Count On Us
Domestic manufacturing businesses carry with them tremendous tax planning opportunities that most small to medium-sized businesses aren't taking advantage.
On the accounting side, manufacturers must keep track of raw materials, work-in-process, and finished goods in order to properly calculate financial standing and performance.
Further, cash management is paramount in keeping the organization healthy.
Manufacturing Deduction (pre-2018)
An important tax benefit for manufacturers is the domestic production activities deduction (DPAD), also known as the manufacturing deduction. The deduction is equal to nine percent of the lesser of the taxable income or qualified production activities income (QPAI). The deduction is available if a business has income from the rental, sale or other disposition of tangible personal property, buildings (but not land), computer software, and other products. The products must have been manufactured, produced, grown or extracted primarily in the United States. The deduction is also available for income from certain services, such as engineering and architecture. The deduction is reported on Form 8903, Domestic Production Activities Deduction.
(DPAD has been replaced with the more generous Qualified Business Income Deduction (QBID))
Depreciation - the write-off of the cost of an asset - is an essential element of tax accounting for a business. Property is depreciable if it is used for business, has a useful life exceeding one year, and may wear out or lose value from natural causes. Property that appreciates in value can still be depreciated if they are subject to wear and tear. Depending on how much income is generated by the business, the general goal in taking depreciation is to be able to write off property over the shortest period available, based on the property’s useful life. Most property is depreciated under MACRS, the Modified Accelerated Cost Recovery System. However, rather than claiming depreciation deductions, intangible property is amortized under Code Sec. 197. Taxpayers can also use cost segregation studies to reduce the period over which specified assets must be depreciated.
Special tax provisions provide accelerated write-offs of assets. These include bonus depreciation and the Code Sec. 179 expensing election. Depending on the current state of the law, companies claiming first-year bonus depreciation may be able to write off 50 percent or more of an asset’s cost, in addition to the deduction allowed under MACRS depreciation. The expensing election allows a company to write off the entire cost of an asset up to the limit in the tax code. For 2013, the limit is a total of $500,000. If Congress does not extend this provision, the limit will drop to $25,000 in 2014.
Accounting - Repair Regulations
To accelerate deductions and avoid having to depreciate asset costs over a period of years, companies may treat certain costs of maintaining its assets as repairs or maintenance, generally deductible in full in the year paid. In late 2013, the IRS issued so-called "repair regulations" that explain when taxpayers must capitalize costs and when they can deduct expenses for acquiring, maintaining, repairing and replacing tangible property. The final regulations take effect in 2014, although taxpayers can elect to apply them to 2012 or 2013. The regulations have many provisions that enable taxpayers to deduct their costs more easily and that reduce the need to maintain depreciation schedules. These provisions include the de minimis expensing rules, the write-off of expenses for materials and supplies, the deduction of recurring maintenance costs, and the replacement of building systems.
Accounting - Inventories
Taxpayers that produce merchandise and goods for sale are required to account for raw materials, supplies, work-in-progress and finished goods that comprise the items being manufactured. Taxpayers required to use inventories generally must use the accrual method of accounting. Accounting for inventories must reflect the best accounting practices of the taxpayer’s trade or business and must clearly reflect income. Permissible inventory accounting methods include FIFO (the first-in, first-out method); LIFO (last in, first out) and average cost. Some taxpayers may also use the lower of cost or market (LCM) method.
Companies may claim the research tax credit for increased research expenditures in business-related activities. The credit generally is equal to 20 percent of the increase in qualified research expenses over a base amount, although there is an alternative simplified credit (ASC). The research credit has been extended for one or two years at a time since the 1980s and currently applies through 2013. It is expected that Congress may simply extend the credit for another year, to avoid the high cost of making the credit permanent. The credit is not available for research activities conducted after the beginning of commercial production of a business component.
Investment Tax Credit
Companies are allowed to claim an investment tax credit (ITC) for particular expenditures. The ITC includes certain energy credits, the rehabilitation credit, and the therapeutic discovery project credit. In some cases, taxpayers can claim the credit for progress expenditures; otherwise, the credit may be claimed for the year that the property is placed in service. The taxpayer’s basis in the property must be reduced when the taxpayer claims the credit. A credit that is disallowed for the current year may be carried back one year and carried forward for 20 years.
We have highlighted only some of the many federal tax laws that impact manufacturing companies. Every business is unique and has particular tax considerations. Please contact our office so that we can set a time to discuss your business in more detail
Research Credit Under the PATH Act of 2015
The Protecting Americans from Tax Hikes (PATH) Act of 2015 modifies and makes permanent the credit for increasing research activities (research credit). The PATH Act also adds the research credit to the list of general business credit components designated as “specified credits” that may offset alternative minimum tax as well as regular tax, effective for tax years beginning after December 31, 2015. In addition, a qualifying small business may make an election to apply a specified amount of its research credit for the tax year against the 6.2% payroll tax imposed on the wages that it pays to its employees.
