Category: Manufacturing and Distribution

Posted on Mar 4, 2016

manufacturing audit, R&D credit, icdisc, manufacturing tax credits, manufacturing dallas, manufacturing employment

In the past year, manufacturing employment in the Dallas/Fort Worth area has dropped by 2 percent. This statistic alone seems negative, but the overall outlook for manufacturing is trending positive with increased focus on innovation, simplified supply chains, diversification into customer-focused services and creativity with materials performance and fuel sourcing. It’s still a challenging industry, but this real or perceived lull in growth is the perfect time to assess the structure and vision of your company. Strengthen the basics with strategic planning to be ready for what’s next.

Strategic PlanningManufacturing Outlook

A slower year or two for revenue may be the opportune time to pursue a transfer of assets to the next generation. If earnings are down 15-20 percent, for example, savings on the transfer and estate tax can be significant if owners act now.

Also, if year-to-year revenue continues to be flat or even less than the previous year, your CPA can help you consider reporting an operating loss and cleaning up the books through carrybacks and refunds from years when revenue was higher.

Even if the company is in good financial health and sustaining a moderate profit, now may be a good time to revisit the company vision, your business model, your KPIs and your tools for tracking them. There are many more integrated solutions that tie the sales side of the house to supply chain, to production and all the way through to realization. Leaders should take time now to explore and demo these various management tools.

Manufacturing Tomorrow

Significant global growth in manufacturing is forecast mainly in Southeast Asia, India, the Middle East and Eastern Europe. By 2025, it is expected that a new global consuming class will have emerged in these developing economies as wages rise and demands for more goods and services increase.

As these manufacturers mature, they will have to focus on reducing costs, appealing to a broader base of customers and finding more skilled workers. In the end, all manufacturers will have to respond faster to market shifts based more on a global pulse than what is happening in their backyards.

In established markets, customers are already dictating variation in products, after-sales customer care and advanced or more environmentally friendly materials. These buyers are doing the majority of research on their own, interacting with the producer only briefly, then hitting the submit button. If they have a bad experience, they report it on social media. Producers are serving increasingly knowledgeable customers who want it their way…or they will go somewhere else.

On the supply side, manufacturers will continue to deal with volatile resource prices and a shortage of highly skilled talent. Difficulty obtaining supplies, regulatory and labor risks and lack of public infrastructure will influence the location and relocation of production facilities.

All of these predictions point to the need for manufacturers to be tech-savvy and globally aware. Even if home base is Dallas/Fort Worth, the market is the world. Work with advisors who recognize this shift. Get your financial and strategic house in order to invest in tomorrow’s opportunities.

If you have any questions about how to add operational efficiencies, reduce taxes or plan for transfer of ownership in your manufacturing operation this year, talk to the manufacturing team at Cornwell Jackson.

GJ HeadshotGary Jackson, CPA, is the lead tax partner in the Cornwell Jackson’s business succession practice. Gary has built businesses, managed them, developed leadership teams and sold divisions of his business, and he utilizes this real world practical experience in both managing Cornwell Jackson and in providing consulting services to management teams and business leaders across North Texas.

 

Related Posts

Posted on Feb 17, 2016

manufacturing audit, R&D credit, icdisc, manufacturing tax credits, manufacturing dallas, manufacturing employment

Batten the Hatches

In times of uncertainty in the manufacturing industry, it’s natural to huddle up and think through strategies that protect the short-term while preparing for the long game. Companies will often turn to their advisors between waves of growth to review their operations and make sure they are taking every precaution and advantage.

There is always plenty to talk about in manufacturing. As stated in a previous Manufacturing Outlookarticle, the disruption of oil and gas and energy consumption has impacted companies in the region in direct revenue, but also in their relationships with related industries that rely on the oil and gas industry.

Some of the strategies we’ve seen manufacturers employ have included adjustments to work shifts and right-sizing. However, they are also looking at ways to reduce inventory, improve processes, look for tax breaks and even step up estate planning and succession. The following are areas of the manufacturing business that owners and management can review for savings and efficiency.

