A cost segregation study—which identifies parts of a building (usually nonstructural elements such as carpeting, wall coverings, lighting, signage and certain mechanical, plumbing and electrical costs) which can depreciate more quickly—and identifying production improvements which qualify for a research and development (R&D) tax credit are tried and true methods for improving cash flow.
“I don’t believe there’s a broad understanding of the potential synergies with cost segregation and the R&D tax incentives,” says Tom Windram, a managing director with RSM McGladrey Tax Services and R&D practice leader. “In manufacturing, for instance, a more traditional cost segregation study might uncover a number of building components that may be eligible for a shorter depreciation period, but there may also be certain component development and engineering that could be treated as currently deductible research and experimentation expenditures. Also, something as basic as a manufacturing process improvement project could qualify for additional savings with the research tax credit.”
While the typical depreciation schedule for a building is 39 years, a cost segregation study can identify many nonstructural assets and exterior site improvements which can depreciate more quickly—five to seven years for personal property and 15 years for land improvements.
This accelerated depreciation can reduce a company’s current taxable income and improve short-term cash flow. For example, a community bank based in Alexandria, Va., paid about $30,000 for a cost segregation study that saved $335,000 in taxes. The owner of an office building spent $48,000 on a study that saved about $600,000 in taxes.
Likewise, businesses eligible to take advantage of the federal R&D tax credit can reap additional tax savings of up to 6.5 percent on qualified R&D expenses. A furniture manufacturer who made improvements to their production line, for example, recovered more than $300,000 in tax credits.
Whether the tax savings comes from a cost segregation study or the R&D credit, the money can be used to address your company’s cash-flow needs.
Cost Segregation Studies
Cost segregation studies began in the late 1980s, when Congress extended the depreciation period of commercial property from 19 to 31.5 years (that period was further extended to 39 years in 1993). Because of these changes in the tax law, financial managers had greater incentive to separate the asset value of an actual building from the value of other nonstructural assets, such as landscaping, carpeting, wall coverings, specialized plumbing and electrical costs and certain equipment and furnishings. Those assets can usually be depreciated on a five- to seven-year schedule.
“Getting these accelerated deductions is like receiving an interest- free loan from the IRS,” says Tony Urban, a managing director with RSM McGladrey Tax Services and cost segregation practice leader. “If you had $1 million in deductions over 39 years, and you accelerated them into seven years, you’re still getting the $1 million of deductions, just sooner. That’s where the cash-flow savings really show up.”
Because proper asset classification is key to an effective cost segregation study, most experts recommend a detailed “engineering approach” over a less-rigorous invoice analysis. The engineering model involves a blueprint review, physical inspections to characterize on-site assets and tax research. While this process is more costly and time-consuming, it also provides a defensible paper trail which can greatly reduce the risk of an Internal Revenue Service audit adjustment. The investment in this approach, however, often pays for itself seven to 10 times over.
Meanwhile, the R&D tax credit is available for companies that incur costs in connection with the development of new or improved products, processes, formulas, software or other technical business components. Businesses may qualify for R&D tax savings of up to 6.5 percent on qualified research expenses (in addition to the benefit of deducting those costs), if the research meets all of the following criteria:
- Involves the discovery of information which is uncertain at the onset of the project or activity. The uncertainty can relate to the capability, method or appropriate design of the product.
- Involves a process of experimentation where one or more alternatives are evaluated to resolve the uncertainty.
- Is technological in nature, based on the biological or physical sciences, computer science or engineering.
- Is related to a new or improved business component—research for style, taste, cosmetic or seasonal design factors doesn’t count.
There are other exceptions to the qualifications, including research after commercial production, research outside the United States, adaptation of a business component for a specific customer and research in the social sciences and humanities.
About three-quarters of the businesses that apply for the credit are in the manufacturing sector, but computer software developers and other types of firms are also eligible. The credit covers the W-2 wages of employees involved in the research, plus the cost of materials and supplies, and 65 percent of the fees paid to outside consultants hired for research. Companies typically have a three-year window of “open” tax years during which they can file for this credit (the time frame can vary for state tax; for example, in California, it’s four years).
Although the R&D tax credit has been on the budget chopping block several times since it was first enacted in the early 1980s, it continues to survive. The credit was most recently extended from June 2004 to the end of 2005, a period during which the Congressional Budget Office estimates qualifying taxpayers will cash in on an estimated $7.6 billion in federal tax credits.
Like a cost segregation study, a well-designed R&D analysis should involve a detailed business review, with the goal of identifying current and past activities and expenses which may qualify for the credit. If the analysis determines that qualified activities took place over the past three years, you may amend and re-file your business tax returns to claim the appropriate credit refund. In addition to potential linkage with cost segregation benefits, Windram says tax professionals should also investigate if a business qualifies for additional state-level and foreign country credits and incentives for R&D projects.
The potential cash flow and tax benefits of combined cost segregation and R&D studies can significantly outweigh the cost. Consider an example:
Assume a small furniture manufacturing firm builds a new $9 million facility. A cost segregation study using the engineering approach determines that 27 percent of the total facility costs could be reclassified from structural assets to personal property, and another 18 percent could be characterized as land improvements. The accelerated depreciation in this example lowers the company’s current taxable income, generating approximately $150,000 in additional first-year cash flow.
Meanwhile, assume this same company made significant improvements to its production line operations, which met the four criteria for the R&D tax credit. If the total outlay for the research project which led to the improvements was $2 million, the company would qualify for $130,000 in federal tax credits.
Factors to Consider
In general, tax professionals say business leaders may want to take a closer look at potential cash flow and tax opportunities if:
- The company has built a new facility, purchased real property, renovated or made leasehold improvements during the past 17 years.
- The cost of the projects exceeds $500,000.
- The company is in the manufacturing and distribution, public utility, telecommunications, commercial construction, banking, entertainment/leisure or restaurant industries (though other businesses with a high level of specialized capital equipment may also benefit).
- The firm has invested in research, development or process improvements which meet the general parameters of the R&D tax credit qualifications.
If your business meets some or all of these conditions, a cost segregation or R&D credit study could prove to be a timely investment. IBI
Very good article. I would have not considered that.