Taxation: Deductions, Credits, and Strategies You May Be Missing

2/6/2014 - By Glenn Scharf, CPA, CVA and John Mascaro, CPA

Many manufacturers continue to miss the boat on taking advantage of all aspects of the tax code. A lot of times manufacturers are already participating in the efforts that are needed for these deductions, credits and strategies but they don’t even know it. They are leaving tax dollars on the table that could be invested back into the company. Most CPA’s are not familiar with quantifying and qualifying these benefits so an outside advisor who specializes in these areas could be necessary.

Research & Development Tax Credit

Most of the time when we talk to owners of manufacturing companies and bring up this credit the first words that I hear are “We don’t do R&D”. This is a common misnomer in the industry. R&D for tax purposes is much different than the perceived notion of how R&D is traditionally defined. We have yet to find a manufacturing company that does not partake in the activities described in the Internal Revenue Code. This means that many manufacturing companies are overlooking this credit. They are leaving free money on the table. If you are already conducting R&D as defined by congress then why not take the credit. To briefly describe the credit, if you have new or improved products, processes, formulas, techniques, software development (including CNC coding) and patents then you are probably conducting R&D credit activities.

The activities must be technological in nature, must have technical uncertainty in the project and you must show a process of experimentation. Documentation of your activities is the key to successfully taking this lucrative credit. The R&D credit is not just for big businesses. All size manufacturers can qualify. Furthermore, the credit can be claimed on an amended return, so any open year tax return can be amended to claim the credit.

For instance, assume a small manufacturing company could obtain an average $30,000 a year credit. The 2010-2013 years would still be open. That could amount to an immediate $120,000 tax refund. Interest Charge Domestic International Sales Corporation (IC-DISC) An IC-DISC is a tax vehicle that is used by manufacturing companies that export goods. With the use of this strategy ordinary income can be converted into dividend income. For an S Corporation owner at the highest tax bracket, that is a reduction from 39.6% to 23.8% tax rate. For a C Corporation the benefit could be as much as 28%.

As one would guess there are certain requirements that must be met for export goods to qualify:

Property must be manufactured, produced, grown, or extracted in U.S.
Property must be held primarily for use outside of the U.S.
Property must have at least 50% U.S. content

The benefits of the IC-DISC are only taken on a prospective basis so you can’t go back to prior periods to get a missed benefit. Finally, having this strategy is transparent to customers. They never see anything related to this and it is business as usual to them.

ACCELERATING DEPRECIATION

Fixed Asset Reviews Many manufacturing companies are unaware they have additional cash flow just sitting around their business – sometimes literally - on the shop floor or in their building’s walls! This is where a fixed asset and building cost segregation depreciation analysis can be incredibly beneficial. While cost segregation (discussed in next section below) focuses only on a building or facility as a whole, a fixed asset depreciation analysis includes things like fixtures, equipment, furniture, machinery, and vehicles. Frequently, these assets are misclassified due to routine changes in tax codes and regulations, adjustments for the age of the asset, and just a general lack of understanding what qualifies. Your CPA, together with a qualified engineering firm, can step in and help you find these hidden savings.

This study helps manufacturers uncover significant cash flow that could be utilized through accelerated tax deductions on their tangible assets and to determine the remaining useful life of the asset for classification purposes and budgeting, as well as identify the asset’s salvage value. A proper fixed asset depreciation analysis and review takes a comprehensive look at your company’s assets and includes the following:

Recommendation for appropriate depreciation vs. capitalization
Revised depreciation schedules
Comprehensive review by a licensed team of accounting and engineering professionals
IRS Form 3115, to take a retroactive corrective deduction, where applicable

Cost Segregation for Buildings

When a building or manufacturing facility is acquired or constructed, often the knee-jerk reaction is to lump all the cost of the building into 39 year commercial property (or 27.5 year for residential rental property) for tax depreciation purposes. A cost segregation study is a federal income tax tool that accelerates the tax depreciation deductions on certain qualifying structural components in your building or manufacturing facilities from such improper longer recovery periods to shorter periods. This increases cash flow and helps accelerate the return on capital from your investment in such property, and applies whether your property is newly constructed, purchased or renovated. It does so by carving out into 5, 7, and 15 year lives certain qualifying portions of your building that are normally buried in 39 or 27.5 year categories.

Qualifying properties usually follow these parameters for the highest cost-benefit:

New Construction (placed in service within the past 5 years)
Purchase or Acquisition (within the past 5 years)
Over $500,000
Properties with large amounts of added features, high-end finishes, and components necessary to operate.

On average, manufacturers typically get to reclassify as much as between 30%-45% of costs that were improperly classified as 39 year property! Consequently, manufacturers as an industry reap some of the highest possible cost segregation benefits as they tend to have many structural components whose related structural systems may be reclassified to shorter depreciation periods.

Tangible Property Analysis: Capitalization vs. Repair & Maintenance

Recent tax courts cases and Final Regulations from IRS have paved the way for Capitalization vs. Repair & Maintenance studies, which are generating significant tax benefits for many manufacturers. These Final Regulations, which are effective for years beginning January 1, 2014 (though they may be adopted earlier for years 2012 and 2013), now clarify many issues on what you can expense and what you should capitalize. In addition, they define matters such as incidental and non-incidental materials and supplies, and how acquisition, improvement and disposition/abandonment costs are treated.