Tax Incentives/Deductions

Smaller manufacturers don’t always perceive a qualification for the politically popular R&D credit. They should take another look. Some companies have discovered areas defined as R&D under the tax law that fit them perfectly even if they don’t consider themselves innovative. For example, an improved or proprietary process can qualify even if you don’t have an on-site lab or clean room. Also, think about that customer who asked you to make a small adjustment to the machining of a part. If you engineered it, it may qualify as R&D.

When companies are busy, owners or management aren’t always aware of qualifying innovation happening on the production floor. Consult with your CPA to bring those opportunities to light so they are communicated to staff and recorded regularly.

Other tax reduction strategies can be found in how manufacturers handle personal property taxes. Old assets should be removed from the books when new assets are purchased. Some assets may be improperly classified, resulting in overpayment. Many types of “equipment” can be exempt. In addition, certain idle equipment due to lack of demand may also be factored to reduce the personal property tax.

Of course, bonus depreciation is another go-to tax provision. Manufacturers may qualify under fixed asset expensing or through the Domestic Production Activities Deduction (DPAD). This allows for an additional 9 percent deduction of the lesser of taxable income, or 9 percent of “qualified production activities income” (QPAI). QPAI is equal to the amount by which gross receipts from eligible manufacturing and production activities exceed related expenses.

Activities include, but are not limited to:

  • Manufacturing, production, growth or extraction of tangible personal property in the U.S.
  • Construction of real property in the U.S.
  • Performance of engineering or architectural services in the U.S. in connection with real property construction projects in the U.S.

A manufacturer may also qualify for additional tax rate reduction benefits under the interest-charge domestic international sales corporation (IC-DISC). This tax rate reduction is generated by creating a separate entity organized as a C-Corporation. The C-Corp is deemed to participate in the exporting process of the operating entity and earns a “commission.” That commission is paid by the operating entity, and it is an ordinary deduction, reducing ordinary income. Qualification for this type of tax reduction requires exploration of a manufacturer’s operation and sales chain as well as planning to set up the entity.

There are many other areas that manufacturers can explore with their CPA to improve their tax position.

Process Improvements for Manufacturing Operations

Manufacturers can look at various ways to improve efficiencies and reduce waste in the production line as well as save on utilities, maintenance and materials. In addition to integrated components and sensors to alert staff to potential breakdown, the design of production floors can improve workflow and move product out the door faster.

Manufacturers are also looking at simplifying the steps in each manufacturing process to speed production and make training and improvements easier later. Again, some of these may qualify for R&D, depending on the complexity of the changes and their impact on a particular product or the industry itself.

A lean process study and revamping of core processes could provide a double benefit of both improved profitability and production qualifications for the R&D credit.

Labor and Benefits

Texas-based manufacturers may experience more frequent inquiries by state and federal authorities regarding citizenship and fair labor practices.

Immigration and Customer Enforcement (ICE) will look at companies with a large workforce and ask for I-9s or proof of U.S. citizenship. If they find violations, they will give the owners a time period to comply or face fines. These inquiries and fines cause a disruption in business and unexpected costs. Manufacturers need to take a careful look at their employment rolls to avoid this turbulence.

The same can be said for trends in class action suits that target large groups of employees to pursue claims for unpaid overtime or unfair labor practices as outlined in the Fair Labor Standards Act. Employers, for example, that incentivize employees with bonuses based on production must also demonstrate compliance with any overtime owed to meet those production goals.

Manufacturers can receive incentives for hiring veterans or other special worker classes, but they must be careful when hiring these workers if reductions in force are required later. They don’t want to be perceived as manipulating the system, keeping employees only until requirements are satisfied.

On the benefits side, some larger manufacturers are setting up captive entities to self-insure the operation and/or employees — essentially paying premiums to their captive entity rather than to a third-party payer. If income is steady at $5 million to $6 million a year, a captive can provide another tool for owners as they plan for succession and retirement.

