Nobody buys a machine because of a tax break
Let's quickly level set as we start.
- This isn't a political or philosophical post. It's about helping B2B companies engaged in complex capital equipment sales adapt quickly
- The biggest competition most companies face today is the status quo - and the status quo prevails when it's unclear how a positive outcome will result
- Companies don't buy because of regulatory or tax relief. However, if they're on the fence (e.g. think they have new demand they could capture if they had more capacity, but stable without it) then they could very well hesitate when short and medium term regulatory and tax uncertainty prevails
- Late 2017 surveys into manufacturing growth, employment and optimism indicate that companies are investing in growth because they're less concerned about new, unexpected regulations which would jeopardize their investment
In other words, companies are more inclined to invest in growth than they have been for some years - and the major drivers are growing demand on the one hand, and lower anxiety about regulatory headwinds on the other.
And now we add the tax bill (The Tax Cuts Act). Companies have an opportunity to proactively help prospects understand how they can benefit from the terms of the tax bill - and boost capital equipment sales in the process. This is a mutual win.
The obligatory note - this isn't tax advice for you, or your customers. Check with professionals on whom you rely. The purpose of this article is to frame how you think about the current market opportunity to grow your sales and help your customers' leverage the opportunity to their benefit.
Here's a tease - your customers could end up cash positive in year one by buying your machine PLUS realize all the business benefits that makes the purchase itself appealing.
And as Peggy Noonan wrote recently, companies have a chance to "make a difference."
They can in some new way see themselves as citizens—as members of America, as people with a stake in this nation, a responsibility for it. They can broaden, invest, hire, expand and start the kinds of projects that take the breath away. They can literally get young men and women out of the house, into the workplace, learning something. They can change and save lives.
The capital equipment manufacturers with which I often work typically sell to two types of buyers. Family owned/privately held small and middle market manufacturers and large publicly traded multi-nationals.
The former tend to be pass-throughs (e.g. an S-Corp or LLC) for which profits are reported on the owners' personal returns and taxed at the individual tax rate. The latter obviously are taxed at the corporate level, and then dividends are taxed at the individual level. Further, while both typically use accrual (vs. cash) accounting, the latter often distinguishes between tax accounting and public reporting according to GAAP.
Finally, different state tax structures can impact the bottom line in other ways that vary widely.
I won't dive deeply into these factors, but they do create some differences that may be important to understand depending on who you're selling to.
The new law makes several important changes.
- The top rate for pass throughs is reduced from 39.6 to 37% - BUT most of the pass throughs to whom you sell will pay a functionally lower rate of 29.6% due to a 20% income deduction
- The rate on "C" corporations (a few of your privately held and most of your publicly held customers) drops from 35% to 21%
- Bonus depreciation allows companies to deduct 100% of the cost of new and used "qualifying property" (life under 20 years, like most of your machinery - but not a new factory) in the first year. This depreciation can create a loss which can be carried forward against future profits (NOL)
- Section 179 depreciation (which cannot be used to create a loss) has been modified so that companies can immediately deduct up to $1,000,000 of investment in qualified property. (Before you say "Well, ours is only $300K so we're not close." remember that it's the cumulative total of everything they're acquiring for the year.)
If you're not familiar with accrual accounting, you can learn more about depreciation here. The short version is that a company pays all the cash for a new machine, but is only allowed to deduct a portion of the cost from its taxable income. In other words, they've paid for the whole thing and don't have the cash available, but for tax purposes they're assumed to only have paid a fractional percentage each year from 7 or 20 years. It makes capital investment tougher for privately held business that doesn't have access to public capital and debt markets.
First, the bad news
The tax bill actually increases the functional cost of your machinery and automation to buyers. How can that be you ask?
For a pass through which would have been taxed at a rate of about 40% on retained earnings (profits the company generated and kept in the bank to use in the future), a $100,000 investment in equipment actually only cost a net $60,000 in 2017. With the new rates that $100,000 investment will actually cost $10K more, net, in 2018 ($100K-29.6%=70.4K) vs simply retaining the earnings. That's a 17% higher functional cost.
For your publicly held customers, the functional cost will increase even more dramatically. As rates fall from 35 to 21% the net cost (vs. simply holding the cash) goes from $65K to 79K - a 22% functional bump.
But...of course nobody makes capital investment to reduce tax exposure as a primary objective. Instead that investment is made for other reasons which include new production, increased output, reduced operating cost, shorter lead-times, higher quality, etc.
So let's look at the implications from the perspective of your customers that see opportunities to grow sales or improve profitability by investing in your equipment.
