Don't Overlook Tax Deductions

December 26, 2007
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GRAND RAPIDS — There are a number of tax benefits that businesses can take advantage of but have a tendency to overlook.

One of them is cost segregation. When a company constructs a $10 million building, for example, it typically puts the cost of the building on its depreciation records as a $10 million building that’s depreciated over 39 years. But within the building there are a lot of subtleties in how the depreciation rules work, said Jerry Jonckheere, a partner in Plante & Moran’s Grand Rapids office.

By segregating and properly classifying construction costs, businesses will be able to identify those costs that should be treated as components of machinery and equipment rather than as part of a building. The proper classification of fixed assets can result in increased depreciation deductions and increased tax savings, he explained.

“If you’re able to split out some things and give them a seven-year depreciation, you get the benefit of that deduction over seven years rather than 39 years,” Jonckheere said. If, for instance, a company builds a warehouse and puts in a cement slab, the cost of four inches of cement is depreciable over 39 years, but if it has to put in an 8-inch slab, the additional four inches is depreciable over seven years.

However, if a cost segregation study is done without the oversight of an engineer to validate the deductions, it will come under a lot more scrutiny by the Internal Revenue Service, he noted.

“The IRS is definitely more active and organized these days, and businesses have to be a little more careful of IRS documentation requirements and documentation explanations,” Jonckheere said. “The IRS is requiring taxpayers to become more formal in how they document some of these tax savings ideas.

“When you’re dealing with the IRS, you’re dealing with an adversarial party that doesn’t know anything about your business,” he remarked “The IRS wants you to apply the knowledge of the business, the knowledge of the transaction, the knowledge of the tax code, and then come up with a validation for why you’re entitled to the deductions.”  

The Alternative Simplified Credit, which is new this year, allows taxpayers to claim a research credit regardless of their research history or gross receipts levels. Research and experimentation credits are available to all kinds of companies that do process improvements, where they’re finding ways to make their equipment more effective, Jonckheere stressed.

“Some companies think that since they don’t have the guys in white coats doing science, that they don’t qualify,” he noted.

In today’s competitive environment, there are a lot more businesses involved in process improvements, so there are a lot of companies eligible for the research and experimentation credits that may not be taking them. He explained that the credit is based on the company’s increasing expenditures on R&E over time. If a company keeps its R&E expenses constant, the company likely won’t get a credit, but it can qualify for the credit if it continues to spend at least 50 percent of the average amount of research costs incurred in the previous three years, he said. 

The Domestic Production Activities Deduction is available to all kinds of businesses engaged in domestic production activities, including manufacturing, farming, extraction, software development, architectural, engineering or construction work. The income tax deduction for 2007 through 2009 is 6 percent of income from qualified activities. Jonckheere said many architectural firms don’t realize that they qualify for this deduction.

Companies can also save on taxes by claiming deductions for charitable contributions to organizations that support/care for children, the ill or the needy. If a corporation, say, donates $1,000 in inventory items to any of those three types of charities, it actually gets  a larger deduction than the full amount of the gift, Jonckheere said, because instead of writing off $1,000, the company can write of the fair market value of the donated items.

Using the cash method of accounting instead of the accrual method is another way to save on taxes, particularly for service companies that maintain very few inventories, such as professional and personal service, construction, transportation and leasing companies, as well as certain types of custom manufacturers. Under the accrual basis, if a company sells a customer something today but doesn’t collect the money until next year, the company has to record the income the same year the sale was made. But under a cash basis it wouldn’t have to record the income until the following year, he explained. Companies with revenues greater than $10 million may be eligible to change to the cash method if their business is predominately service based and they have no inventory, but to make the change they would have to apply to the IRS before the end of their tax year.

“The cash method is a significant benefit for companies that have a lot of account receivables,” Jonckheere observed. “It gives them an opportunity to simplify their tax reporting and record keeping and to substantially defer income when it has significant uncollected receivables at the end of the year.”

For tax purposes, more and more businesses are electing S corporation status instead of C status. S corporations are organized as “flow-through” entities, such as partnerships or limited liability corporations. An S corporation has only one level of tax. C corporations, on the other hand, file their own tax returns and are subject to two levels of tax: They pay tax on their income and their shareholders pay tax on dividends distributed by the company. Businesses that are adversely impacted or likely to be impacted by double taxation should consider electing S corporation status, Jonckheere said, because it’s a good election for smaller companies and more closely held companies.

“Right now, the S corporation is still a very good election, but if we start to see some of the changes that are being proposed by Congress, the S corporation would not be a good idea,” Jonckheere cautioned. “What we can expect in the future is individual rates going up and corporate rates going lower, and that is actually going to slow down the number of S corporations going forward.”

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