If you have any questions about how to add operational efficiencies, reduce taxes or plan for transfer of ownership in your manufacturing operation this year, talk to the manufacturing team at Cornwell Jackson.

GJ HeadshotGary Jackson, CPA, is the lead tax partner in the Cornwell Jackson’s business succession practice. Gary has built businesses, managed them, developed leadership teams and sold divisions of his business, and he utilizes this real world practical experience in both managing Cornwell Jackson and in providing consulting services to management teams and business leaders across North Texas.

 

Related Posts

Posted on Jan 18, 2016

manufacturing audit, R&D credit, icdisc, manufacturing tax credits, manufacturing dallas, manufacturing employment

In the past year, manufacturing employment in the Dallas/Fort Worth area has dropped by 2 percent. This statistic alone seems negative, but the overall outlook for manufacturing is trending positive with increased focus on innovation, simplified supply chains, diversification into customer-focused services and creativity with materials performance and fuel sourcing. It’s still a challenging industry, but this real or perceived lull in growth is the perfect time to assess the structure and vision of your company. Strengthen the basics to be ready for what’s next.

Oil drives Texas. It’s no surprise that the manufacturers we talk to are concernedManufacturing Outlook
about the drop in oil and gas prices. Many of them are tied to the industry as suppliers, fabricators and general contractors. Still, other manufacturers that are dependent on freight and shipping costs are more than happy to see fuel prices drop.

Then we have the valuation of the dollar against foreign currencies that affects trade. Manufacturers trying to compete against materials and products shipped cheaply from other countries must look for efficiencies besides price reduction. China’s economic slowdown does not seem to have helped the cause of U.S. based manufacturing, with weak performance reported around the world.

Although the Dallas/Fort Worth area outpaced many other states in overall economic growth in 2015, rather flat manufacturing performance did not help the cause. This fact was predictably offset by positive gains in hospitality, business and professional services, utilities and transportation, according to an economic update by the Federal Reserve Bank of Dallas.

Flat growth is not the final word. A pause in business is sometimes the perfect opportunity to review the vision, business model, processes and procedures, technology and other foundational contributors to growth. Let’s take a look at the current state of manufacturing and what manufacturers should focus on this year to prepare for the next wave of growth. If you clean house now and invest in the foundation of your business, you will be in a better position to seize opportunities when growth resumes.

Manufacturing Now

Manufacturing in developing countries continues to provide a path to rising incomes and living standards. In advanced economies, it is a source of innovation and competitive strength for exports and productivity. When the Recession hit the industry hard, employment fell with it, delaying the demand for skilled labor.

Well, the demand for labor isn’t necessarily back to the fever pitch of pre-Recession times simply because manufacturers have looked for ways to offset labor with equipment and automation. Manufacturers that have invested in automation since 2010 have survived and even thrived. They are crediting the investment — along with the trend in the Internet of Things (IoT) — to help them efficiently monitor inventory and productivity. Automation has also helped them anticipate and head off problems on the line or in the supply chain — reducing outages and downtime.

In fact, U.S. manufacturers may spend more than $5 billion on new robotic orders by the end of 2016, according to the Freedonia Group. In turn, the demand for labor has shifted to the types of employees who are skilled at both hardware and software. Manufacturers investing in IoT units to reduce maintenance costs and risk of outages will be ahead of their competitors as that industry ramps up in the next five years.

A strong base of defense and aerospace firms in Texas does support this move to what some are calling “advanced manufacturing.” Leaders are calling for the state to continue to create policies and make investments in higher education to support advanced manufacturing infrastructure.

An article in the December 2015 Dallas Business Journal also noted that Dialexa, a consulting firm for technology start-ups, planned to expand its hardware lab, which includes the company’s electrical engineering, embedded software, mechanical design, 3D printing and electrical assembly research and development. This is one example of a company working in emerging technologies that will incubate new types of manufacturing in the Dallas/Fort Worth region.