Getting more....for much less
The biggest impact will be the bonus depreciation. Let's look at the difference using a pass through with $1,000,000 in profits buying an asset for $100,000 which would depreciate over seven years. Their first year cash outlay would be roughly $495K. ($100K for the machine, plus 40% tax on $986K - the $1,000,000 in profit less $14K or 1/7th of the new machine that could be depreciated.)
Under the new rule their first year cash outlay will be roughly $370K. ($100K for the machine, plus 30% tax on $900K - the $1,000,000 in profit less the fully deductible cost of the equipment.)
For the publicly traded firm the first year cost will go from roughly $445K to about $290. (Although to present favorable earnings to the market they'll likely continue to reflect only a $14K depreciation cost in their GAAP reporting.)
That leaves an additional $125K and $155K in the pass through and public company's bank accounts respectively. That could be held as a safety reserve, or invested in additional equipment, staff, R&D, marketing, etc. They've realized the same increase in capacity or reduction in operating cost, but at a much lower cash cost.
So, for the owner of the private company who may actually balance capital investment against college tuition payments, etc., this could make desired upgrades feasible where they simply weren't in the past....or where the status-quo was just a bit safer. It may be that simple!
Let's sweeten the pot - net cash positive capital investment
Typically, however, when a company implements new capacity it takes some time to leverage it. Costs come down gradually as the operation is optimized, and new capacity takes time to fill as it's gradually sold. So the calculation, or rather the gut check for an owner, may be more complex.
Many companies opt for financing when making capital upgrades, preferring to keep cash for other purposes. Publicly traded companies may float bonds, but pass throughs often rely on additional bank financing.
That creates an interesting opportunity with capitalized leasing.
In the 90s leasing was quite popular as companies used the vehicle to make what were essentially installment purchases that were characterized as operating expenses. That allowed them to fully deduct the amounts they were paying.
The IRS began to crack down however, distinguishing between operating leases (you use it for a couple years and then send it back - having paid only for your use and the decline in value as a result, plus some carrying cost) and capitalized leases (often buy it for $1 at the end of the term.) This is an important distinction because of the impact on reported profits and tax collection as discussed above in the context of bonus depreciation.
Here's where the tax changes could be really impactful for SMB manufacturers.
With interest rates still quite low, the cost of funds is not a significant factor in many short term decisions. In other words it's cheap to borrow and lease. So a typical pass through could use that to enormous advantage to bridge the ramp-up time until the investment pays off. Here's how.
Let's return to the example of the $1,000,000 in profits and $100,000 machine. If the purchase is made in April on a five year capitalized lease at 5%, the outlay for the machine in the first year will be approximately $15,200 (8 months at $1,900/month.) So the total cash outlay in year one would be $285K (30% tax on the $900K profits after bonus depreciation plus the lease payments.)
Even more startling is the actual net positive. Had they not bought the machine they would have paid $30oK (30% tax on all the profit.)
Buying the machine in this example, realizing bonus depreciation and using a capitalized lease, is actually a $15K cash boon from the company perspective.
They have more cash AND they have the new capacity/technology/efficiency.
Implications for your capital equipment sales & marketing
Your sales people aren't accountants. Neither are many pass through business owners. Capital equipment sales are built on a sound understanding of customers' "jobs to be done." Nothing changes that or the basics of salesmanship.
However, most of my clients and similar companies find the biggest competitor they face today is the status quo. Folks want to make investment, but just aren't completely convinced that the benefit outweighs the risk.
The tax bill enhances the benefit, and reduces the risk by reducing net cost today (to the extent that the asset could be resold later if necessary.)
That makes the transaction itself perhaps more advantageous.
But further, we know that buyers ascribe more value to sellers that help them with insights. Here's an opportunity to supplement your "jobs to be done" insights with transactional ones.
I'd recommend finding a leasing partner (you probably have at least 5 calling every week) and make the process simple. (They'll pay you immediately, often including progress payments, and own the long-term debt and risk.) Work with your accountant and marketing team to develop a simple one to two page overview of how the tax bill changes prospects' net procurement cost, and how leasing can actually be net cash positive in year one.
And start fast. Why?
The tax bill is likely to lead to rapid growth. Adding the capacity early means that as consumption grows your customers will be better positioned to grab market share from overwhelmed competitors that were slow to react.
And all those stalled deals, no decisions and open projects are a perfect place to start!
Similarly, for companies like yours, you want to start ramping up your lead generation early too, in support of capital equipment sales which will likely grow. As companies start to invest to meet the actual or anticipated growth, they'll be looking for solutions.
That means actively working on:
- inbound marketing
- outbound business development
- and account based marketing
That requires a highly refined digital presence, a deep strategy and rigorous execution.
Want to explore how to use the tax bill to position your company and your team for rapid capital equipment sales success? Or to take a bigger picture look at positioning yourselves for strong growth on a solid, global, digital base? Let's schedule an introductory conversation.