Mid-sized manufacturing companies face a number of pressures — inflation, a weak dollar, growing foreign demand and stagnant domestic sales — but targeted tax incentives can help businesses decrease their tax and allow them to breathe a little easier.
Two incentives drawing interest from employers are the Last-In, First-Out (LIFO) method of accounting and establishing an IC-DISC (Interest Charge-Domestic International Sales Corporation) entity, says Philippe Simoens, CPA, partner in tax and strategic business service for Weaver.
“Although the U.S. has one of the highest corporate tax rates in the world, there are ways to get more sophisticated with your tax planning through LIFO, IC-DISC or other special deductions and credits to help control your tax situation,” says Simoens.
Smart Business spoke with Simoens about how manufacturers can efficiently attain tax savings with LIFO and IC-DISC.
How can LIFO accounting or launching an IC-DISC help manufacturers and other businesses?
The LIFO method allows manufacturers to use the price of the most-recently purchased inventory (last-in) as a basis for determining the cost of goods sold (first-out). This method works well when inflation and supply costs are increasing, as the manufacturer declares small net profits on goods sold, leading to lower taxes.
To simplify the calculation process, companies can follow simplified methods such as dollar-value pooling. One particular method uses indices from the Bureau of Labor Statistics, which make it simple to calculate inflation.
Companies also are turning to IC-DISCs with the demise of other U.S. export incentives. When a business exports products that are extracted, grown or manufactured in the U.S., the company can set up an IC-DISC. This separate entity receives a commission of 50 percent of export profits or 4 percent of gross receipts. The IC-DISC then pays out at the dividend rate of 15 percent, while the remaining profit is taxed at the regular corporate rate of 35 percent. Employers may have some products that qualify for the deduction and others that do not. So, a periodic review of export sales is required at least annually after the IC-DISC is set up.
Right now, more companies are taking advantage of IC-DISC than LIFO accounting, but both can offer savings.
What types of businesses benefit from LIFO or IC-DISC?
Both tax incentives are mostly targeted at U.S. manufacturing companies, but some distributors and/or producers may be able to take advantage of them, as well.
The benefit that businesses receive from LIFO depends on the types of inventory and products manufactured, and also varies by industry and regional location. Companies that process raw materials that have steadily increased in price could be a good fit, such as those in the food or metal fabrication sectors.
In general, companies within specific global industries that make substantial allowances for inflation in financial and production planning would also benefit from the increased cash flow LIFO brings. However, a business that produces technological components, such as a computer manufacturer, would not usually gain an advantage because productivity gains and a short inventory life cycle do not lead to increasing inventory costs.
When considering setting up an IC-DISC, companies need to consider whether they meet the requirements. Businesses that sell only in the domestic market or that have a foreign supply chain won’t be able to leverage the IC-DISC as a general rule, as one requirement is that the exported item must be manufactured or produced for at least 50 percent of its value in the U.S.
Are there drawbacks to either tax incentive?
One issue for employers is the uncertainty of the world market and tax laws. For example, with the euro currency crisis, commodity prices may fall, which would curtail the advantages of LIFO accounting. At the same time, there is uncertainty as to what Congress will do in this election year, which means tax rates could change based on the outcome of the November election for the 2013 tax year. The 15 percent dividend tax rate may increase or be extended unchanged; while there could also be changes to corporate taxation and special accounting methods and deductions.
In addition, there is a debate about federal corporate taxation. Many politicians want to reduce the top federal corporate tax rates and repeal special deductions and credits. However, under the current system, a profitable mid-market employer can start with a marginal tax rate of 35 percent; however, after applying tax incentives that reward manufacturing companies that create domestic jobs in the U.S. — such as the domestic production activities deduction, IC-DISC benefit, the R&D tax credit and the LIFO benefit — the resulting effective tax rate can drop substantially.
One should also note that the LIFO method could be repealed under the current process of convergence to IFRS.
Another potential barrier is these tax incentives can be complicated to implement and calculate, and they require a solid understanding by company management. If an employer is considering a capital transaction with a private equity group or putting the company on the market, having these methods in place may not appeal to buyers. For example, the new partner or owner of a consolidated group may prefer to use an alternative method, such as maximizing earnings per share, which is impacted by LIFO accounting.
That said, a mid-market company owner that wants to implement effective corporate tax planning would be well served to explore special deductions such as LIFO accounting or creating an IC-DISC, among others, to see if the benefits may outweigh any challenges.
Philippe Simoens, CPA, is a partner in tax and strategic business services at Weaver. Reach him at (832) 320-3215 or [email protected].
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