Manufacturing At Your Service

Another interesting shift in the industry is the expansion of services offered by manufacturers. Rather than strict product manufacturing, some industries employ half of their workforce in non-production roles. This includes R&D engineers, logistics staff and after-sales support and maintenance services. A report from the McKinsey Global Institute predicts that the role of manufacturing in advanced economies leans toward innovation, productivity and trade more than growth and employment. These advanced manufacturers also consume and provide more services than manufacturing facilities in developing countries.

A survey by Grant Thornton on technology trends found that the majority of more than 300 manufacturers surveyed in the U.S. believed that new technologies would bring new opportunities. The top five technologies cited were: robotics, advanced materials, IoT (sensors, interconnected machinery), 3D printing and big data (analytics).

The use of real-time data and analytics, for example, allows manufacturers to run more “what if” testing, according to the report. It can reduce risk and materials costs while improving quality and accelerating new product development.

What is holding back many manufacturers from taking the leap into all of these new technologies?  The biggest reason cited in the Grant Thornton report was economic uncertainty, followed by the perceived risks of adopting technology that isn’t completely proven.

Manufacturers are entrepreneurial, but when it comes to capital outlay they’ve learned to be cautious. Still, a move toward diversification seems to be a natural evolution. Manufacturing can now encompass proprietary customer designs, production and implementation and also after-care services. This diversification is already paying dividends for the job shops whose saavy owners realized the potential for value-added services. More services per customer leads to more loyalty and profit.

If you have any questions about how to add operational efficiencies, reduce taxes or plan for transfer of ownership in your manufacturing operation this year, talk to the manufacturing team at Cornwell Jackson.

GJ HeadshotGary Jackson, CPA, is the lead tax partner in the Cornwell Jackson’s business succession practice. Gary has built businesses, managed them, developed leadership teams and sold divisions of his business, and he utilizes this real world practical experience in both managing Cornwell Jackson and in providing consulting services to management teams and business leaders across North Texas.

Related Posts

Posted on Nov 19, 2015

If you are part of the plant production management team, you are always looking for ways to increase throughput and lower maintenance down times. Of course, one of the go-to year-end capital expenditures strategies is to utilize a CAPEX budget in Q4 to purchase machines, equipment, or do a significant retrofit of existing equipment.

In addition to the return on assets analysis requested by the CEO and CFO, you also have to predict an elusive variable of “the potential tax savings implication in 2015.”

Unfortunately, answering this question has become a variable that might be best handicapped by Vegas and not by a production manager.

 

The bad news.

There is no definite bright line that will allow you to know with a high degree of certainty if the Sec. 179 dollar limit for expensing will be $25,000 or $500,000 in 2015.

There is also not a definite way to know if 50% bonus depreciation is available or unavailable by the end of the year 2015.

 

The good news and current status.

In July 2015, the Senate Finance Committee voted to extend bonus depreciation and the enhanced section 179 deduction through 2016. The full Senate has not indicated if or when it will act on this legislation and the House is not scheduled to act on extender legislation until late 2015. However, if passed this will create planning certainty for 2 years.

In addition, in September, the House Ways and Means Committee passed HR 2510, a bill by Congressman Pat Tiberi (R-Ohio) that proposes to go a step further and make 50% bonus deprecation a permanent part of the tax law and not part of a sun setting extender that has to be renewed annually.

There is considerable support for this bill from a strong ally, Representative Paul Ryan. Ryan wields considerable influence in the house as both Chairman of the House Way and Means Committee and as the newly elected Speaker of the House. Ryan has publicly supported the bonus depreciation incentive and its impact on investing in making manufacturers and businesses more productive.

As House Ways and Means Chairman Paul Ryan (R-Wis.) put it at today’s markup, “H.R. 2510 is about small-business people refurbishing their store or manufacturers buying new equipment. They aren’t earning income. They’re investing in our country. They’re investing in our children. They’re creating jobs. This is exactly what our tax code should support.”

