Webinar: Tax Saving Strategies for Manufacturers

Highlights from the May 18 webinar hosted by Amy Reynallt, Senior Manager and Co-Director of HBK Manufacturing Solutions; and featuring Source Advisors executives Al Schmitt, Director for the Midwest, Great Lakes Region; Brian Coddington, Director, Tax Accounting Methods & Credits; and Jordan Fazio, Director, R&D Tax Credit Consulting. Source Advisors is an HBK partner and specializes in tax credits and strategies to reduce tax liabilities, including LIFO inventory valuation and R&D credits.

R&D Tax Credit

Enacted in 1981 to encourage American investment in innovation, to keep manufacturing in the U.S. as opposed to going offshore. Has evolved over time to become more applicable and beneficial to many more companies. Was renewed year to year, but is now permanent. The TCJA helped increase the net credit amount from 5 to 6.5 percent to 10 percent of qualified research expenses and had a positive impact on use of the credits by both C-corps and pass-throughs. Permitted Purpose: making a new product or process, or improving a product or process

Technological in nature: applying hard sciences

Elimination of uncertainty: figuring determining how to eliminate technical uncertainty in developing or improving a product or process

Process of experimentation: activities involved in ensuring a new product and process will work, such as testing and prototyping

Qualifying research expenditures include salaries and wages, which are typically the largest cost, but also supplies, contractor/outsourced assistance, and computer rental and cloud costs.

Credits can be carried back one year and forward up to two years. Can amend back three years.

R&D lifecycle often starts in sales and marketing, then goes to research and design, testing and prototyping, and can extend to production. Production doesn’t typically qualify, but some things done in production and manufacturing can qualify as process improvements.

Understanding how to feather out and incorporate all individuals touching R&D tends to lead to a better and more accurate tax credit.

Two main qualifying industry buckets: manufacturing—making something work faster, better, safer, cheaper, more reliably—and software development

There is no correlation to revenue or sales but is about the people doing the work and the type of work being done.

There are also state credits available, though not in all states. Generally, just for the technical people working in that particular state.

Qualifying manufacturing activities include but are not limited to:

product development using computer-aided design

development of second-generation or improved products

tooling and equipment fixture design and development

designing innovative manufacturing equipment

creating alternative materials

streamlining manufacturing processes through automation

The general rule of thumb for qualifying software is that it will need to be the development of proprietary software, not implementing software generated by a third party. Have to own the rights to the software; must carry the financial risk and rights.

Potential challenges

For federal credits, you need to be paying federal income taxes.

To qualify, you need to have more than 50 percent control or ownership of the product or process.

Have to consider whether passive shareholders will be negatively impacted by taking the credit.

Documentation is key to substantiating or justifying claims, if needed.

LIFO

An accounting methodology that allows companies to reduce taxable income by the inflation cost in ending-year inventory, removing the negative effect of inflation on inventory costs. It assumes older, less expensive inventory remains on hand for the calculation of taxable income. It is an annual adjustment that does not affect daily operations. It involves comparing costs of inventory at a certain point with costs for prior years to calculate an inflation index.

There have been discussions over the past 20 years of getting rid of LIFO, but tax reform rendered the threat to LIFO no longer present.

Any company not on LIFO but with considerable inventory should consider it.

Misconceptions about using LIFO include:

inventory turning too often

bankers not understanding the method

what would happen if inflation ceases

the effect of falling inventory levels

permanence of using LIFO once you start.

None of these are generally relevant.

Can elect to be on LIFO for tax and book purposes. IRS allows you to get off LIFO after five years, so we look at LIFO as a five-year commitment. But the IRS does allow the taxpayer to submit a manual accounting method change and pay a user fee, and they’ll review the facts to determine if they can go off LIFO before five years. But those requests don’t often occur, because LIFO tends to be beneficial.

Companies on LIFO should look at the IPIC (Inventory Price Index Computation) method. Sometimes referred to as external vs. the traditional LIFO internal index method. Analyze internal vs. IPIC methods to maximize the tax benefit.

Often IPIC reveals more inflation than people are typically seeing. Most years companies should consider both methods, but IPIC has been better from a tax perspective in recent years.

Internal method measures year-ending actual cost as an inflation factor. With IPIC there are sub-methodologies that can provide benefits and options to maximize the tax benefit over and above the traditional method.

Traditional LIFO method:

Most companies that have adopted LIFO are using the traditional method.

Measures inflation based on changes in internal costs.

Has many different variations.

Weaknesses include lack of documentation from previous years’ calculations.

Can be more complicated and invite more controversy with the IRS.

Possibly provides a better tax benefit vs. IPIC method.

Can automatically switch from internal to IPI if IPIC becomes better.

Must compare identical items or be able to argue a reconstruction method properly reflects income.

The lower your inventory the higher inflation has to be to maximize the LIFO tax benefit.

LIFO can produce significant tax benefits at times of high inflation.

Adoption and ongoing calculation of LIFO requires minimal investment in time.

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