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Tax Incentives for Manufacturers

Simulation Association

December 6, 2011

Steve Roark, CPAMarni Spence, CPA

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Overview

• The Tax Formula• The Research Tax Credit • Cost Segregation &

Depreciation• IC-DISC

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The Basic Tax Formula

Key to Savings

Key to Savings

Gross Receipts (Income) 2,000,000$ Less

Deductions (1,500,000) (reduce taxable income)

(e.g., Depreciation, COGS, Payroll, etc.)

Total Taxable Income 500,000

Income Tax Rate 35%Tax Due 175,000

Tax Credits 150,000($ for $ savings)Tax Check to IRS 25,000$

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The Research Tax Credit

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The Research Tax Credit

• Background– Qualified Business Components– R&D versus R&E– General Process

• Contracting Considerations– Rights, Risk, Funding and Contracts

• R&E Timeline• Documentation• Credit Calculation

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Overview of the Research Credit

• Created in 1981– Temporary part of the tax code – available through

12/31/2011– Recent guidance has given much better definition of

what qualifies and what a valid claim must contain– Benefit highly lucrative if claimed correctly

• Business Component – New or Improved Product or Process– New to client (not necessarily the world)– Process Improvement and/or Redesign may qualify

Buzzwords: Patent, Patent Pending, New, Improved, Engineer, Coder, Design, Test, Prototype, Alpha/Beta, Upgrade

Buzzwords: Patent, Patent Pending, New, Improved, Engineer, Coder, Design, Test, Prototype, Alpha/Beta, Upgrade

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The Picture

IRC §174Direct CostsIn-Direct CostsOverhead / G&AReimbursable CostsNo Exclusions

IRC §41 = R&EWagesSuppliesContract Research

Experimental or laboratory sense = discover info that eliminates “product” development/improvement uncertainty

• Hands on, direct support & direct supervision allowed

• Patent = safe harbor• New to client (not to world)• Pilot Model, Process,

Formula, Invention, or Technique

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Contracting Decision Tree

Contract Awarded/Grant Received

Part/ComponentFixed Price

Payment Contingent on Successful R&E?

Do you have Rights to Use R&E results?

No, Disallowed

(Yes)

Allowable

No, Disallowed

Cost Plus orTime & Materials

CLINs

Separately Considered

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Market Research

&/or Reverse Engineering

Timeline Perspective

Process of Experimentation

to Eliminate Uncertainty

Final Analysis of Information to

Make a Production Decision

Commercial Production Approval

New Problem Identified during

Production

DisallowedActivities

DisallowedActivities

Allowable ActivitiesTesting &

Analysis of Test Results

May Potentially LeadBack to R&E

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Industry Specific R&D Timeline

ECP

DisallowedActivities

DisallowedActivities

Allowable Activities

May Potentially LeadBack to R&E

Pre-Contract Award Work

Market Research

Vendor Research

State of Technology/Training

Reverse Engineering

Design

Prototypes/Mock-ups and Models

Fixtures

Testing Program Mgt

- CMM Safety

- Functional / Flight Test FAA Certification Training

- Destructive Test Part 21 - Dem/Val Technical Writing

- HALT Overseas R&E

Production

PreProduction Planning

Creation of new production Machinery/Processes

Tooling up for Production Debugging

Qualification Testing Trouble Shooting

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Credit Claim – a 3 Step Process

Quantify expenses related

to qualified activities

Document qualified activities

Identify qualifying research activities

Documentation creates NEXUS or a tie between activities and expensesDocumentation creates NEXUS or a tie between activities and expenses

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Credit Calculation

2008 2009 2010 2011$0

$50,000

$100,000

$150,000

$200,000

Example of Base Period Hurdle

20%

Reg

ular

14%

Alte

rnat

ive

Credits Offset Tax Dollar-for-Dollar & Offset 2010 AMTCredits Offset Tax Dollar-for-Dollar & Offset 2010 AMT

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LarsonAllen Approach

• Phase I - Initial Assessment– Determine framework to establish Nexus between

qualifying activities and expenses– Estimate potential credits– Determine utilization of benefit– Go/no-go recommendation

• Phase II - Substantiation– Construct actual Nexus between qualifying activities and

expenses– Document activities & Finalize Credit Calculation– File on tax return – potentially 4 returns

GOAL: Minimize Impact on Client – Maximize Benefit – Create Audit SupportGOAL: Minimize Impact on Client – Maximize Benefit – Create Audit Support

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Cost Segregation

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Cost Segregation

• Why perform a cost segregation?– Maximize tax deferral

◊ Tax deferrals are accelerated into early years◊ $1 worth more today than 40 years from now

– Increase cash flow◊ Tax savings in early years generates additional cash flow to

reinvest

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Cost Segregation• Classify separate component lives

– 39/27.5 year property re-classed to 5, 7 or 15 year lives (see Rev. Proc. 87-56)

• Activities that benefit include:– New Construction– Purchase of an existing building– Additions– Renovations– Leasehold or tenant improvements

• Benefit – More depreciation in early years

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Cost Segregation• Example: ($3.9M building, renovation, etc.)

