Outside-of-the-box TAX IDEAS
Universal Advisor, 2005 Issue No. 3
Welcome to Universal Advisor’s 2005 Year-End Tax Guide. This year’s Guide was coordinated by Plante & Moran’s Emerging Tax Issues Committee (ETIC). The ETIC is Plante & Moran’s team of tax specialists committed to providing our clients and staff with the latest updates on recent and emerging tax developments.
In past issues, we’ve focused on traditional year-end tax-planning ideas. This year’s Guide uses a more “outside-of-the-box” approach, focusing on targeted solutions that may substantially minimize your personal or business tax liability. In addition, it alerts you to potential tax exposures that may be minimized or eliminated with advance planning. Although many of these techniques can be reviewed at any point during the year, they’re particularly timely as the year end is approaching.
We hope you find the information in this year’s Tax Guide helpful. There’s likely to be an idea for everyone, although manufacturers may have more ideas from which to choose, since they’ve been targeted for relief by most recent tax legislation. If you’d like to know more about any of these ideas, please contact the Plante & Moran team member showcased by the relevant topic or anyone from the ETIC.
Domestic Producer’s Deduction
The American Jobs Creation Act of 2004 created a new tax deduction for tax years beginning after December 31, 2004 which, when fully phased in, will equal 9% of “qualified production activities income.” The new deduction will reduce the effective tax rate on domestic production activities by up to 3% (9% deduction multiplied by a 34% corporate tax rate or 35% individual tax rate).
The Domestic Producer’s Deduction will benefit a wide range of businesses and entities (corporations, LLCs, partnerships, and individuals) involved in “domestic production activities,” which include:
- The manufacture, production, growth, or extraction in whole or significant part in the United States of tangible personal property, software, or music recordings
- Construction in the United States, including residential and commercial buildings and infrastructure
- Engineering and architectural services performed in the United States and relating to the construction of real property
- Production of electricity, natural gas, or water in the United States
- Certain film production activities conducted in the United States
The Deduction is being phased in over five years with a 3% deduction in 2005 and 2006, 6% in 2007 and 2008, and 9% in 2009 and after. The Deduction can be used in combination with the Extraterritorial Income Exclusion (which is being phased out). It’s limited to the lesser of the statutory percentage multiplied by qualified production activities income or total taxable income and may not exceed 50% of domestic wages.
Taxpayers that have both qualified and non-qualified production activities will be required to allocate cost of sales and other expenses between the qualified and non-qualified activities in order to determine qualifying income. Although the IRS has provided simplified methods for the allocation of costs and expenses for some taxpayers, many taxpayers should analyze their situations to maximize their Deduction. The IRS is expected to release comprehensive guidance before the end of the year that will address many of the unanswered questions regarding allowable expense allocations and eligibility for the Deduction.
Example:
Diversified Company is involved in manufacturing activities, as well as architectural and engineering services. Since all of these activities qualify as “qualified production activities,” Diversified Company will receive a 3% deduction in 2005 on its taxable income. If its taxable income is $1,000,000, this deduction will equal $30,000 and will reduce Diversified’s federal tax by $10,200 (from $340,000 to $329,800). In 2009, when the deduction is fully phased in, the deduction will equal $90,000 and will reduce Diversified’s federal tax by $30,600 (from $340,000 to $309,400).
Acceleration of Fixed Asset Depreciation
The IRS allows taxpayers to obtain tax refunds by making corrective changes to depreciation methods and lives and to expense items inappropriately capitalized. As a result, capital-intensive companies should periodically review their depreciation schedules to determine if there are opportunities to recover their investments more quickly.
Recently, our Fixed Asset Analyzer Team reviewed the fixed assets of a mid-market manufacturer with $16 million of net property, plant, and equipment, with approximately $2 million of annual capital expenditures. As a result, the company realized additional depreciation deductions of approximately $2 million and a first-year tax savings of $700,000.
Domestic International Sales Corporation
The American Jobs Creation Act also phases out the favorable Extraterritorial Income (ETI) Exclusion, which provided a 15% deduction for manufacturers on their export profit. Transactions occurring in 2005 and 2006 realize an 80% benefit and a 60% benefit, respectively.
Most companies that benefited from the ETI Exclusion will also benefit from the formation of a Domestic International Sales Corporation (DISC). The DISC was originally legislated in the early 1970s to help domestic manufacturers compete with foreign exporters.
A DISC is a separate legal entity that receives commissions from a domestic manufacturer or distributor. (That can be a corporation, LLC, partnership, or individual.) The domestic manufacturer receives a deduction for the commission paid or income allocated to the DISC, while the income of the DISC is taxed at the qualified dividend rate of 15%. The tax savings are generated from the tax rate differential between the corporate and individual rates (which can be up to 35%) and the qualified dividend rate.
A DISC is easy to establish and maintain and should be considered by domestic manufacturers or distributors that have significant exports.
Cost Segregation Studies
Tax savings from depreciation can also be found on new or old construction projects. A cost segregation study can help identify qualifying assets that can be depreciated using shorter lives than the 39-year life attributable to the building. The present valued tax savings from accelerating the depreciation can be as high as 5% to 10% of the cost of a facility. This benefit can be realized by taxpayers that own most types of property, including retail, office, and industrial. Examples of costs that may be eligible for shorter depreciation lives include land improvements, process-related utilities and foundation costs, and image-related costs for retail facilities.
The IRS recently issued professional standards for the performance of cost segregation studies. To comply with these standards, cost segregation studies should be performed by tax professionals and experienced engineers.
LIFO Inventory Methods
LIFO (Last in, First out) is an inventory valuation method used to sequence the flow of costs through inventory in a manner that allocates the most recent costs incurred to cost of sales while retaining the earliest costs in inventory. When costs are rising, the LIFO method allocates the higher current costs to sales, thereby reducing taxable income. Now may be a good time to consider or reconsider this inventory method due to the increased level of inflation that some industries (such as plastics, lumber and wood products, packaging, and metal products) are experiencing, even though overall inflation is not high by historical standards.
Companies that are already on LIFO (as well as those newly adopting LIFO) may be able to reduce their tax liabilities and improve administrative efficiencies by electing the Inventory Price Index Calculation (IPIC) method. IPIC helps simplify the LIFO computation by using a government-computed index rather than the time-consuming computation of an internal index.
Any savings derived by switching to LIFO will depend on your company’s industry, level of inflation, and amount of inventory.
Research and Development Credits
Taxpayers that attempt technical advances or attempt to resolve technical uncertainties should determine whether they’re eligible for the research credit. The research credit applies to activities, such as the development of new or improved products, development of new or improved manufacturing processes, engineering efforts that reduce manufacturing costs, production of custom parts, development of prototypes, and development of internal use software. The credit can be as large as 6.5% of qualified research expenditures.
The IRS recently finalized rules that liberalize the rules for calculating the research credit using the “alternative incremental credit method.” This method is based on the taxpayer’s research intensity in relation to gross receipts. In light of these rules, taxpayers that incur research expenditures should reexamine whether they’re calculating their maximum credit.
