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In order to keep investment from going offshore, U.S. policymakers created incentives for domestic companies to keep jobs and capital in America. One of these incentives is the research tax credit, better known as the R&D tax credit.
Every successful company is potentially eligible for R&D tax credits in some amount. This is especially true for companies with increasing revenues and expanding markets. The perception exists among many businesspeople that only high-tech activities qualify for the R&D tax credit. Companies in many industries are surprised to discover that much of what they do to keep their businesses profitable and growing also qualifies them for significant tax credit benefits.
Opportunity is especially broad for manufacturing operations. Creating new and improved products, developing new processes (or improving existing processes), implementing new manufacturing systems, and writing software for internal use are just some of the expenses that qualify for the credit. Under current U.S. Internal Revenue Service (IRS) rules, these activities-and many others-can result in substantial R&D credit dollars if they are properly identified and documented.
What is the R&D Tax Credit?The R&D tax credit was created by Congress as part of the Economic Recovery Tax Act of 1981 to encourage American industry to invest in research and development activities. The purpose of the credit was to stimulate R&D activities among businesses through tax incentives. To understand the complexity of the R&D tax credit, consider the fact that it was enacted in 1981 as a temporary credit. Since that time, it has expired 14 times and been extended 13 times, often retroactively, over its almost 30-year history. It took the Treasury over 23 years to issue final regulations defining qualified research activities.
In addition, multiple methods are used to compute the credit based on a company's fact pattern and elections made as long ago as 1984. Recently, President Obama unveiled an economic plan that includes improvement and expansion on the R&D tax credit. He also proposes to make the credit permanent. Though nothing is certain, experts say it is likely that the credit will be extended at least temporarily, given its bipartisan popularity and job creation appeal.
As such, now is a good time for companies (especially those that may not have taken advantage of the credit before) to determine whether they could qualify. In fact, no matter what happens politically on the federal level, companies should keep in mind that many states offer similar R&D tax credits. Federal and state tax credits provide permanent benefits to reduce tax rates and generate cash flow.
The R&D tax credit is a dollar-for-dollar credit against taxes owed or taxes paid. A company can take advantage of the tax credit for all its open tax years (the three past tax years, plus the current year). A business may go beyond this time period if it has former net operating loss (NOL) or tax years open by agreement. As part of the general business credit, the R&D tax credit can now be carried back to offset past year's taxes and carried forward for 20 years.*
How Do You Get Your Fair Share?The first step is to determine if your business qualifies for the R&D tax credit, which can be a challenge for businesses because the R&D tax credit regulations are complex and illogical. The reality is that tax laws are not written by businesspeople. Once written and passed by Congress, tax laws are transformed into elaborate tax regulations by the IRS.
Accountants or tax preparers who do not specialize in the R&D tax credit often find it difficult to interpret the regulations and assist their clients in claiming their R&D tax credits. Frequently, these tax preparers mistakenly conclude that their clients do not qualify for the R&D tax credit when they actually do. Consequently, companies often lack the resources to provide the requisite mechanism for documenting and keeping their credits.
In order to qualify for the credit, a product or project must satisfy the four-part test specified in Internal Revenue Code (IRC) §41* Congress has enacted a very broad definition of qualified research activity. It is much more expansive than the academic definition of research and development. Examples of initiatives that may be eligible for the R&D tax credit include those which:
- Increase overall knowledge or capabilities, where the information on how to do this is not in the public domain.
- Create or appreciably improve a process, material, device, product or service; or duplicate an existing process, material, etc., but in a new or appreciably improved way.
- Attempt to achieve desired geometry at the limit of the material's formability.
- Result in the development of a formed material, part of which would meet the required form while achieving deformation requirements under impact and conforming to manufacturing constraints.
A significant number of prototypes and eligible consumable materials were also associated with these development areas.
The second step in claiming the R&D tax credit is to identify and gather qualified research expenditures (QREs), which fall into three specifically defined categories:
- Wages: Taxable wages incurred for employees involved in qualified activities are eligible. This includes direct involvement, direct supervision and direct support of the R&D activity.
- Supplies: Qualified supply expenses include tangible supplies that are used up in the R&D activity. Depreciable assets are not qualified supply expense.
- Contract research: Amounts paid to third parties for direct involvement, direct supervision or direct support of R&D activities are eligible. Qualified contract research costs are included at 65%.
The next step is to calculate your R&D tax credit. In recent years, companies basically have two tax credit options: the regular research credit (RRC) or the alternative simplified credit (ASC). The RRC is complicated, and it involves looking at expenses over a historical period (1984-1988), taken as a percentage of revenue, and comparing that to your revenues and how much you are spending now. The RRC is allowed for spending in excess of a specified base amount-a ratio of R&D to sales expenses. Firms that existed from 1984 to 1988, the base period, receive a 20% credit on R&D. For newer firms, the credit is calculated on a sliding scale.