Sample Depreciation Property Break Out ~ 25%5-Year 7-Year 15-Year 39-Year Total

900,000 - 60,000 2,940,000 3,900,000

5-Year 7-Year 15-Year 39-Year Total Savings 35% Tax Savings1 50,000 540,000 0 31,500 37,692 609,192 559,192 195,717 2 100,000 144,000 0 2,850 75,385 222,235 122,235 42,782 3 100,000 86,400 0 2,565 75,385 164,350 64,350 22,523 4 100,000 51,840 0 2,310 75,385 129,535 29,535 10,337 5 100,000 51,840 0 2,079 75,385 129,304 29,304 10,256 6 100,000 25,920 0 1,869 75,385 103,174 3,174 1,111 7 100,000 0 1,770 75,385 77,155 (22,845) (7,996) 8 100,000 0 1,770 75,385 77,155 (22,845) (7,996)

16 100,000 0 885 75,385 76,270 (23,730) (8,306)

39 100,000 0 75,385 75,385 (24,615) (8,615) 40 50,000 0 37,692 37,692 (12,308) (4,308)

Total 3,900,000 900,000 0 60,000 2,940,000 3,900,000

Values Repeat for Year 9 - 15

Values Repeat for Years 17 - 38

Year of Asset's Life

Federal Depreciation

before Cost SegFederal Depreciation after Cost Seg

5-Year Depreciation Increase 804,616 35% Tax Rate (Total Savings first 5 years) 281,616 Present Value of Savings at 7% 190,239

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Depreciation Alternatives• Cost Segregation

– Applied to New Construction, Renovations, Additions, Leasehold or Tenant Improvements

– Breaks Out Items into Shorter Lives (5, 7, 15 year, etc.)– Can Perform After the Fact– Single Lump Sum Retro Catch Up Okay

• Bonus Depreciation – new only– 100% of purchase price, class life of 20 years or less, thru 12/31/11– Decreases to 50% in 2012– Unlimited Amount

• Section 179 – new and used– $500K max - Purchase Price/Lease of equipment/software– Phase out ($ for $ reduction over $2M)– $125K max tax years beginning in 2012 – Phase out lowers to $500K

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IC-DISC(Interest Charge - Domestic International Sales Corporation)

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IC-DISC

• Company sells goods• Pays a commission to the IC-

DISC and deducts the amount of the commission

• DISC can loan commission money back to exporter, or

• DISC pays a dividend to shareholders• Currently 15% tax rate

B

A

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IC-DISC Example

Without IC-DISC With IC-DISCCombined Exporter IC-DISC Total

Foreign Trading Gross Receipts 10,000,000 Foreign Trading Gross Receipts 10,000,000 Cost of Goods Sold (6,000,000) Cost of Goods Sold (6,000,000) Selling, General, and Admin (3,000,000) Selling, General, and Admin (3,000,000) Export Net Income 1,000,000 Export Net Income 1,000,000 1,000,000 Tax Rate 35% IC-DISC (Greater of):Tax Paid 350,000 1) 50% of Export Net Income 500,000

2) 4% of Export Gross Receipts 400,000 IC-DISC Commission 500,000 IC-DISC Deduction (500,000) Taxable Income 500,000 500,000 Tax Rate 35% 15%Tax Paid 175,000 75,000 250,000

IC-DISC Net Tax Savings: $350,000 - $250,000 = $100,000

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IC-DISC – Key Points• Export sales filed as commission income via

1120 IC-DISC• Reclassifies export sales from ordinary income

to qualified dividend– Reduces tax rate from 35% to 15%– $10M Exports generate minimum of $80K tax

savings, sometimes much more

• Paper corporation only– Customers need not know of existence

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Conclusion• Tax credits, deductions, bonus depreciation and

other tax planning mechanisms create significant incentives for businesses

• Recent Events:– Add urgency to acting now– Are Designed for Businesses to Create Cash Flow– Sustain Jobs and Incentivize Investment

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Discussion