operating in the spirits industry — as well as the owners of those businesses. What follows is a brief discussion of those highlights with special relevance for distillers.
Federal Excise Tax Reduction Is Real, and Is Really Short-lived
“The only difference between death and taxes is that death doesn’t get worse every time Congress meets.” — Will Rogers
By far, the biggest piece of tax reform sought by the distilling community over the last several years has been a reduction in federal excise tax (FET) on spirits. Indeed, FET reduction over the last several years has been a key priority for the Distilled Spirits Council of the United States, the American Craft Spirits Association (ACSA) and the American Distilling Institute. At a minimum, these organizations sought to find a way to achieve FET parity for spirits in relation to wine and beer manufacturers.
Indeed, spirits producers for some time have been disproportionately impacted by the level of FET imposed on the production of their products, with an obligation of $13.50 per proof gallon (calculated as one liquid gallon of spirits that is 50% ABV at 60 degrees Fahrenheit) of spirit removed from bond. Using estimates and assumptions prepared by the Congressional Budget Office — and recognizing that the taxes are levied on different liquid measures for the different categories of product — this meant that prior to passage of the TCJA the excise tax leveled on spirits was roughly 21 cents per ounce of alcohol, compared to about 10 cents per ounce for beer (assuming an average ABV of 4.5%) and 8 cents per ounce for wine (assuming an average ABV of 11%). [Note: It should be pointed out that there is no real rational basis for this disparity — the operative intoxicant in beer, wine and spirits is exactly the same, the only difference is the relative amount of it in solution. But who needs rationality when it comes to tax policy?]
With the enactment of TCJA, this disparity is not eliminated, but it is significantly lessened. Specifically, for tax years beginning on or after January 1, 2018, the FET obligation for spirits producers is reduced to $2.70 per proof gallon for the first 100,000 proof gallons removed from bond and $13.34 per proof gallon for the next 22,030,000 proof gallons. To the extent that a distiller owes FET on anything above 22,130,000 proof gallons in a single year, it will be taxed at the prior rate of $13.50 per proof gallon.
In terms of demographics, this means that the vast majority of distilleries in the U.S. will see a significant reduction in their FET obligation for the simple reason that most distilleries in the United States don’t produce anywhere near 100,000 proof gallons in a year. In fact, according to the ACSA’s Craft Spirits Data Project, approximately 2% of craft producers remove in excess of 100,000 proof gallons from bond on an annual basis. That 2% group, which consists of distillers that remove at least 100,000 proof gallons but less than 750,000 proof gallons annually, accounts for roughly 57% of all craft spirits sold in the United States. Notably, 92% of U.S. craft producers remove less than 10,000 proof gallons from bond on an annual basis. Extrapolating from the data, we should expect that roughly 98% of all spirits producers in the United States will end up paying $2.70 per proof gallon in FET.
There is of course a catch — in that the reduction may be short-lived. Specifically, the TCJA only provides this relief for FET obligations incurred before December 31, 2019. After that date, unless Congress acts to extend the relief, FET will revert back to $13.50 per proof gallon starting with the very first spirit coming off the still.
So how should distillers plan for the reversion of FET to pre-TCJA levels? If you’re asking the question, you’re already ahead of the game, as the biggest danger here may be for distillers to become accustomed to the reduction in FET and overextend themselves as a result. At the same time, however, this (extremely) temporary tax relief — when combined with other effects of the TCJA — may provide distillers with an opportunity to quickly expand production and, as a result, take advantage of other efficiencies to reduce their cost structures.
Corporate Income Taxes Are Reduced for Most and Increased for Some
“I’m proud to pay taxes in the United States; the only thing is, I could be just as proud for half the money.” — Arthur Godfrey
Immediately before passage of the TCJA, by some estimations the United States had the highest corporate income tax rate in the industrialized world. In fact, according to Tax Foundation, the “nation’s leading independent tax policy research organization,” the United States had the fourth highest corporate income tax rate in the entire world — at 38.91% (comprised of the highest federal statutory rate of 35% plus the average of the corporate income taxes levied by the states). In their estimation, this put the United States behind only the United Arab Emirates, Comoros and Puerto Rico. It should be noted that Tax Foundation isn’t entirely without bias here, and their focus on marginal tax rates as opposed to effective tax rates might be characterized as somewhat misleading. Nevertheless, their broader point is reasonably accurate; U.S. corporate income tax rates have historically been higher than similar tax rates imposed by most other countries.
With the passage of TCJA, the federal corporate income tax rate is now pegged at a flat rate of 21% for all tax years beginning on or after January 1, 2018. For many corporations, this will mean a reduction in rates. [Note: Prior to TCJA those corporations with taxable income between $0 and $50,000 previously paid tax at the rate of 15%. Therefore, for those corporations generating the least amount of profit, the 21% rate is actually a rate increase.] In addition, the TCJA eliminates the corporate alternative minimum tax — a 20% hit previously applicable to some corporations with average annual gross receipts of at least $7.5 million in each of the three preceding tax years.
