The R&D tax credit: where to look and what to look for.
Many businesses attempt to improve revenues and margins by adding to and improving their product offerings. They continually fight competitive pricing pressures by working to improve efficiency and reduce costs. Businesses doing these things should be aware that the federal government could help finance such activities through the R&D credit.
Section 41 of the Internal Revenue Code provides a tax credit for a taxpayer’s spending on “qualified research.” The credit is computed as a percentage of the amount a business’ qualified research expense exceeds a “base amount” calculated using the business’ history of such expenditures and its gross receipts. The credit is in addition to the tax deduction for research expenditures and the benefit results in a dollar-for-dollar reduction of the business’ income tax liability. In certain circumstances, the benefit can be further increased by claiming a state credit for the same research.
What activities qualify?
Expenses related to activities companies do every day to stay competitive can generate credits. Creating new products, improving existing products, improving existing processes – it is not necessary for the improvements to be significant enough to be patentable, just that they meet the following requirements:
• Technology – a hard science such as computer science, engineering, chemistry, or physics;
• Uncertainty at a project’s outset related to capability, method or appropriate design;
• Development that uses a process of experimentation including the evaluation and testing of alternatives;
• New or improved function, performance, reliability or quality of a business component.
The three major categories of qualified research expense that qualify for the credit are:
• W-2 wages for employees engaged in the qualified research activity;
• Materials and supplies consumed in the research and development process;
• Costs of an outside consultant hired to conduct research.
If an employee spends at least 80 percent of his or her time performing qualified services, then all of the employee’s wages qualify under the “substantially all” provision. The rules allow qualification of not only an employee that directly advances the research, but also if they directly supervise or support the research as well.
For contract research payments to qualify, the taxpayer must retain substantial rights to the fruits of the research (but not necessarily exclusive rights); and the taxpayer must be at risk for the research (it pays regardless of results). The amount paid or incurred by the taxpayer to another person to perform qualified research for the taxpayer is limited to 65 percent by statute, however, costs for certain tax-exempt research organizations are limited to 75 percent.
Many taxpayers think that tax credits for research and development (R&D) are enjoyed only by high-tech manufacturing businesses. However, many businesses other than traditional manufacturers have had good success recently in identifying activities qualifying for the credit – food processors, farmers, recyclers, utilities, biotech, financial services, engineering firms, wholesale distributors – all have found credits and refunds with some earnest “digging.”
Many businesses qualify
Final regulations released in late 2003, which allow a broader array of businesses to qualify for the credit, are applicable for all open years. A taxpayer can amend returns to claim credits it missed in prior years. However, with a three-year statute of limitations, every year a business may lose substantial credits that could have been claimed. Also, because records get archived or destroyed and memories fade, a business can put together better documentation to substantiate a research credit claim the sooner it acts.
In order to be eligible for the deduction and credit for research activities, a business must be able to support the calculation of which costs qualify, including a breakdown of the costs incurred by category as discussed above. This is where a formal research credit study can be most beneficial. The first step in an R&D study is to conduct a feasibility analysis to determine whether the company’s expenditures fall under the R&D credit definitions. If the initial assessment shows potential savings, a complete assessment is conducted that typically includes a site visit, a review of key financial and project information, and interviews with subject matter experts involved in the R&D process, including engineers and product developers among others. If any R&D credit savings are discovered, the process is applied to not only the current year, but also for the prior three years as well.
The bottom line is, your company could be paying too much in taxes. Although the R&D credit has been in effect for a number of years, we have found that a surprisingly high number of companies fail to take full advantage of this opportunity. Why? Among the reasons are underestimating the scope of the credit, assuming that the credit only applies to manufacturing companies, lack of understanding the applicable tax law and failing to claim the credit in a timely manner. Engaging outside expertise in the R&D tax credit can help many companies derive the most benefit from this incentive in the tax law.
Gerald Parshall is director, Tax Services and Keith Koland is director, Tax Consulting, at RSM McGladrey, Inc., a business services firm offering mid-sized companies business and tax consulting, wealth management, retirement resources, payroll services and corporate www.rsmmcgladrey.com.