Best Tax Deductions for Manufacturing Small Business Owners
How to minimize taxable income and still stay out of jail.
Tax considerations
There are unique tax opportunities and responsibilities that come with operating a manufacturing business. Knowing what those are can help you to minimize your taxable income and put cash back in your hands for reinvestment. This guide covers common deductions, record keeping best practices and strategic considerations so you can make informed decisions whether filing taxes or planning for the future.
Cost of Goods Sold (COGS)
For many manufacturers, the biggest single category is the cost of goods sold. COGS encompasses all direct costs associated with production: raw materials, labor and factory overhead. Tracking COGS lowers gross profit and is typically the most tax-advantaged calculation. Monitor purchases, inventory changes and production costs closely, and adopt a consistent method (FIFO, LIFO or weighted average) to assess your inventory that represents your actual business.
Depreciation and Section 179 Expensing
Enhancements to facilities, equipment and machinery are long term capital investments. Depreciation amortizes the cost of these assets over their useful life, reducing taxable income each year. Or, for tax-support choices: Section 179 expensing (or other similar immediate-expensing options if available) to immediately write off the full cost of qualifying equipment the year it’s placed in service.
Determine whether to choose depreciation schedules or immediate expensing by evaluating your current tax rate, forecasts of future profits and cash flow requirements.
Repairs and Maintenance
Day-to-day repairs to maintain equipment in operating condition are generally deductible in the year you pay them. That’s different from upgrades that extend the life of an asset, which may need to be capitalized and depreciated. Keep clear records that differentiate repairs from capital improvements to back up your deductions if you get audited.
Credits and Deductions From Research and Development (R&D)
Manufacturers usually incur research and development credits as they develop new products, processes, or manufacture new products. The R&D tax credits can be used to directly offset tax liability, and some R&D expenses may even be deductible. Record project objectives, technical risks and development efforts to support claims.
Employee Compensation and Benefits
Business income generally refers to wages, salaries, payroll taxes, retirement-plan contributions and employer-paid benefits. Providing tax-advantaged benefits – retirement savings plans and select health-related benefits, for example—can be a way to lower taxable income and help retain the workforce. Ensure payroll records are accurate and current to support claims of deductions.
Utilities, Rent, and Facility Costs
Electricity, water and heating costs, facility rent/lease payments or property taxes and insurance or fire insurance costs of manufacturing area are deductible in connection with production activities. For combined business and personal use, divide costs between business and personal use and maintain appropriate documentation to support allocations.
Business Interest and Financing Costs
Any interest paid for the money used for the operation of a business or to buy capital items may be deductible, within limits. Interest on borrowed funds to purchase machinery or expand plant facilities may be deductible, in whole or in part. Know the deductibility limitations, loan documentation requirements and filing details.
Vehicle and Transportation Expenses
If trucks or vehicles are used for deliveries, supply runs or company trips related to production, the costs of that use — fuel, maintenance, insurance and depreciation — can be deductible. Use standard mileage methods and/or actual expense methods, depending on which provides a larger deductible amount, and maintain well support vehicle use and business miles.
Supply and Small Tools Expenses
General consumables, such as hand tools, safety gear and spare parts for day to day production use are generally deductible on purchase. Keeping receipts and categorizing expenses properly can ward off disputes during reviews.
Outsourced Services and Contract Labor
Subcontractor payments are deductible as business expenses, while consulting fees, quality inspection services, and contracted maintenance are all deductible. Correctly classifying workers as employees or independent contractors is of the utmost importance; misclassification can result in penalties and back taxes.
Training and Education
Costs associated with training the workforce, by increasing its skill level or acquiring safety certifications that enhance operations or comply with specific regulations, can typically be deducted. The Longer Answer There are tax advantages and other benefits to providing education for employees.
State and Local Tax Considerations
State tax treatment of deductions may vary from federal rules. Some states are strict adherents of federal rules, and in other areas they differ because of credits, or when it comes to depreciation or thresholds for expensing. Consider state-specific rules in your overall tax planning so you're not blindsided.
Recordkeeping and Documentation Best Practices
Detailed, timely records are the foundation of deductible expenses that will stand up to challenge. Keep detailed updated records of purchases, invoices, timesheets, receipts, contracts and mileage logs. Be transparent about the taxes and give clear names to the different categories, which should include production, adminstration and investment costs. Well-maintained documentation helps make preparing for taxes go more smoothly, justifies your position in the event of an audit.
Strategic Year-End Moves
Think about the timing of purchases of certain items, placements or repairs of equipment to maximize tax effects for the current tax year. If you think your profits will be greater next year, then postponing deductions is not going to benefit you as much as accelerating them this year. If, on the other hand, next year’s tax rate will be lower, stretching the deductions over several years could produce better after-tax results.
Common Pitfalls to Avoid
- Bad records: Without receipts, invoices or logs to back them up, reasonable deductions may be disallowed.
- Personal × business expenses mix up: Do not mix accounts in order to prevent unintentional disallowance.
- Misclassifying workers: Make sure your contractors meet the standards for independent contractors.
- Overlooking state rules: Consider state and local tax rules when planning.
Working with Advisors
A tax counselor with experience in manufacturing can assist in matching tax strategy to business objectives—whether that involves taking deductions faster for near-term cash flow or structuring amortization and depreciation schedules optimally for long term planning. “It’s regular tax planning, and it’s not just a year-end compliance,” Shivaram says “It helps keep surprises at bay and make sure the credits specific to manufacturing are captured.”
Conclusion
Manufacturing business owners are able to leverage a variety of deductions and credits ranging from COGS and depreciation to R&D incentives and employee benefits. The right choices vary according to operations, cash flow and future plans. Make a point of carefully documenting all company activities, choose your timing wisely and get teriffic advice to maximize the manufacturing tax deduction available to you while keeping within the rules! By leveraging tax planning as a critical component of business strategy, you can defend margins and support long-term growth.