By Ed Meyette of Crowe LLP
As this month’s Capital Spending Outlook discusses, food & beverage processors are investing significant amounts to build new plants or reconfigure and modernize existing ones. Federal income tax principles generally recognize these types of expenditures as fixed assets that result in a benefit beyond the current year.
Because of the assumed future benefit, the federal tax rules require the deduction for the cost of these assets to be taken over a number of years through depreciation expense. Invariably, these plant-related projects include a combination of costs, such as equipment, buildings, building improvements, land improvements and process-related assets that might cross the threshold between building and equipment.
When a plant project includes this kind of mix of personal property and real estate-related costs, it is important for the company to be able to identify each specifically because there is a significant difference in the rate at which a company may take federal income tax depreciation deductions on the various classes of property.
For instance, building assets must be depreciated on a straight-line basis over 39 years. On the other hand, items of personal property, certain building improvements considered qualified improvement property (QIP) and land improvements are afforded much more accelerated rates of depreciation. Since 2001, the special depreciation allowance commonly known as bonus depreciation has supercharged this acceleration by allowing taxpayers to expense a large percentage of the basis of nonbuilding property in the initial year the asset is placed into service.
Therefore, properly classifying fixed assets related to a plant project can have a dramatic positive effect on a company’s current year tax liability. Ensuring that all personal property, QIP and land improvements are properly identified and segregated from the building assets will significantly accelerate the depreciation deductions and defer federal income tax liabilities.
To make sure they are optimizing their depreciation deductions related to large plant projects, companies typically engage specialists to perform cost segregation studies. These studies apply the federal tax depreciation principles to the construction elements of the facility under study to determine which portions may be classified as personal property, land improvements or QIP and which must be classified as building assets.
The benefit of cost segregation results from the acceleration of deductions and can be easily quantified with a present-value computation. Typically, as part of its presentation of results, the cost segregation provider shows a comparison of the construction costs – first, as the company would have depreciated them without a study and then per the results of the study. Finally, a present-value rate is applied to the resulting differences in depreciation deductions over the life of the property.
Generally, depending on the nature of the facility and construction project, companies might experience a net present value benefit in the range of 2-10% of the cost of construction from cost segregation.
The following example illustrates the impact of cost segregation:
Beverage Co. is reconfiguring and expanding its milk processing plant. It has engaged a construction firm to complete the changes to the facility. The firm’s contract amount for the construction project is $20 million. Beverage Co. engages a third party to complete a cost segregation study, which identifies $13 million as property other than building, namely personal property, land improvements and QIP. The accelerated depreciation deductions on this $13 million result in a current year tax deferral of nearly $2 million and a net present value benefit of $1.6 million, or approximately 8% of the construction costs assuming a combined federal and state tax rate of 25% and a present value rate of 6%.
Companies can experience significantly different tax results depending on the mix of the assets added in a plant-related capital expenditure. It is important for companies to understand that mix and to employ all the resources and tools available to properly record the assets in order to optimize the resulting tax depreciation deductions and reap the cash tax rewards.
Ed Meyette is a partner at Crowe LLP, an audit, tax, advisory and consulting firm. Contact him at [email protected].