So staying fluid and flexible is the name of the game. We are advising our clients to not rely on bonus for 2015, but we give it our personal handicap score of somewhere north of 60% chance of passage over the next 30-40 days before Congress adjourns for the holidays.

 

Maximizing deductions for a year-end acquisition.

(This is an example from the Congressional Research Center using 2014 tax rules and regulations since we do not yet have the new regulations for 2015.)

In the case of assets that were eligible for both bonus and section 179 expensing allowances, a taxpayer may recover their cost in the following order. The Section 179 expensing allowance would be taken first, lowering the taxpayer’s basis in the asset by that amount. The taxpayer then could apply the bonus depreciation allowance to the remaining basis amount, further reducing their basis in the property. Finally, the taxpayer was allowed to claim a depreciation allowance under the MACRS for any remaining basis, using the double-declining balance method.

A simple example from a 2014 acquisition illustrates how this procedure might work. Assume that a company made an acquisition of a new CNC laser cutter system at a total cost of $700,000. Such a purchase qualified for both the Section 179 expensing and bonus depreciation allowances for that year. Therefore, it was permitted to recover that cost for federal tax purposes as follows:

  • First, the company could take a Section 179 expensing allowance of $500,000 on its federal tax return for that year, lowering its basis in the property to $200,000 ($700,000 -$500,000).
  • Then it could claim a bonus depreciation allowance of $100,000 ($200,000 x 0.5), further lowering its basis to $100,000 ($200,000 -$100,000).
  • Next, the company was allowed a deduction for depreciation under the MACRS on the remaining $100,000. Given that the MACRS recovery period for laser cutters is five years and five-year property is depreciated using the double-declining-balance method, the company could claim an additional depreciation allowance equal to 20% of $100,000, or $20,000, using the half-year convention. ( this presumes no mid-quarter convention issues)
  • The company could recover the remaining basis of $80,000 ($100,000 -$20,000) by taking MACRS depreciation deductions over each of the next five years at rates of 32%, 19.2%, 11.52%, 11.52%, and 5.76%, respectively. ( this presumes no mid-quarter convention issues)
  • Thus, the company was able to write off nearly 89% of the cost of the CNC laser cutter in the same year it was purchased and placed in service.

 

Key Points to Remember for Year-end Planning

This is not an all-inclusive list – instead key points to remember before pulling the trigger on any capital expenditure before year-end.

  • Only 50% of cost is eligible for bonus depreciation
  • Bonus is not available for USED equipment
  • Not all states acknowledge or utilize bonus depreciation or Sec. 179
  • Newly constructed or original use property with a recovery period of 20 years or less (real or personal), qualified leasehold improvements, certain computer software, and water utility property is eligible for bonus depreciation. The only new property is eligible for bonus depreciation; used property is not eligible.
  • Qualified leasehold improvements are generally bonus eligible if made under a lease to the interior portion of a building occupied by a tenant and placed in service more than three years after the building was first placed in service.

We generally advise our manufacturing clients during year-end tax planning to avoid making long-term decisions based on tax allowances, but it can be a strong incentive due to the significant cash flow savings in March when the final year-end tax bill is tabulated.

If your current tax advisor hasn’t talked to you this year about bonus deprecation, LIFO, cost segregation or R&D credits and how they could impact your business in 2015 and 2016, then let us help. We’re tax experts.

 

Blog post written by: Gary Jackson, CPA, Tax and Consulting Partner

Related Posts

Posted on Sep 1, 2015

The leaders of the manufacturing clients that populate our firm’s client base are by their very nature – innovators. Innovators that are constantly experimenting, refining processes, and trying to determine how to do things better, faster, and cheaper. In particular they are interested in how to create innovations that can bring long-term value to their organizations and their customers.

