When operating a manufacturing business, there are several taxes at the federal, state, and local level that must be considered. Depending upon “what” you’re selling and “where” you’re selling, some manufacturers may be subject to a wider variety of taxes whereas others may not. In either case, it is critical that manufacturers understand the tax laws and remain in compliance to avoid costly penalties, interest, and audits that could create a significant financial hardship. As such, our DHW Manufacturing Team offers the following guidance on the top areas for audit risk and suggestions on how to navigate through the most common taxes and credits to help your organization remain compliant.
- Research and Development (R&D) Tax Credits: The IRS offers tax credits for qualifying research and development activities. Manufacturers involved in developing new products, processes, or technologies may be eligible for these credits, however, be careful to properly document and support the qualifying activities and costs when calculating the credit as there could be many interpretations and subjective evidence that could fall outside the IRS rules and regulations and thus, the IRS could deem an aggressive position has been taken and deny or reduce the credit. Also, consider working with a qualified professional that can assist with calculating the credits and support any positions taken if examined.
- Cost Segregation: Cost segregation is a tax strategy that involves examining the component costs of a manufacturing facility and reclassifying them to lesser depreciable lives in order to accelerate depreciation deductions to reduce taxes and boost cashflow. It can be particularly relevant to manufacturers who own or lease real estate, as it can help maximize tax savings. Typically, a study will be performed that examines the structural components of the building for costs such as those related to process piping, interior walls, wiring, and other building occupancy items. The IRS mandates cost segregation studies be performed by qualified engineers and professionals that will examine engineering and construction data to determine the requisite assets that qualify for a shorter depreciable life.
- Tangible Property Regulations (TPR): The IRS has specific regulations governing the treatment of tangible property expenses, including repairs, improvements, and depreciation. Understanding these regulations can help manufacturers properly account for and determine when an asset can be immediately expensed versus capitalized and depreciated over its useful life. While there are certain de minimis and safe harbor elections that some taxpayers can qualify for, taxpayers should be cautious when taking an aggressive position on the deductibility of certain asset purchases. As such, knowing and understanding the various thresholds and qualifying criteria when taking business deductions in connection with capital expenditures is critical.
- Employment Taxes: Manufacturers should stay updated on IRS and various state and local requirements related to employment taxes, including payroll taxes, tax withholding, and reporting obligations. If your entity has multiple locations or has employees who work in multiple states, be sure to understand the state and local laws in connection with employment taxes as those can vary from state to state. It is also critical to understand the rules for classifying workers as employees or independent contractors. Examining the degree of control taxpayers have over their workers will be the key to properly classifying workers as employees or independent contractors. In short, the more control a taxpayer exercises over a worker, the more the IRS will deem them as an employee.
- Transfer Pricing Considerations: As opportunities arise abroad, manufacturers who engage in international business may need to comply with IRS rules and regulations related to transfer pricing. Charges for goods or services between U.S. and foreign entities will be scrutinized for market pricing to ensure income shifting is not occurring when an entity is operating in both significantly higher and significantly lower tax jurisdictions. Aggressive deductions for charges between entities could be challenged by the IRS and accordingly, be reduced or denied. As such, make sure your entity is conducting a routine study to validate the pricing and markup on these transactions to ensure they are reasonable and within the IRS rules and regulations.
- Sales Tax Nexus: Manufacturers selling products across state lines may have sales tax obligations in multiple jurisdictions. Understanding sales tax nexus rules, particularly in light of evolving e-commerce regulations, can help manufacturers comply with their tax obligations. In 2018, the Wayfair case changed the way states traditionally taxed out-of-state sellers from a physical presence test to an economic nexus test that may capture more taxpayers for state sales tax compliance. The economic nexus rules vary from state to state but generally rely upon meeting a “sales threshold” or a “number of transactions” test. For those exceeding these thresholds, an obligation to charge, collect, and remit sales tax for that particular state and/or local jurisdiction may be required. As such, manufacturers should conduct a regular test of where their sales are occurring and have a full understanding of their U.S. tax footprint to ensure they are in compliance and are fulfilling their sales tax obligations.
- Inventory: Manufacturers often carry inventory as part of their operations. Understanding the IRS rules and methods for valuing inventory, such as the last-in, first-out (LIFO) or first-in, first-out (FIFO) methods, can impact tax liabilities and financial reporting. Also, accurately calculating and documenting cost of goods sold (COGS) under the Section 263A Uniform Capitalization Rules (UNICAP) requires manufacturers to capitalize certain costs, such as direct and indirect production costs, as part of the inventory valuation process. As such, understanding and applying the Section 263A rules accurately is crucial for manufacturers, and an annual refresh should be performed to ensure that any new or deleted departments, processes, or production lines are taken into account when calculating the annual UNICAP adjustment.
- International Tax Reporting: If a manufacturer engages in cross-border transactions, they may have reporting requirements under IRS guidelines, such as filing Form 5471 for ownership in foreign corporations or Form 5472 for reporting transactions with foreign entities. Common reportable transactions include sales, purchases, rents, interest, or services paid or received. The penalties in connection with these forms can be substantial therefore, it is critical that manufacturers understand the requirements in connection with these forms. Manufacturers should also understand the various rules and reporting requirements for foreign financial accounts (FBAR) and the Foreign Account Tax Compliance Act (FATCA) provisions as well.
- Employee Retention Tax Credit: To help businesses navigate through periods of economic uncertainty and disruptions due to the COVID-19 pandemic, the CARES Act created the Employee Retention Credit (ERC) for those businesses that were shut down due to governmental orders or those who experienced a significant reduction in gross receipts in 2020 or 2021 as compared to the same calendar quarters in 2019. While this credit provided significant assistance to businesses, it was also ripe for fraud and aggressive positions that were taken by some fraudulent promotors and providers basing their ERC qualification on criteria that the IRS has deemed as a “stretch” of the rules and regulations. As such, if your manufacturing entity based an ERC claim on criteria outside the aforementioned shut down or revenue tests, you should be prepared to defend your position as the IRS is placing heavy scrutiny on ERC claims and has gone as far as placing a pause on processing any further claims as they focus on the aggressive filings.
- Excise Taxes on Certain Goods: Manufacturers involved in the production or sale of specific goods, such as alcohol, tobacco, firearms, or gasoline, may be subject to excise taxes imposed by the IRS. These laws can be complex and therefore full of opportunities for miscalculations and incorrect interpretations and filings. Changes in these laws can occur which require taxpayers to continuously monitor new or updated guidance. As such, manufacturers should take considerable care in understanding the applicable excise tax rates, filing requirements, and record-keeping obligations. In addition, strict controls and cross training employees on these taxes when turnover or other disruptions in the accounting and finance department occur can be key as one small failure can turn into a major issue if not detected in a timely manner.
Summary
The manufacturing industry is full of rules and regulations that can seem daunting to keep abreast of and navigate. However, manufacturers that take a proactive approach to understanding them and implement the proper controls and procedures are those that will have a higher chance of remaining compliant and avoid the excess costs that can come with interest, penalties, and staff time in connection with responding to notices and managing audits. For more information on how these concepts impact your manufacturing organization, please contact Tim Reynolds via 828.322.2070 or at tim@dhw.cpa.