Take Advantage of Tax Credits
Recent revisions to R&D Tax Credit legislation can help offset the cost of new equipment purchases
By Richard J. Wright, Jr., CPA
Senior Tax Manager
Freed Maxick & Battaglia, P.C.
Recent federal rules have helped to clarify ways in which companies can qualify for research and development (R&D) tax credits, and have eased the associated reporting requirements. The old idea that you had to have a laboratory in the back room, with employees wearing white gowns, employing Bunsen burners, and resembling Albert Einstein is quite out of date.
The R&D Credit has been part of the Internal Revenue Code since 1981; however, a large number of companies have not taken advantage of this provision. In the past, the rules were very confusing. It was hard to determine who qualified, let alone which products or processes might qualify. While the rules are still complex, a company may be able to claim the credit providing that they are conducting research in the US, and if they meet the four following criteria:
- Permitted Purpose: The activity must result in a new or improved process, function, product, performance, reliability, quality, or significant reduction in cost. Probably the most common type of activity overlooked by companies regarding these specific criteria involves significant improvements made to production-line operations. A very common example of this sort of improvement would be the updating of production-line capabilities by a manufacturer that ultimately improved efficiency, increased production capacity, and eventually yielded an overall reduction in costs. An example of this type of activity would be a company that manufactures heavy equipment, and relied upon a labor-intensive approach to production. If that company were to implement improvements in its manufacturing process, by way of automation or some other means that required investment in new equipment for the plant floor, then it's very possible that the costs associated with the implementation of the new production process could be eligible for the R&D tax credit.
- Elimination of Uncertainty: Were the activities conducted and intended to eliminate uncertainty concerning the development or improvement of a product? This criterion specifically involves the identification of information that is uncertain at the onset of the project or activity. Such uncertainty can relate to the capability of the product, the method used to produce it, or the appropriate design of the product. The examples that we typically encounter when consulting with clients in this arena deal with issues such as: Will the new or improved manufacturing process integrate with our current system, on any level? Will our new product development meet the customer specifications? Will the potential benefits outweigh the potential risks? Or will the new or improved product or activity even work?
- Technical in Nature: Does the research fundamentally rely on the principles of engineering, physical or biological science, or computer science? This criterion is usually a fairly easy one to deal with. What it really does is eliminate the soft sciences from the formal definition of technology. In other words, products or activities that are predicated upon literary, historical, or social sciences do not qualify for the R&D Tax Credit. In all of our experiences, this technology criterion has never been an issue when performing an R&D study for a manufacturing company.
- Process of Experimentation: Does the activity involve developing one or more hypotheses for specific design decisions, testing and analyzing those hypotheses, and refining and discarding the hypotheses? A key factor regarding the Process of Experimentation hurdle was recently crystallized, when Treasury Regulations changed the wording to evaluation of one or more alternatives. Previous language defined the process as evaluation of more than one alternative.
Generally, the credit will be 13% of qualifying expenditures that exceed a base amount. So, as you can ascertain, the potential for R&D Credits to be large amounts is very reasonable. In fact, it is not uncommon for R&D Credits to be in excess of $100,000 per year. The base-amount calculation is probably one of the more challenging calculations of the entire project. You must be aware that if the company was conducting qualified research, and had qualified expenses and gross receipts from the period 1984 through 1988, then the more complicated calculation in developing a base period amount will result in significantly more R&D Credits than the short-cut technique, Alternative Incremental Research Credit Method. Conversely, if the company did not conduct qualified research until after 1989, then they are deemed to be a startup company, and must calculate their base period amount using the Start-Up Method.
The first step is to determine whether the expenditures fall under the R&D Credit definitions. This determination needs to be made by a qualified, experiencedteam of accountants and tax experts. If the initial assessment shows potential savings, a complete assessment is conducted. This assessment process normally involves site visits and interviews with financial personnel, product developers, engineers, and IT staff. The process ultimately results in the production of an encompassing R&D Credit Study Report that's delivered to the company. It captures the information connected to the various qualifying projects.
The costs that qualify for the credit include:
- All W-2 wages for employees engaged in qualified research activities. This number includes the wages of personnel directly involved in, supervising or supporting research and development efforts. If an individual spends 80% or more of their time working in the R&D area, then 100% of their wages are counted when calculating the R&D credit. If the percentage of time spent is less than 80%, then the actual percentage of time the individual spends in the R&D area is multiplied by his or her salary and allocated.
- Non-capitalizable materials and supplies. Things that don't qualify for the R&D tax credit are things such as capitalizable assets. If a company purchases equipment and depreciates the equipment (which is done almost 100% of the time), then the cost of the equipment does not qualify for the credit computation.