This value creation from innovation creates jobs and is the main reason that the R&D credit exists in our tax code. So why aren’t more middle market manufacturers claiming this credit? – It seems to me that is likely for one of the four reasons explained below:

  1. Lack of Knowledge

Many manufacturers are third or fourth generation businesses, which could mean a third or fourth generation CPA relationship that may have not kept pace with innovation and current tax law and regulatory changes. Another possibility is that perhaps many years ago you re- engineered your own company tax returns to be performed by an internal department that gets no reward for taking any risks or innovating with new ideas. Sorry to be that blunt, but if the shoe fits- at least take a look at it.

  1. Fear, YES I said Fear

A fear that claiming any credit or incentive is jumping the shark with the IRS and certainly most of my manufacturing clients have enough scrutiny and regulations, that they certainly aren’t prone to invite more regulatory oversight unnecessarily. The fear thing, well it’s natural and is developed in all of us to govern behavior and preserve our lives, so we are by nature created with this emotion for a reason. That being said, this isn’t a fight or flight situation. So it should not freeze us like Elsa from Frozen (blatant Disney grandkid reference) in a business situation that can be assessed, measured, reasoned, and controlled to benefit our company and the families that work in it. Remember, middle market manufacturers create most of the jobs in your respective communities. So our government is helping you help them, which should not be a reason for fear.

  1. Cost/Benefit Uncertainty

This seems to be the main reason that clients don’t embrace the credit. To combat this, our firm has aligned with several engineering firms and specialty tax consulting firms that specifically do an upfront cost/benefit analysis to help clients assess the credit, do a rough estimate, and propose a plan to file and claim the credits. Generally, a rough estimate of the tax benefit can be attained before you start spending any consulting dollars with us or one of our specialists. If you are a Texas manufacturer- beginning in 2014 you also get to add to the analysis a bonus of a 5% credit against your Texas Franchise tax or margin tax on your gross margin. This can be used to offset up to 50% of your franchise tax in any year. Even my smaller manufacturers are seeing significant Texas credits in 2014 and 2015. Also, once you build the model you can repeat it in future years.

  1. Ignorance of the Law

Many leaders of manufacturing firms come from an engineering background, and they just want to know how things work before they dive in. They want to understand what it takes to qualify and how the credit is calculated. So to help with this natural curiosity- here is an example of the basic calculation of the Alternative Simplified Credit:

It’s the sum of your qualified expenses in the current year less (the average of the three years previous qualified expenses multiplied by 50%), which gives you the amount subject to the credit multiplied by 14% to get the actual credit amount.

Assuming you spent $280,000 of qualified activities costs( which is really easy to accumulate if you have any engineers and other smart guys on your management team, ( see the qualifiers below ) in 2014, and the average of your three prior years was say $100,000, then the delta would be $180,000 of qualified expense multiplied by 14% which equals $25,200. If you add the Texas credit to the federal credit that’s an additional $9,000 resulting in$34,200 in tax savings in one year. Better than a poke in the eye with a sharp stick.

So what kind of qualified expenses qualify- I found this great summation of the rules written for manufacturers in this article written by FreedMaxick CPA’s, a New York State firm that does quite a bit of R&D credit work. Here’s their summary and examples of the four qualifiers for the credit.

Four-Part R&D Credit Qualifier Test per FreedMaxick CPA’s:

