With contributions from Flora Leavitt
What comes to mind when you think of research or experimentation? Men and women with lab coats and PhDs, creating some never-before-dreamed-of product or process?
If so, your manufacturing business may be losing out. Because research is really so much more. In the eyes of the IRS, R&D doesn’t have to result in something new to the world or new to an industry, just new to your company.
Redesign your production process to reduce waste or improve safety or efficiency. Create a new robotic arm for your assembly process. Develop software to enhance your quality control. Or perhaps you’ve simply developed a stronger adhesive for your cardboard packaging. You may qualify for a federal tax credit.
The R&D tax credit (aka research tax credit) was enacted to encourage investments in U.S.-based research and experimentation. Unfortunately, many manufacturers and other companies eligible for the research credit have not claimed it. In fact, nearly 80 percent of the annual tax benefits go to just a very small number of the country’s largest companies. Not-as-large manufacturers are missing out.
Companies often wildly underestimate the value of the things they routinely do to enhance their manufacturing processes or implement quality improvements. In doing so, they miss the opportunity that the R&D tax credit offers to provide cash for their operations. In truth, the activities and expenditures that qualify for the credit are so much broader than most realize.
R&D Tax Credit Basics
The federal R&D tax credit is a credit against a company’s federal income tax based on a percentage of qualified research and experimentation expenditures.
Importantly, this research credit is not a tax deduction—which only reduces a company’s taxable income—but rather a dollar-for-dollar reduction in its federal income tax liability.
The credit can be claimed by individuals, C corporations and S corporations, partnerships, as well as trusts and estates. It is available to manufacturers and other companies operating in such diverse sectors as aerospace, automotive, tool and die, construction materials, food processing, software and information technology, energy, electronics and telecommunications, biotech and medical technology, and pharmaceuticals and chemicals, to name a few.
If you’re planning to be acquired, it’s worth mentioning that available R&D tax credits can typically be passed on to your acquirer, potentially increasing the value of your company.
Also note that, even without the credit, the research and experimental expenses you incur in connection with your manufacturing business can be deducted from taxable income each year — or deferred and amortized over a period of not less than 60 months. However, you cannot claim the deduction and tax credit for the same expenses.
Qualifying Activities: The Four-Part Test
The IRS has identified four criteria — commonly referred to as the four-part test — that your research activities must satisfy to be eligible for the R&D tax credit. In general, they require that the research involve new or improved products, processes, or software; be technological in nature; work toward elimination of uncertainty; and involve the process of experimentation.
Permitted Purpose Your research must be intended to create a new or improved product, business component or process that increases performance, function, reliability, composition or quality — or reduces cost. This criteria does not require that the innovation be new to your industry, only to your company.
Technological in Nature The research must fundamentally rely on principles of the hard or physical sciences, such as engineering, physics, chemistry, biology, or computer science. Research based in the social sciences, arts, or humanities are not eligible.
Uncertainty You must demonstrate you’ve attempted to eliminate uncertainty about the method or capability for development or improvement of a product or process, or the appropriateness of its design.
Process of Experimentation The approach to the research must demonstrate — through modeling, simulation, trial and error, refining a hypothesis, or other method — that you’ve experimented and evaluated alternatives.
The following activities are generally not eligible for the R&D tax credit:
research conducted outside of the U.S.
research performed after the start of commercial production
surveys and studies
research funded by a governmental entity or another person or organization
research adapting a product or process to suit a specific customer
duplication of an existing product or process
research related to certain internal-use software
Qualified Research or Experimental Expenditures
Generally, qualified research or experimental expenditures for purposes of the research credit are amounts paid or incurred during the year for U.S.-based in-house and contract research.
They typically include such things as supplies, W-2 taxable wages for in-house labor that supports or supervises the research, computer time-sharing costs, and a percentage of contract research payments to contractors in the U.S.
If any of your basic research is done by a university or tax exempt research organization, or you have energy research done by an energy research consortium, a portion of these expenditures may also be factored into the amount of your credit.
Documenting Qualifying Expenditures
To be eligible for the credit, you’re required to retain sufficient documentation (paper or electronic) to substantiate your expenditures, including contemporaneous records from project accounting and timekeeping systems.
To identify qualified expenditures for purposes of the research tax credit, manufacturers often start with research and development expenses as classified in their financial accounting systems. If you claim any expenditures that are not classified as research and development for financial statement purposes, the IRS will likely require additional justification.
Also retain any project accounting and time-tracking records, patents, testing reports and documents, tax records, project notes, product or project designs and revisions, paper and electronic correspondence, contract agreements, and models related to the research.
You have considerable flexibility in terms of how you capture the data, depending on your accounting system. Regardless of how you capture the data, your approach must be consistent and your results auditable.
Calculating the Amount of the R&D Tax Credit
There are two basic methods for calculating a manufacturer’s credit based on its own research and experimentation expenditures: regular and alternative simplified, sometimes referred to as the reduced research credit. The details of the calculation are complex, but the basics are as follows.
Regular Research Credit
Under this method, the credit is calculated as 20 percent of the amount of qualified research expenses for the year that exceed a specified base amount. The calculation is designed to incentivize increasing investments in research and experimentation, not consistent levels of investment.
Alternative Simplified Credit
As an alternative to the regular method, a manufacturer can claim a credit of 14 percent of the amount by which its qualified research expenses for the year exceed 50% of its average qualified research expenses for the preceding three tax years.
Further, if you did not have qualified investments in any of the preceding three tax years, you can claim a credit equal to 6 percent of your qualified expenses during the current tax year.
As a result, under this alternative method, a business with consistent or even declining investments in research and experimentation may be eligible for a research credit.
Options to Use the R&D Tax Credit to Offset Payroll Taxes or AMT
Say you have the activities and expenditures to qualify for a credit. Problem is, your manufacturing business doesn’t actually have an income tax liability, or it’s too small to absorb the entire credit.
For situations like yours, Congress enacted a payroll tax offset for young companies and a lesser-known offset to the alternative minimum tax (AMT) for certain small businesses.
To use either offset, you must first qualify for a federal research tax credit, having incurred expenditures for qualified research during the tax year.
Payroll Tax Offset for Startups
To be eligible for the payroll tax offset you must be a qualified small business, defined as a for-profit C or S corporation, partnership or person that satisfies the following requirements:
Your manufacturing business has not generated gross receipts for longer than the last five years. If you generated any gross receipts that extend back further than the five-year period that ends in the current tax year, you do not qualify.
It’s a stringent test. As the rules are currently written this includes receipts of any kind, including investment income — and in any amount, no matter how small. That means, for example, earning $25 as interest on a bank account outside of the five-year period precludes you from using the payroll tax offset.
Your gross receipts in the tax year for which you are claiming the credit are less than $5 million. Generate more and you do not qualify.
AMT Offset for Small Businesses
To qualify for the AMT offset you must be an eligible small business, defined as a nonpublic C or S corporation or a partnership or sole proprietorship that satisfies the following requirements:
Your business’ average annual gross receipts for the previous three years cannot exceed $50 million.
For partnerships and S corporations, the maximum gross receipts requirement applies to the business and, separately, to each of its partners and shareholders.
The federal tax rules for the research credit are detailed and complex, and cannot be fully explained in this overview. If you have additional questions about the impact of these regulations on your tax filing — or you need help accounting for, or maximizing the tax benefits from, your investments in research and experimentation — give us a call.
Want to know if your business can qualify