- Fully 65% of costs of contracted research, or 75% of contract research performed by a qualified research group (normally a university or consortium).
The rules for software development are still somewhat complicated, but one recent clarification states that if customized software is developed for sale or lease (not for internal purposes), then it is not subject to the extra hurdles of the High Threshold of Innovation Test. If a company develops internal use software, however, it may still qualify for the R&D Credit, providing that:
- The software is innovative,
- The development involved significant economic risk, and
- A similar product is not commercially available.
If the above three criteria are met, then the cost of developing software for internal use may qualify for the R&D Credit.
If any R&D Credits are discovered involving expenditure during the previous three years, you may amend the tax returns of the company or individuals in the case of flow-through entities.
Let's take a look a R&D case study that our company recently completed for a client. Company XYZ is a manufacturer of customized shipping crates and containers. They build shipping containers for products that range from fragile ceramic needles all the way to containers used for 17-story satellite towers. The fouryear average of gross receipts for XYZ was just under $10 million.
When we first met with the executives of XYZ, they didn't believe that their company was carrying out any type of R&D activities. As a matter of fact, the company's president commented that they were not a hightech, innovative, or blue-sky-research company. After a few days of interviewing engineers, production managers, and designers at XYZ, however, we determined that XYZ Corp. had been involved in about a dozen large projects and activities per year for the previous three years that initially qualified under the permitted purpose criteria described above.
After initial conversations about the various projects and activities we had discussed with XYZ personnel, we examined the types of uncertainties encountered by those engineers, managers, and designers as they related to the projects and activities we had identified. Based on our interviews, we determined the uncertainties encountered during the development of these special-purpose shipping containers. Uncertainties such as:
- How much vibration would the container withstand before any damage would be done to the contents?
- How far (in inches) could these containers drop or inadvertently fall without damaging the contents?
These uncertainties are excellent examples of the sorts of things that satisfy the Elimination of Uncertainty criterion under US Treasury Regulations.
The third step was for us to interview personnel at XYZ who actually conducted the tests (vibration and drop) on the containers for the specific projects listed. We went through their notes and their documentation of the evaluation process of these tests. We were also able to meet with other XYZ employees who had intimate knowledge of these evaluations.
The final step that we needed to deal with for XYZ was: did the process rely upon the hard sciences? This criterion, as mentioned earlier, was fairly easy to overcome. It was clear that principles of engineering and physics were the major development components relied upon for construction of the custom creates.
Once all of the technical requirements of the R&D credit were satisfied, the next step was to look at XYZ's financial information. Subsequent to meetings with XYZ financial personnel, as well as the executive management team, we were able to determine that there were qualifying wages in the amount of approximately $280,000. Additionally, we also discovered an additional $40,000 worth of material and supplies expense directly related to these projects, as well as approximately $30,000 of outside consulting as it related to the actual tests performed on the customized crates.
Once we completed the R&D study, XYZ had more than $115,000 in federal R&D tax credits available. This was like found money! Amended returns were promptly filed and refund checks were received by the shareholders (XYZ is a Sub Chapter S Corporation) approximately 90 days later.
Another study that we recently completed for a company located in Western New York was one that involved a significant overhaul of their entire manufacturing process. This company, from 1958 through 2001, essentially employed the same manufacturing process, which relied heavily upon the use of manual labor. In 2000 the company decided to move forward with a new type of manufacturing process, which was significantly more efficient, with a great amount of reliance placed on automation and technology.
Subsequent to the installation, testing, and actual construction/integration of the new manufacturing process, it was determined that there was a research and development tax credit in the amount of approximately $100,000. It was derived from the actual wages that were paid to employees who were assisting in the design, implementation, and testing of the new manufacturing process.
Therefore, it's important to remember that in addition to the development and improvement of specific products, a significant improvement in the entire manufacturing process can qualify for the R&D credit as well.
It's important to note that if your company is considering a R&D tax credit study, one of the previous items in the Treasury Regulations has been changed. Previous law stated that contemporaneous documentation had to be taken at the time the R&D work was performed. Finalization of the regulations has cleared up this issue, however, by eliminating the contemporaneous documentation requirement.
One last item; while the R&D Credit has been on life-support for the past few years, it was extended through 2005. Most observers expect the credit to continue to be extended, or made permanent, because it promotes research and development in the US as opposed to outsourcing these functions to other countries. As of the drafting date of this article, the proposed continuation of the R&D credit is currently working its way through Congress and should be passed very soon.
This article was first published in the December 2005 edition of Manufacturing Engineering magazine.