  1. Permitted Purpose
    The activity must result in a new or improved process, function, product, performance, reliability, quality, or significant reduction in cost. Probably the most common type of activity overlooked by companies regarding these specific criteria involves significant improvements made to production-line operations. A very common example of this sort of improvement would be the updating of production-line capabilities by a manufacturer that ultimately improved efficiency, increased production capacity, and eventually yielded an overall reduction in costs. An example of this type of activity would be a company that manufactures heavy equipment, and relied upon a labor-intensive approach to production. If that company were to implement improvements in its manufacturing process, by way of automation or some other means that required investment in new equipment for the plant floor, then it’s very possible that the costs associated with the implementation of the new production process could be eligible for the R&D tax credit.
  1. Elimination of Uncertainty
    Were the activities conducted and intended to eliminate uncertainty concerning the development or improvement of a product? This criterion specifically involves the identification of information that is uncertain at the onset of the project or activity. Such uncertainty can relate to the capability of the product, the method used to produce it, or the appropriate design of the product. The examples that we typically encounter when consulting with clients in this arena deal with issues such as: Will the new or improved manufacturing process integrate with our current system, on any level? Will our new product development meet the customer specifications? Will the potential benefits outweigh the potential risks? Or will the new or improved product or activity even work?
  1. Technical in Nature
    Does the research fundamentally rely on the principals of, engineering, physical or biological science, or computer science? This criterion is usually a fairly easy one to deal with. What it really does is eliminate the soft sciences from the formal definition of technology. In other words, products or activities that are predicated upon literary, historical or social sciences do not qualify for the R&D Tax Credit. In all of our experiences, this technology criterion has never been an issue when performing an R&D study for a manufacturing company.
  1. Process of Experimentation
    Does the activity involve developing one or more hypotheses for specific design decisions, testing and analyzing those hypotheses, and refining and discarding the hypotheses? A key factor regarding the Process of Experimentation hurdle was recently crystallized, when Treasury Regulations changed the wording to evaluation of one or more alternatives. Previous language defined the process as evaluation of more than one alternative.

So now that you know the rules, you can quantify and control the risk, and you can rest assured you are in the fairway not in the rough. So, now it’s time to see if you have created enough innovation recently to qualify for the credit.

Alright then, my innovative bunch of manufacturers, we have one more year of certainty with the R&D credit and we have the ability to amend and claim up to three years of credits until you slide past your extended filing deadline. So as part of your yearend planning, capital expenditure budgeting, and tax forecasting for 2015 and projecting for 2016, please consider the R&D credit and look at the improvements you made to your business in 2014 and 2015. You more likely than not manufactured an R&D credit along with that bazillion widgets you produced for ACME Industries last year!

To find out more about R&D credits and other tools in the manufacturing tool box, or if you would just like to talk some things over about your manufacturing business, contact Gary Jackson, CPA at Cornwell Jackson, PLLC.

Blog post written by: Gary Jackson, CPA, Tax and Consulting Partner

 

Related Posts

Posted on Jun 29, 2015

Why are we hearing more about Captive Insurance Companies at happy hours, networking deals and professional conferences? Well, it’s simple… people are more open now to new ideas to lessen their tax burden than they were in 2011.

It doesn’t take an Ivy League education to figure out that out of the top 5% of taxable income earners in America – (the vast majority being hard working successful business owners like you) have watched their effective tax rate increase from the low 30’s to an effective rate of almost 40% in the last couple of years. Between our wars in Iraq and Afghanistan, and the “sucking sound” created by promises in the Affordable Care Act – there is no relief in sight from these higher tax rates in the foreseeable future.

Regardless of the reasons or your political persuasion, – John or Jane business owner operating in North Texas, whether in a growing service business, a construction company, a small manufacturer, or a franchisee with 10 dry cleaners, are getting taxed… and taxed hard.

When these business owners become tax “stunned” they become both more creative, more resilient, and more receptive to ideas to help them save on their tax bill. When that occurs certain ideas that were previously reserved for a few (the fortune 500 or fortune 1000 size companies)…. start having traction with middle market companies that may have revenues of 10MM to 200MM, have a strong cash flow, or a fairly predictable earnings history year over year.

So, enough about the why. How do captives work for the common business owner? What does he need to be aware of?  Where is the sizzle in the steak? And finally… What risks do you need to avoid if you are a 5%-er that wants to explore Captives?

 

How They Work

The operating or income producing company (your company) forms a captive and basically pays annual premiums to ensure against risks and pays the premiums to a newly formed insurance company that you own and/or control…

By paying premiums of $500K and you will receive a $500K deduction. Your insurance company receives the $500,000, pays $70k to $100k in operating expenses, small claims settlements and maintenance costs, and assuming no major claims occur- your insurance company makes a profit of around $400K per year.