Together, these changes mean that most businesses that have elected to be taxed as traditional corporations (i.e., not sub-chapter S corporations or businesses that have elected to be taxed as partnerships) will see a reduction in their federal income tax liability. But if your distillery is operating as one of the unlucky few that is taxed as a traditional corporation while generating less than $50,000 in taxable income, this may be a good time to chat with your accountant about changing your approach — especially given the 20% deduction available on flow-through income under new Internal Revenue Code Section 199A, discussed below in the context of entity selection.
Not All Interest Is Equal
“The wages of sin are death, but by the time taxes are taken out, it’s just sort of a tired feeling.” — Paula Poundstone
TCJA ushers in some significant changes in the treatment of interest paid by a business with respect to debt. Under prior law, this interest was generally deductible when computing the business’ taxable income (subject — of course — to a number of exceptions and limitations). However, under the TCJA, for tax years beginning on or after January 1, 2018, large businesses’ deductions for net interest expense are limited to 30% of the business’ adjusted taxable income. Smaller businesses — those with average annual gross receipt of less than $25 million — are not subject to this limitation. [Note: Those taxpayers who are occasionally frustrated at the disconnect between the concepts of financial accounting and tax accounting should be advised that, for tax years 2018 through 2021, adjusted taxable income will be computed without regard to deductions allowable for depreciation and amortization — meaning that a business’ adjusted taxable income in those periods will be roughly equal to a metric commonly used to analyze business performance — EBITDA (earnings before interest, tax, depreciation and amortization).]
To the extent that your business can’t manage to deduct all business interest in the year it is incurred, it will be treated as business interest paid or accrued in the succeeding tax year and can be carried forward in this fashion indefinitely. In other words, if your business eventually stops incurring business interest (say, for example, your business pays off the loan it took out to fund the buildout of your distillery), then you should eventually be able to use all of your business interest deductions to offset taxable income.
This ability to push interest deductions forward into future tax years is important for distillers — possibly even more so because of another facet of TCJA — a change to interest capitalization rules. In general, Internal Revenue Code Section 263A, and its associated rules, requires certain direct and indirect costs allocable to real or tangible personal property produced — such as spirits — to be included in inventory or capitalized into the basis of the related property if (i) the production period exceeds two years or (ii) the production period exceeds one year and costs more than $1 million. Because spirits are often aged, and the aging period has historically been included within the IRS’ views of the production period, this meant that producers of aged spirits most commonly needed to capitalize interest incurred during the production period with respect to those products, and that same interest could not be currently deducted as business interest.
The TCJA changes this, and specifically excludes from the production period for wine, beer and spirits any aging period following production. The effect of this change is to shorten the production period (for purposes of tax) of these products for purposes of the interest capitalization rules. As a result, spirits producers should no longer be required to capitalize interest associated with the production of their products simply because they are aged before sale.
Copper Just Got a Bit Cheaper
“What’s the difference between a taxidermist and a tax collector? The taxidermist takes only your skin.” — Mark Twain
Distilling is a fairly capital intensive business, and unless you’re simply bottling someone else’s production and putting your own label on it you are likely to need large pieces of stainless or copper equipment sitting around and needing to be cleaned and polished. That lovely piece of Vendome or Forsyths engineering is expensive, however. Thankfully, the TCJA will help at least a bit when it comes to paying for it.
Specifically, under TCJA taxpayers will now be able to immediately expense 100% of the cost of certain property acquired and placed into service through the year 2022. This means if you buy the new still today, you won’t need to depreciate the cost of the purchase over the life of the asset — you get to write it off immediately against taxable income. Further, immediate expensing is now available even if you buy a used still (and even if you do so in connection with the assets of an existing business). You will obviously need taxable income in order to get a meaningful benefit from this change — so it may not be particularly helpful for some startup producers. But if your startup is a traditional C corporation this change may help generate losses that can be carried forward, and if your startup is taxed as a partnership it may generate losses that can be used to offset the owners’ other taxable income. And for established distilleries that want to take advantage of the reduction in FET, step up production and try to get big quickly — this could be a significant benefit.
Entity Selection Just Got a Bit Trickier
“Tax reform is taking the taxes off things that have been taxed in the past and putting taxes on things that haven’t been taxed before.” — Art Buchwald
One of the more complicated aspects of TCJA is found in the creation of a new deduction for income from small businesses found under Internal Revenue Code Section 199A. Under this addition to the Code, many business owners organized as flow-through entities (other than certain entities in personal service industries) can now deduct the lesser of: (i) 20% of their earnings from business operations; or (ii) 50% of W-2 wages paid. Note that here we’re talking about the owners of the businesses, not the businesses themselves. And taxpayers below certain income threshold amounts — $157,500 adjusted gross income (AGI) for single filers and $315,000 AGI for those married filing jointly — will be entitled to deduct 20% of their business income without regard to the wage-based limit described above or the nature of their businesses. If you are a taxpayer with income above these threshold amounts, but below the phase-out amounts — $207,500 AGI for single filers and $415,000 AGI if married filing jointly — then you may be able to receive a ratable share of the deduction, but you will need to make sure you qualify.
