Most manufacturing companies meet at least some of the criteria for claiming an R&D credit. Some qualifying companies may be leaving a significant amount of money on the table by not taking the credit. Now is a good time for all companies to re-examine their activities and determine whether they aren't simply passing up opportunities to reduce taxes and perhaps receive refunds.
Despite the significant dollars available via the R&D credit, many companies have not taken advantage of these benefits. With the profusion of changes through the years and the continual cancellations and reinstatements of the credit, it has led many taxpayers and their representatives to view the potential credit negatively and simply disregard any potential benefits. Surprisingly, the numerous changes have made it more readily available to companies of all sizes. Knowing more about the following areas will help in determining your qualification for the credit and how to obtain it.
- What costs qualify?
- What does not qualify?
- What records are needed?
- How much is the credit; how is it calculated?
- How is it claimed?
- IRS audit techniques
What Costs Qualify?
- Costs that are undertaken for the purpose of discovering information that is technological in nature
- The application of the research is intended to be useful in the development of a new or improved business component
- Substantially, all research activities constitute a process of experimentation
- The experimentation is for a permitted purpose
Specifically, the costs will include:
- Wages of those employees directly involved in the R&D activity, limited to gross wages as per Form W-2
- Supplies consumed in the activity
- Contract expenses paid to outside contractors and others limited to 65% of cost
- Wages of senior executives and technical sales personnel who directly participate with customers and staff in design alternatives, reviewing results, supervising staff in technical activities, and consulting with customers as to design requirements. Allocations are permitted.
- Adaptation of an existing product to a particular requirement or customers need would qualify only if there is uncertainty as to the capability or method of accomplishing the adaptation
- Validation testing to ensure that a design or process meets its objective
- An underlying premise for costs to qualify for the credit is that the company must be at risk for the success of the project. There is no requirement that the improvement or initiation of a product or process be significant or successful to qualify as an R&D expense.
If 80% of an activity constitutes a process of experimentation, then 100% is eligible for the credit even if the remaining 20% does not qualify. This could mean that a design department working primarily on new products could qualify for 100% inclusion for the credit although other company departments do not qualify.
A prototype department, new tooling methodology, engineering design for new products, certain software applications, and process improvement projects might all qualify as R&D costs for a manufacturer. Additionally, much of the technical staff employed for these activities might also qualify. Each department would be individually examined for the 80% test.
What does not Qualify?
Costs for the following activities do not qualify for the R&D credit:
- Ordinary testing or inspection of materials or products for quality control
- Surveys, management studies, advertising or promotions
- Research in connection with literary or similar projects
- Research conducted outside the United States
- Acquisition of another's patent, model, or production process
- Administrative costs
- Costs for the acquisition of depreciable property
- Wage fringe costs such as payroll taxes, vacation or holiday pay, deferred compensation, insurance, etc.
- Any ordinary production activity
- All costs of selling
What Records are Needed?
The taxpayer should maintain records to substantiate the credit claimed. The records should include a detailed technical description of the activity underlying the claim for credit, which should address all aspects showing how the activity satisfies the credit criteria mentioned in the section "What Costs Qualify?" The technical description can best be supported by time records of the involved employees. In many instances, particularly where a taxpayer is applying for credit for prior open tax years, time records might not be available to the extent claimed, thereby accentuating the importance of the written technical description.
Taxpayers would be wise to maintain time records in greater detail in subsequent years to attempt to validate the prior year's claims. When applying for credit by amending prior years, returns documentation might be more sketchy than currently available. Hence, subsequent records might help prove the prior year's assertions.
Invoices for supplies and for contracts with outside suppliers should be readily available and retained for all open years.
How Much is the Credit; How is it Calculated?
The credit is stated as 20% of R&D eligible costs. However, taking the 20% requires the taxpayer to reduce expenses by the credit amount in order to obtain the benefit. Presuming a 35% corporate tax rate, then the tax cost of the expenses reduction of 7% (35% x 0.2) produces a 13% effective credit. An election is available to reduce the claimed credit from 20% to 13%, negating any reduction of expenses.
Claiming the 13% also permits the taxpayer to eliminate the requirement to add the expense reduction to their taxable state income, thereby increasing their state tax liability. As a result, other than in special circumstances, 13% is the effective credit before limitations.
The credit is calculated on the lower of 50% of qualifying costs or the product of a fixed base percentage of average annual gross receipts. For example, if qualifying costs were $2 million and 50% of that amount was lower than the gross receipts product then the credit would be $130,000. ($2 million x 50% x 13%)
The base year calculation depends on the age of the company. The law also permits an Alternative Incremental Credit and an Alternative Simplified Credit. Both of these methods generally produce lower credits than that produced by the Regular Credit method.
How is it Claimed?
The credit is claimed on Form 6765, Credit for Increasing Research Activities, attached to the applicable tax return. Unused credits can be carried back to all open years and forward for the next 20 years.
Generally, the three years prior to the current year are open for amendment by the taxpayer or the government. The credit is used as a reduction of any corporate tax due for a C corporation and for cash refunds to shareholders of an S corporation, subject to alternative minimum tax limitations. R&D credits flow through to S corporation shareholders and beneficiaries of trusts or estates.
IRS Audit Techniques
In the event of an audit, the agent will first examine the underlying expenses and then the underlying technology. They will examine work paper documents and determine whether alternative documentation is available. They will review the written descriptions of the project. They will also ask for the company's instructions to employees and directly ask employees why certain costs are included as R&D, and how that was determined. They might also ask for job descriptions and organizational charts, plus materials and brochures promoting R&D activities to potential customers. The agent will determine if the activity meets the general criteria and will search for activities claimed that do not comply.
In the foregoing example, R&D costs of $2,000,000 generated a credit of $130,000. Had that example been a company, then amended returns for the prior open three year period and the current year would have generated $520,000 ($130,000. x 4). That is serious money and not merely a vague concept to consider. It should not be a complex matter for any company, using the materials herein as guidance, to estimate their potential cash benefit from an R&D credit and proceed accordingly.