A specific code section and available election under Sec. 831b, available only to small closely held captives with premiums of less than $1.2 MM annually, keeps the captive from having to pay tax on the premiums it receives at the insurance company level, and it only has to pay tax on its investment earnings.

Meaning, you are getting a deduction for 500K, and your captive is not paying tax on the $400K on the other side.

If your business does this for ten years with no major claims- then your insurance company and its owners has amassed $4,000,000 inside the insurance company which they can dividend or liquidate at 20 to 24% tax rates to the owners of the Captive (you and your family).

If you and your spouse’s net worth exceeds 10MM, you can also, with careful planning, set up your Captive ownership outside of your estate, saving your family an additional 50% of that 4 million in estate taxes that can be passed on to your heirs instead of the IRS.  Over ten years you have likewise saved $2,000,000 in your operating company from ten years of getting $200,000 a year in tax benefit (500,000 x 40%).

In other words, you are getting a 40% deduction and accumulating wealth on a deferred tax advantaged basis over time, which lets you accumulate faster and achieve greater returns.

So friends that’s where the SIZZLE in the steak comes from – the tax rate arbitrage and the estate planning you can accomplish by having your kids own the shares of the captive. Keeping your captive outside of your estate makes for a nifty tax advantaged structure for building wealth transfer to future generations.

 

So, that’s The Good News. What’s the Downsides- or Things to Avoid?

  1. First and foremost – illegitimate or thinly veneered promoters that are selling captives as promoted tax shelters versus an experienced risk management insurance company or Captive management company that operates in the fairway and will advise you correctly on insurable risks and doing it right, with real actuaries that have been doing this a long time.
  2. Insuring faux (not legitimate) or real risks inside your company. For example, anti-terrorism insurance for a small group of doctors versus real risks like malpractice.
  3. Not evaluating your liquidity needs, knowing what is reasonably possible regarding funding of premiums, and how realistic it will be annually to manage your premium levels and payments. While it is possible to change your risks that you cover to toggle or increase or decrease your premiums actuarially, it may reduce the efficacy of your insurance company.
  4. Making sure under your accounting method you can properly deduct the premiums, kind of a bad deal if you go through all this and then remember your cash basis business has to write a 500K check by 12/31 and it doesn’t have the funds to make this happen.
  5. IRS scrutiny- Captives primarily because of the promoters mentioned in #1 above have received a jaundiced eye by our friends at the IRS, and captives even made the dirty dozen list published by the IRS annually for targeted tax scams.
  6. So there are some of our clients that would not be comfortable with this kid of exposure legitimate or not , and then there are some clients that are ok with it because they have done the right things by having the right kind of advisors and captive operators that don’t deal in the fringe element.
  7. Claims- if your captive is legitimate – you will have claims and occasionally some of those could be expensive. How your operating company manages its risks as well as how your Captive manages its reserves and risk can be a difference maker in this area.

 

So If This Is Something You Want To Explore Further, What Are Your Steps?

First, a business owner through his insurance company, financial advisor, or CPA is referred in to a company that can help him form and organize a new Captive Insurance Company and manage its operations going forward.

The CPA works with the captive management company, the business management team, their existing insurance agents or risk manager to come up with a team approach to risk management and evaluate the overall feasibility of using a Captive as a part of the overall risk management plan of the business.

A captive insurance company is a fully licensed insurance company owned by the business or the business owners. It is a unique entity and is a standalone insurance company with policies, policy holders, risks, claims, and a license to do business in various domiciles – some domestic and some off shore.

What does this cost – well of course it varies – but the set up seems to run somewhere between $50K and $70K – with some variability to this figure if you use a domestic captive (with higher initial capital formation requirement), or a foreign captive that may have less stringent initial capitalization requirements.

Done well, a CIC strategy can be a great tool for tax-advantaged risk management and wealth preservation- the veritable combo pack that most of us are looking for. To learn more about it contact Gary Jackson or Cornwell Jackson’s strategic alliances and advisors in this area.

Blog post written by: Gary Jackson, Tax and Advisory Partner

Related Posts