First, you will need to confirm that the business for which you are receiving income and want to use the deduction is one that falls outside the definition of a specified service trade or business, or “SSTB.” SSTBs are generally defined to include professions involving law, health, accounting, performing artists, consulting, athletics, financial services, actuarial services, brokerage services or any other trade or business where the principal asset is the reputation or skill of one or more employees or owners — although this oddly does not include architects and engineers. In the spirits world, this is where things can get messy.
Certainly your average spirits brand is going to fall outside the definition of an SSTB. But suppose, on the other hand, your business is that of a distiller-for-hire, retained by your clients to provide them with your unique skill — evidenced by your reputation as the go-to for creating exciting new flavor profiles. Your business may be an SSTB. Similarly, if you make your living by traveling the world, nosing and tasting new spirits and advising businesses on blending or how to improve their products – your business may be an SSTB. So you may not be able to take full advantage of this new deduction (but please don’t expect us to feel badly for you, since you do get to make your living by traveling the world and tasting booze!).
Second, you need to remember that the deduction, if available, is going to be capped at the lesser of (i) 20% of your qualified business income; or (ii) the greater of (a) 50% of W-2 wages paid or (b) the sum of (x) 25% of W-2 wages paid, plus (y) 2.5% times the cost of depreciable assets in the business (subject to various time limits). That’s crystal clear, right? Seriously, this is an area where most potentially implicated taxpayers will want to consult with an accountant or tax attorney to ensure that their business is set up in the most tax efficient structure possible. For some, that will mean incorporating sole proprietorships, making subchapter S elections, and paying themselves a reasonable W-2 wage. For others, making a check-the-box election such that their LLC is treated as a subchapter S corporation will be the right answer. And for a few, incorporating or making a check-the-box election such that their LLC is treated as a traditional C corporation will be the right answer. No one size is going to fit all taxpayers – some analysis will be required.
Not All News Is Good
“I’ve been held responsible for taxes I know nothing about.” — James Brown
Of course, no piece of legislation is uniformly positive for any individual or any industry. TCJA is no exception. Specifically of note for the distilling community is the adverse impact that the law may have on sales of spirits products as a result of the elimination (in its entirety) of the ability to deduct business entertainment expenses.
The simple fact is that entertaining business prospects, customers or clients is (and has long been) a key component of doing business in the United States. And in many cases, alcohol is a component of that entertainment.
Over the last several decades, up to 50% of business entertainment expenses have generally been deductible by taxpayers. The TCJA changes that, and completely disallows the deduction by a taxpayer of business entertainment expenses in tax years starting on or after January 1, 2018. Business entertainment can include “entertaining guests at nightclubs” as well as “meeting persona, living or family needs of individuals, such as providing meals…”
It is reasonable to expect that if businesses are no longer permitted to deduct any portion of business entertainment expenses, they may begin to spend less. And if they begin to spend less on business entertainment, then those businesses that rely on business entertainment expenditures for a portion of their revenues will suffer. All of this is a nice way of saying that if you, for example, know that a lot of your product is featured in the fancy suites or sky boxes at the local sports arena, you should be aware of the fact that those expensive tickets are no longer going to be partially deductible by their corporate purchasers — and the arena (or the company managing hospitality for the arena) may not need quite as much of your product going forward if it can’t sell those tickets.
Home Cooking Is Still Problematic
“They can’t collect legal taxes from illegal money.” — Al Capone
As many readers will know, the FET reduction discussed above was originally included in the Craft Beverage Modernization and Tax Reform Act (the “Bill”) introduced into Congress in each of the last several years. That bill received gradually increasing support over the years, culminating with co-sponsorship by a majority in both houses.
For many years, the Bill included — tucked in among its other provisions — a provision that would have legalized the home distillation of alcohol for personal consumption. Such distilling is currently legal under the laws of several states but, like state laws relating to cannabis, those state laws are in conflict with federal law on the topic and therefore technically invalid under the Supremacy Clause of the United States Constitution. In its most recent iteration, the Bill dropped the provisions that would have permitted home distillation. And that “drop” was carried over into the TCJA. Accordingly, TCJA does not provide any manner of relief for those otherwise law-abiding citizens who might wish to try their hand at home distilling. Individuals who wish to become skilled in separating the heads, hearts and tails prior to launching a spirits business will, therefore, continue to need to develop their craft either legally (in the context of an educational program or work experience) or — as is perhaps more likely — illicitly in the context of home-based experimentation.
There you have it — some of the key highlights of the TCJA that impact smaller distillers. If you’ve made it this far in the article (or any article about taxes), pat yourself on the back. You have the kind of tenacity it takes to succeed in whatever venture you choose, and if you choose to make spirits, well, I look forward to seeing your bottle on the shelf.