Over the past few years, both the U.S. House of Representatives and the U.S. Senate have worked to craft comprehensive tax reform, as well as compile temporary “extender” provisions for popular tax benefits.
In 2015, two important tax incentives for manufacturers are on the legislative agenda—including an extension of the research and development credit and retroactive institution of "bonus" depreciation. The anticipated extension of these provisions can serve to benefit businesses, particularly manufacturing companies. Understanding available credits, as well as credits and provisions that are likely to be retroactively applied, is crucial in tax planning for the current year and beyond.
Benefits under the R&D Provisions
One thing a number of professionals and politicians agree on is that the research and development (R&D) provisions help bolster the U.S economy. The tax break helps companies reduce the cost of staying technologically competitive, and, at the same time, may help to create and sustain job growth. However, funding the tax break has proven difficult year after year. As such, the credit is still not a permanent fixture in the tax code. Instead, Congress has opted to temporarily extend the benefit 15 times since 1981. The decision to extend it again is at a standstill until negotiations conclude on how long that extension will last and how to offset the perceived tax revenue decrease.
In general, the research and development tax credit is equal to a percentage of qualified research expenses (QREs) for the current tax year. QREs are broadly defined as taxable wages paid for the performance of qualified research, amounts paid for supplies used in development efforts and payments made to third parties for design and testing. If money is being spent to find ways to make a product faster, cheaper, or more efficient, there is likely opportunity for a tax credit under the R&D rules. Even if the changes to the product are merely incremental, the expenses could still qualify for credit.
Some limitations apply, but generally, the credit allows for a dollar-for-dollar reduction in tax liability.
Immediate Fixed Asset Expensing Under Section 179 and Section 168(k)
The maximum deduction and maximum investment thresholds, as described below, represent a substantial reduction from 2010-2013 amounts. In past years, the maximum deduction under section 179 was $500,000, and the dollar-for-dollar phase out was not reached until capital investments exceeded $2,000,000.
Under section 179, certain fixed assets that would normally be depreciated over a 3-15 year period could qualify for immediate expensing in the year of purchase. Absent of new legislation, the following dollar limitations apply for 2014:
- Maximum Deduction Limitation: The amount of the 179 deduction cannot exceed $25,000.
- Maximum Investment Limitation: Generally, if total capital investments during the year exceed $200,000, the 179 deduction will be reduced dollar for dollar. For example, if $215,000 is spent on qualifying capital investments during 2014, the 179 deduction is reduced from $25,000 to $10,000 ($15,000 reduction is equivalent to $215,000-$200,000).
- Taxable Income Limitation: The 179 deduction is limited to taxable income. 179 deductions in excess of taxable income are generally available to be carried over the next tax year. For example, following the facts listed under point 2, if the maximum 179 deduction is computed as $10,000 and taxable income before the 179 deduction is only $5,000, taxable income is reduced to $0. The remaining $5,000 from the 179 deduction can be carried over to 2015. Put differently, 179 deductions cannot create a tax loss.
Until 2014, section 168(k) of the code allowed for immediate expensing of 50 percent of the cost of a fixed asset purchase—otherwise known as the “bonus depreciation” provision. The limitations described under section 179 did not apply, and as such, benefited companies with higher capacity to make capital investments. This popular provision expired at the end of 2013 and at the time of this article, has not yet been retroactively instated for 2014. Congress may decide to resurrect bonus depreciation, but an agreement is not likely to be reached until the new Congress takes over in January 2015.
Permanent Benefit Available Under Section 199—Domestic Production Activities Deduction
Luckily for manufacturing companies, the section 199 deduction is not slated to disappear either through comprehensive tax reform or through an extenders package.
Generally, this incentive is available to U.S. manufacturers and allows for an additional 9% deduction of the lesser of taxable income, or 9 percent of "qualified production activities income" (QPAI). QPAI is equal to the amount by which gross receipts from eligible manufacturing and production activities exceed related expenses.
What manufacturing and production activities are eligible? Activities include, but are not limited to:
- Manufacturing, production, growth or extraction of tangible personal property in the U.S.
- Construction of real property in the U.S.
- Performance of engineering or architectural services in the U.S. in connection with real property construction projects in the U.S.
Activities that are not eligible for this deduction include:
- Service revenue
- Fixed asset disposals
- Investment income
- Resale of purchased products.
Even if part of the production process occurs outside of the U.S., there still may be an opportunity to claim a deduction under section 199. The tax code dictates that the production must occur "in whole or in significant part" within the U.S. To determine whether a process applies, a facts and circumstances test is applied to the manufactured goods, assessing the amount of relative value and cost added to the product within the U.S. as compared to overseas.
The "whole or significant part" rules include a "safe harbor" rule. This could qualify the product for the deduction if the direct labor and overhead incurred within the U.S accounts for 20 percent or more of the total cost of goods sold of the product in question.
If the entire product in question does not meet the "whole or significant part” test, the component parts manufactured in the U.S could still qualify for the deduction. The classic example illustrating this provision is one in which a shoe manufacturer makes the leather and rubber soles in the U.S., but imports the shoe uppers. The gross receipts generated from the sale of the shoe itself may not qualify for the deduction, but the component of gross receipts derived from just the soles could qualify. Certain adjustments to taxable income are temporary, meaning that the benefit received in one year will reverse in future tax years. The 199 deduction, however, represents a permanent adjustment to taxable income lowering the effective tax rate and generating a real cash savings in the year of deduction.
Tax Rate Reductions Available under the IC-DISC
If your company has profitable export sales, you may be able to increase after-tax cash flow by up to 20 percent. This may be possible by converting what would be ordinary income—taxable at a maximum rate of 39.6 percent for flow-through entities or 35 percent for C-Corporations—to capital gain income taxable at a maximum rate of 20 percent. If the products in question have already been deemed to qualify under section 199, than rate reduction benefits under the interest-charge domestic international sales corporation (IC-DISC) may also be available.
The tax rate reduction is generated by creating a separate entity organized as a C-Corporation. The C-Corporation may be able to apply for IRS approval to be treated as an IC-DISC. Once approved, the IC-DISC is deemed to participate in the exporting process of the operating entity and earns a “commission.” That commission is paid by the operating entity, and it is an ordinary deduction reducing ordinary income. Under the IC-DISC rules, commission earned by the IC-DISC is tax free to the C-Corporation. When the IC-DISC distributes the income it earns to its shareholders, the distribution is treated as a dividend taxable at capital gain rates, rather than ordinary income rates.
Benefits of the IC-DISC can only be derived after the IC-DISC has been formed making year-end the perfect time to consider this tax planning strategy for 2015.
While this provision has been in consideration for elimination several times in years past, for now it is here to stay.
Though legislative maneuvering may create uncertainty around popular tax provisions like the R&D credit and bonus depreciation, manufacturing companies don't need to be stifled by inaction. Despite this uncertainty, opportunities like the section 199 deduction and the IC-DISC remain in place and represent legitimate strategies for manufacturing companies looking to optimize cash flow for 2015 and beyond.
Material discussed is meant to provide general information and should not be acted on without professional advice tailored to your firm's individual needs.
Doug Bekker, CPA, is a tax partner with BDO USA LLP, the United States member firm of BDO International, a global professional services network.