When it was first enacted in 1981, the research credit was to terminate after four and a half years. However, it has been extended several times over the years, and was allowed to expire at one point without a retroactive extension back to the prior termination date. The latest extension applied to any amounts paid or incurred for qualified research and experimentation before January 1, 2015. Manufacturing associations lobbied to make the credit permanent. In making long-term plans for research projects, they can now be assured that the tax incentive will continue to be available.
The research credit was provided to encourage taxpayers to increase their research expenditures and is the sum of the following three components:
20 percent of the excess of qualified research expenses for the current tax year over a base period amount;
20 percent for basic research payments to a university (or other qualified organization) in excess of a qualified organization base period amount (available only to C corporations); and
20 percent of the amounts paid or incurred by a taxpayer in carrying on any trade or business to an energy research consortium for qualified energy research.
Alternative Simplified Credit
Taxpayers may elect an alternative method to calculate the research credit amount using an alternative simplified credit. Under the alternative simplified credit method, a taxpayer can claim an amount equal to 14 percent of the amount by which the qualified research expenses exceed 50 percent of the average qualified research expenses for the three preceding tax years. If the taxpayer has no qualified research expenses for any of the preceding three years, then the credit is equal to six percent of the qualified research expenses for the current tax year. If the taxpayer makes the election to use the alternative simplified credit method, the election is effective for succeeding tax years unless revoked with the consent of the IRS.
Payroll Tax Credit For Research Expenditures
For tax years beginning after December 31, 2015, a taxpayer that is a “qualified small business” during a tax year may elect to apply a portion of its research credit against the 6.2 percent payroll tax imposed on the employer’s wage payments to employees.
The payroll tax credit portion of the research credit is equal to smallest of the following:
An amount, not to exceed $250,000, specified by the taxpayer in its election to claim the credit;
The research credit determined for the tax year (determined without regard to the election made for the tax year); or
In the case of a qualified small business other than a partnership or S corporation, the amount of the business credit carryforward under Code Sec. 39 from the tax year of the election (determined without regard to the election made for the tax year)
Under Code Sec. 39, an unused general business credit, of which the research credit is a part, may be carried back one year and forward for twenty years. The payroll tax credit portion of the research credit for a tax year may not exceed the amount of the general business credit that may be carried forward after carryback, determined as if the election to claim the payroll tax credit had not been made. This means a taxpayer must first apply its general business credit, including research credit, against regular tax liability and, for component credits of the general business credit that are specified credits, including the research credit, against alternative minimum tax liability. An excess is carried back one tax year. The payroll credit is limited to the amount that remains available for carryforward after carryback.
The payroll tax credit portion may only be applied against the taxpayer’s 6.2 percent share of payroll tax liabilities and may be carried forward indefinitely against future liabilities if necessary, as explained below. Any payroll tax credit that is unused in a tax year may not be treated as a general business credit that may be carried carryforward and applied against regular and minimum tax liabilities in future tax years.
A taxpayer has a $35,000 general business credit in 2016, which includes a $25,000 research credit computed without regard to the payroll tax credit. The taxpayer’s regular tax liability in 2016 is $15,000 and it has no alternative minimum tax liability. The taxpayer’s 2015 tax liability was $5,000 and it had no alternative minimum tax liability in that year. After offsetting 2016 and 2015 tax liability, the taxpayer has a $15,000 general business credit carryforward to 2017 without regard to the election to claim a payroll tax credit. The maximum payroll tax credit that may be claimed in 2016 is $15,000 since this amount is less than $250,000 and the $25,000 research credit determined for the year of election without regard to the payroll tax credit.
The election may be made five times (i.e., for any five tax years). In determining the number of times that the election has been made, elections made by any other person treated as a single taxpayer with the taxpayer are taken into account.
Qualified Small Business Defined
A partnership or corporation (including an S corporation) is a qualified small business during a tax year if its gross receipts are less than $5 million and the partnership or corporation did not have gross receipts in any tax year preceding the five-tax-year period that ends with the tax year of the election.
A taxpayer other than a partnership or a corporation, e.g., an individual, is also a qualified small business during a tax year if the taxpayer’s gross receipts for the election year are less than $5 million and it had no gross receipts in any tax year preceding the five-tax-year period that ends with the tax year of the election. Gross receipts for this purpose are determined by taking into account gross receipts received by the taxpayer in carrying on all of its trades or businesses. An organization exempt from tax under Code Sec. 501 is excluded from the definition of a qualified small business.
