Most manufacturers that own or lease commercial property fail to take advantage of cost segregation, a tax-reduction strategy that could generate substantial savings in federal income taxes.
Building costs are generally classified for federal income tax purposes into three categories. Each has a different depreciation recovery period and depreciation method under the Modified Accelerated Cost Recovery System (“MACRS”):
Tangible Personal Property: 5 or 7 years, 200 percent declining balance
Land Improvements: 15 years, 150 percent declining balance
Real Property: 39 years, straight-line
A cost segregation study will help you identify items that should be properly classified as tangible personal property or land improvements, rather than real property that is depreciated over 39 years. The tax benefits begin in the first tax year and continue throughout the depreciable life of the identified assets.
Manufacturers that own their manufacturing facility could classify the cost of certain equipment foundations, exhaust and ventilation systems, security systems and electrical distribution as tangible personal property.
ertain site improvements such as landscaping, underground utilities and site lighting could qualify as land improvements.
Some Example Benefits
For a light manufacturing company, on average, 20 percent to 40 percent of the eligible costs can be reclassified to Tangible Real Property and Land Improvements.
For example, if the value of the facility is $4 million, then from $800,000 (20 percent of $4 million) to $1.6 million (40 percent of $4 million) would be eligible for reclassification to personal property with depreciation lives of five, seven or 15 years instead of 39 years. The actual tax benefit would depend on the amounts allocated at five, seven or 15 years.
For a heavy manufacturing company, it’s even greater. On average, 30 percent to 60 percent of the eligible costs can be reclassified to Tangible Real Property and Land Improvements.
Heavy Manufacturing Company Example
The property consists of a single-story manufacturing facility and a connected two-story office building totaling about 502,500 square feet. The steel-framed structure is enclosed and roof construction consists of a metal roof system. The ceilings are suspended acoustical and open roof panels. The manufacturing facility includes restrooms, individual and open office work space, manufacturing area, and warehouse. There is a year-round heating, ventilating and air-conditioning system in the office and gas unit heater in the warehouse and manufacturing areas.
Land improvements include asphalt and concrete paving, concrete curbing, site signage, underground utilities, guard house, truck scale, chain link fence, traffic gate, diesel fuel pump, diesel storage tank, concrete equipment platform, pre-cast concrete wheel stops, site and parking lot lighting, and general landscaping with irrigation.
The property has a cost basis of $6,119,256 and was acquired and placed in service in 2005.
Tax Benefits Summary
Cost basis: $6,119,256
Cost reallocated: $2,010,902
Reallocation percent: 32.9 percent
First-year deferred tax: $71,732
Total deferred tax: $317,250
As a result of this cost segregation study, the manufacturer was able to reallocate $2,010,902, or 32.9 percent, of the assets to shorter recovery. The projected tax benefits on a net present value (NPV) basis were projected to be a total of $317,250 and a first-year tax benefit of $71,732.
Another benefit is a cost segregation study does not require amending your tax returns. All that is needed is to use a Form 3115, Application for Change in Accounting Method, the next time you file, even on a quarterly basis.
Here is a general list of parameters to determine if your company would benefit from a cost segregation study.
A for-profit company
Profitable (adequate tax liability to offset the potential benefits)
Cost basis for your facility (not including land value) exceeds $500,000
A C-Corp, or you have active shareholders
Planning to keep the facility for at least another two years.
Who Should Conduct Your Study?
Knowing the difference between Tangible Personal Property, Land Improvements and Real property is critical. So is the ability to support and document the decisions. That’s why you need expert advice. Identifying items to be reclassified is only half the battle. The other half is to determine the costs legitimately associated with each item.
The complication is locating single-item costs. For example, suppose you know that a portion of your facility’s electrical distribution for specific equipment should be reclassified. The electrical contractor’s costs for the job are bundled into a single number. That’s the problem. How do you identify the costs for that portion of your facility’s electrical distribution for that specific piece of equipment?
Professionals are needed who can unbundle the costs and assign them appropriately – not only the direct costs, but also a portion of any indirect costs such as architect fees, engineering fees, permits, bonds, etc.
Choose a consulting firm that has the experienced professionals that have the knowledge of construction methods, engineering and Internal Revenue Code including the applicable tax court cases and revenue rulings.
heir expertise should include the ability to read blueprints and fully understand construction materials, costs and taxation. A firm that provides audit defense as part of their fee shows confidence because they take any risk away from you.
CPAs do not have this kind knowledge or expertise to conduct a comprehensive cost segregation study. The consulting firm can fill the gap for accountants so a comprehensive, defensible cost segregation ctudy can be completed that maximizes your tax savings.
There is hidden money in your manufacturing facility. A cost segregation study can uncover that hidden money and provide a great tax benefit to you. Contact a consulting firm and ask for a free estimate of your benefits and the associated fee to conduct the study.