They also establish de minimis and safe harbor rules for amounts of expenditures that IRS will not challenge (e.g., $5000 per item per invoice provided your company has audited financial statements and a capitalization accounting policy in place; $500 if the company is not audited, but a capitalization accounting policy must still also be in place). Moreover, there is a Small Taxpayer Safe Harbor for building improvements that allows small taxpayers to elect to not capitalize improvements for eligible buildings owned or leased with an unadjusted basis of $1 million or less. In addition, recent court cases have allowed companies to expense large roof repairs or replacements upwards of $500,000 that would have previously required capitalization. Deductible repairs may include “incidental repairs” that help to maintain an efficient operating condition but do not necessarily prolong its life, add material value, or adapt the property for new or different use.

Expenses incurred or paid for incidental repairs and maintenance are not considered capital expenditures and may be reclassified to accelerate deductions in the current year. Also, if you perform regular and routine maintenance and repairs to your assets, you may be able to recapture thousands of dollars by reclassifying previously classified capital expenses as deductible costs to accelerate depreciation. Routine and incidental repairs, as well as maintenance costs, may be adjusted to reduce taxable income in the current tax year or increase any net operating loss for a potential refund via a carry-back claim.

Under the Final Regulations, capital expenditures include those for building improvements or other long-term betterments, new equipment, architectural fees – even the cost of defending or perfecting your title to the property. Generally, a capital expenditure either adds an asset or increases the value of an existing one. Whether it’s a deductible repair or a capital improvement often depends on the context. For example, if an expenditure is part of a general plan of rehabilitation, modernization or improvement to equipment or other business property, it usually must be capitalized even though by itself it would be currently deductible.

According to IRS Code, you must capitalize expenses that:

Substantially prolong useful life (including replacement of deteriorating assets)
Materially increase value
Adapt the property to a new or difference use

On the other hand, you are allowed to deduct fees and expenses related to routine repairs and maintenance that help maintain the property in efficient operating condition. And remember, as mentioned in the routine maintenance above, you can deduct the cost of parts and labor in order to repair or maintain your business assets, provided that this expense does not increase the value of the asset or prolong the useful life of the asset.

Who Can Benefit from a Tangible Property Regulation Analysis?

The rules apply to most capital-intensive companies that invest significant dollars on routine and incidental repairs and maintenance expenses, thus making manufacturers particularly good candidates. Deductible tangible property expenses may include:

Roof repairs
Replacing lighting
Resurfacing parking lots
Replacing doors and windows
Resurfacing interior or external floors
Painting (interior or exterior)
Rekeying locks Abandonment/Disposition Studies

Are You Still Depreciating Non-Existent Assets?

Taxpayers, including manufacturers, have one last opportunity to clear their books of assets that have been physically disposed of prior to December 31, 2013 but for which their related costs have not been written off the books. This could present a huge bonanza of deduction for 2013 to many manufacturers! For example, when a manufacturer undertakes demolition or renovates a building and tears out old lighting, HVAC units, and other building parts, these assets are physically abandoned.

As such, the book cost value such tangible personal property within the structure (or a part of it) may be deducted based on its remaining depreciable value when the building is demolished, provided such personal property is to be abandoned and was not purchased with the intent to demolish. However the cost of what was abandoned must be identified and valued prior to such abandonment or demolition. This is where an abandonment study plays a critical role by providing objective, engineering based cost assignments to property deemed abandoned by way of the demolition.

Important Reminder: Consider this tax strategy before any demolition and/or renovation is completed or you may lose this opportunity to support the deduction after the fact. What can be abandoned? Under the Final Regulations, qualifying structural components for manufacturing facilities now include lighting systems, HVAC systems or components, or Building Envelope Components. In addition, when you re-light a building and/or bring it up to the latest electrical code, you create both an opportunity for both an Abandonment Study and an Energy Efficiency Modification Study.

For example, the prior lighting that was abandoned and replaced by the new energy-efficient system can be identified, and deducted as an abandonment, while the new more efficient system should qualify for special government energy efficiency deductions. Energy Efficiency Modifications (179D Reviews) This benefit was in place for certain energy efficiency improvement to lighting, HVAC systems and building envelope made after 2005 through 2013, and expired in 2013. However we mention it in this article as there has been some action on Capitol Hill in an attempt to extend (and even increase) the benefit beyond that year.

More importantly, taxpayers, including manufacturers, can still avail themselves of the Pre-2014 rules for energy efficiency improvements made prior to January 1, 2014. Consult your CPA for more details and what opportunities may still exist in your specific case. The benefit essentially consists of up to a $1.80 tax deduction per qualifying square foot of space for which energy efficiency improvements have been made. Up to 60 cents each for lighting, HVAC and building envelope improvements may qualify.

Utility Tax Rebate Reviews

Lastly, a review of utility bills for the prior three months can determine whether there have been incorrect tariff rates applied to the use of either electricity or water. Depending on the manufacturer’s location and specific utility provider, a refund might be possible for prior overpayments and an adjustment of prospective rates can be made.

Download this article