The election must specify the amount of the research credit to which the election applies. The election deadline is on or before the due date (including extensions) of the qualified small business’s income tax return or information return and may only be revoked with IRS consent. In the case of a partnership or S corporation the election is made at the entity level.
Claiming the Credit
A qualified small business taxpayer making the payroll tax credit election claims a credit against its payroll tax liability for the first calendar quarter which begins after the date on which the taxpayer files its income tax return for the tax year of the election. Deductions allowed for payroll taxes are not reduced by the amount of the payroll tax credit
The payroll tax credit applies to tax years beginning after December 31, 2015. The credit, therefore, may be claimed against the payroll tax liability for the first quarter beginning after the date on which taxpayer’s 2016 return is filed (e.g., July - September 2017 quarter for a calendar year individual filing 2016 Form 1040 on the April 15, 2017 deadline).
The IRS is expected to release additional guidance on aggregation rules; recapturing the benefit of the payroll credit if there is a later adjustment; and efforts to minimize compliance and record-keeping. If you are interested in claiming the research credit, we would like to discuss the requirements with you in greater detail. Please contact us at your earliest convenience to arrange an appointment.
DOMESTIC PRODUCTION DEDUCTION (PRE-2018)
Beginning years after December 31, 2017, the Domestic Production Activities Deduction has been suspended. However, most taxpayers who previously qualified for this deduction will now be able to take advantage of the new Qualified Business Income Deduction under Code Sec. 199A. More info to come soon.
Code Sec. 199: Benefits and Burdens
The Code Sec. 199 domestic production activities deduction (DPAD) can be particularly beneficial. The deduction equals nine percent of income from the manufacture or production of qualified property. Qualified property generally is tangible personal property.
The taxpayer must own the property while it is being produced. While ownership is not an issue in many cases, it is important for taxpayers that enter into a contract manufacturing arrangement. In a contract manufacturing arrangements, one party contracts with another, unrelated party to produce the property for which the deduction is claimed.
Ownership depends on who the benefits and burdens for the property, at the time that the property is manufactured or produced. Determining benefits and burdens depends on all the facts and circumstances. Recent developments have spotlighted the issue of benefits and burdens under Code Sec. 199. These include a Tax Court decision, ADVO, Inc., 141 TC No. 9 (2013), and an IRS Large Business & International Division directive, LB&I-04-1013-008 (2013).
The courts have developed at least eight factors for determining benefits and burdens. The Tax Court in ADVO applied evaluated these factors and determined that the contract manufacturer, not the taxpayer who ultimately sold the product, had the benefits and burdens of ownership at the time the property was produced. The court noted that the contract manufacturer held legal title to the property; was required to manufacture the property; had possession; enjoyed the economic gain or had the risk of loss from the sale of the property; controlled the details of the production process without supervision or management by the taxpayer; and was the party intended to manufacture the property. Therefore, the contract manufacturer was entitled to the Code Sec. 199 deduction, not the taxpayer who ultimately sold the product to customers and clients. This decision was a solid win for the IRS.
IRS examiners have historically used a four-factor test to determine benefits and burdens, gleaned from court cases, regulations, and internal IRS guidance (directives): who controls the details of the manufacturing process; who bears the risk of loss or damage during the manufacturing; who has the economic risk of loss from the sale of the property; and who has legal title to the property during the manufacturing process.
Only party can claim the Code Sec. 199 deduction. The IRS has noted that in a contract manufacturing arrangement, both parties may have some indicia of ownership. It may not be clear which party is entitled to the deduction. The IRS does not want to be whipsawed, where both parties claim the deduction for the same product at the same time.
Certification By Taxpayers Under Audit
To address this problem during an IRS audit, the Large Business & International Division has developed a procedure that allows the parties to the contract manufacturing arrangement to decide between themselves who will claim the deduction. The IRS believes this will save resources for both the taxpayers and for the government.
To claim the deduction, the taxpayer must submit a statement explaining the basis for its claim of benefits and burdens and must certify that it can and will claim the deduction. The other party to the contract manufacturing arrangement must certify that it will not claim the deduction. If the taxpayer follows this procedure, LB&I directs it examiners not to challenge the ownership claim. If the directive does not apply, the examiner (and the taxpayer) must apply all the facts and circumstances to determine who owns the property.
As you can see, the benefits and burdens issue can be particularly complex. Determining whether you have ownership of property for claiming the Code Sec. 199 deduction can be challenging. This firm stands ready to help you understand this question, interpret the factors used to determine benefits and burdens, and assist you with any ownership claims. Please contact our firm so that we can help you with this issue.
DOMESTIC PRODUCTION REDUCTION
QUALIFIED BUSINESS INCOME DEDUCTION