The simpler ASC became available in 2007. It replaces the alternative incremental research credit (AIRC), which was available for QREs paid or incurred on or before December 31, 2008. The ASC is a 14% credit for expenses in excess of 50% of R&D expenditures averaged over the firm's three preceding tax years. This allows a firm to continue receiving the credit even if its research costs remain static or decrease.
Companies should carefully evaluate which of the two credit calculation methods, the RRC or the ASC, yield the best results for their particular situation. For example, if a company has a high base amount under the RRC, has incomplete records to determine the base period, has significant growth of gross receipts in recent years, or a complex history of organizational activity (e.g., acquisitions, mergers, dispositions), it may benefit from using the ASC method.
How Do You Keep Your Fair Share?Properly documenting your R&D tax credit is critical. Section 41 allows project accounting or cost-center-based accounting. Companies that use project-based accounting may have an easier time matching a qualified activity to its QREs, but this approach may not include all the qualifying costs.
It is great news to receive the credit, but losing the credit under review by taxing authorities is intolerable. If a company wishes to sustain its R&D tax credit treasure trove under review, it is crucial to demonstrate the highest level of quality in the collection, substantiation, and calculation of the research tax credit from the very beginning. The research tax credit is now a tier 1 issue for the IRS. As a result, IRS examiners are severely adjusting research tax credit claims, even for companies in highly technical industries. Federal and state reviews have become much more onerous and contentious.
The IRS has a bias against research credit projects that use a "look back" methodology. The IRS wants to see research credit claims that utilize contemporaneous documentation. By this, they mean documentation that is collected from several sources in real-time to the QRE being performed.
Examiners also look at the integrity (i.e., reliability) of the documentation. Being created and collected contemporaneously is one litmus test, but another test investigates how secure the documentation is after it is reported. If supporting documents are created and then edited and modified after the fact, the data's integrity is lowered.
Finally, accuracy and completeness are paramount. A documentation system is only as good as the information fed into it. If data is incomplete, not supported by other activities or occasionally incorrect, an examiner will assume that most (if not all) of the documentation is of the same quality. Retaining your research tax credits under review is straightforward if you prepare from the beginning for these challenges.
Be PreparedManufacturers need to look at the way they record expenses and develop a methodology for quantifying associated costs with creditable projects. It is becoming more challenging to retain research tax credits under IRS§41 audits, but the best defense is a great offense.
Prepare from day one by collecting data "contemporaneously" from a wide range of sources; guarantee the "integrity" of your documentation by demonstrating that every document is untouched from the day it was created; and ensure "accuracy and completeness" by collecting a variety of supporting data from an unlimited number of sources and linking that data so an auditor can quickly and easily drill down electronically into any QRE to verify the most finite level of documentation. One option may be to consider a technological solution that addresses and responds to the problematic characteristics of the research tax credit indicated by taxing authorities.
For more information, contact The Miller Group Resource Information Xchange, LLC at 3250 Pt. White Dr. NE, Bainbridge Island, WA 98110; call (206) 619-9500; e-mail firstname.lastname@example.org; or visit www.rixtechnology.com.
Disclaimer: As provided in Treasury Department Circular 230, this article is not intended or written by The Miller Group Resource Information Xchange, LLC, to be used, and cannot be used, by a client or any other person or entity for the purpose of avoiding tax penalties that may be imposed on any taxpayer.
*On September 27, 2010, President Obama signed into law H.R. 5297, which includes significant modification in the law for both corporations and business owners with respect to their utilization of general business credits. Prior to this new law, the maximum amount of general business credits that a company or individual business owner could utilize in a given year could be no greater than the amount that their regular tax exceeded their alternative minimum tax (AMT). Also, if their AMT exceeded their regular tax, they could not utilize any general business credits. With the enactment of H.R. 5297, these limitations no longer exist. General business credits can be utilized up to the full amount of the corporation or individual's tax liability. In addition, the new law allows for a carry-back of 2010 general business credits to any of the previous five years, whereas the previous law only allowed for a carry-back of one year. It is important to point out that H.R. 5297 only applies to general business credits in the 2010 tax year and that you cannot offset AMT if you are carrying back credit from the 2010 tax year to one of the previous five years.
**There is a four-part test for the R&D tax credit: 1. Eliminate uncertainty: eliminate uncertainty concerning capability, methodology or appropriateness of design [IRC 41(d)(1)(A)]; 2. Technological in Nature: Discover information that fundamentally relies on the principles of physical science, biological science, computer science or engineering [IRC 41(d)(1)(B)(i)]; 3. Permitted Purpose: Develop a new, or improve an existing function, performance, reliability, quality or significant cost reduction [IRC 41(d)(1)(B)(ii)]; 4. Process of Experimentation: Substantially all the activity constitutes elements of a process of experimentation [IRC 41(d)(1)(C)].