Today, innovative discoveries are being made at an increasingly astounding rate. This rapid pace is due to accelerated access to information resulting in a proliferation of ideas, discoveries, and new uses for technology fueled by innovation. As businesses continue to embrace technology and innovation to develop new products and processes and search for leverage to reduce tax liability resulting from revenue generated by innovation, they often overlook one of the most grand tax opportunities available – the low-risk, high return Research and Development (R&D) Tax Credit.
The Research and Development (R&D) Tax Credit was enacted in 1981 as an incentive to reverse a decline in U.S. research activities and to encourage companies that engaged in research activities to increase their efforts. At a rate up to 20 percent, this tax credit reduces a taxpayer’s tax liability dollar for dollar. For example, a tax credit of $100 reduces a tax liability by $100. Studies have shown that over time the R&D which drives this incentive has had impact. Because spillover effects from new inventions multiply their benefits to society many times over, the benefits to society stemming from R&D have shown to far exceed the profits that private companies can earn on their R&D investments.
Prior to December 2001, there was strong contention that the requirements necessary to qualify for the R&D tax credit were rather difficult to meet and did not comply with congressional intent. However, in 2004, the IRS issued permanent regulations to reflect more the congressional intent.
Since that time, an increasing number of architecture firms, engineering firms, manufacturers, software developers, defense contractors and other companies have been enabled to realize tax recoveries and ultimately reduce tax payments in future years through a careful application of this tax break.
Determining eligibility for the tax credit is basically a two-step process. First, companies must identify potentially qualifying activities. Then, where the activity meets the specified criteria, certain expenditures related to the activity are included in calculating the tax credit.
To identify qualifying activities, companies must meet each of the following four-part test criteria:
1. Is their work a new or improved product or process?
2. Is their work technological in nature?
3. Was there technical uncertainty encountered for a given product design or process development?
4. Was there a process of experimentation involved to resolve the technical uncertainty?
One might think that this four-part test would greatly restrict the range of companies eligible for this credit. However, the qualifications are fairly broad if these tests are addressed correctly and effectively. The real pivot point is whether your company’s efforts and intellectual capital have created something new or at least incrementally changed something that it would be considered new. In other words, when you design and build a better mousetrap, that new or improved mousetrap would address function, performance, reliability, or quality concerns.
Certain types of activities specifically do not qualify for the R&D credit; for example, research after commercial production of a product begins; adaptation of existing products or processes; duplication of existing products or processes; cost of acquiring another’s patent; efficiency surveys, management functions or techniques; market research and testing; advertising and promotions; routine data collection; and routine testing, inspection and quality control.
The cost drivers for this credit are salaries and wages of selected staff, supply costs involved in the R&D process and costs associated with outside contractors (contract research) working on applicable projects. As you can imagine, for companies that are resource and technology intensive, these cost drivers could represent a lion’s share of their business expenses. If a cost cannot be categorized as one of these three types of expenditures, it will not qualify for the credit.
Supplies can include but are not limited to paper, compact discs, computer supplies, laboratory supplies, shop floor supplies and other incidentals used by researchers, supervisory and support personnel. In addition, supplies also include materials used in constructing prototypes or models or testing the same, components or sub-assemblies purchased from third parties and incorporated into prototypes and extraordinary amounts of electricity or other utilities consumed in the research activity. However, supplies do not include depreciable property or land.
Sixty-five percent of costs (otherwise eligible for the credit) paid or incurred on behalf of the taxpayer by another person other than an employee is eligible for the R&D credit as contract research.
Software development costs are treated as qualified costs if such costs meet the test of a qualified activity and if the software:
• Is developed and sold or given to a third party.
• Becomes part of or is embedded in computer hardware.
• Is developed for use in qualified research activity or as part of a production process.
In order to qualify for the R&D credit, internal use software must meet three additional criteria:
• The software must demonstrate significant innovation.
• The software must have significant economic risk in terms of the resources dedicated to the project.
• The system must not be commercially available for purchase, lease, license or use without requiring modifications.
Since pursuit of the R&D Tax Credit is a fact-and-circumstance driven endeavor, it must be adequately documented and supported to provide substantiation for IRS examination. Among the most important supporting documents are those that demonstrate the process of experimentation, uncertainty and level of innovation or novelty of the particular qualified activity. This does not require that the results of the experiments be recorded in any specific manner. The results of the experiments should be recorded in a manner that is appropriate for the particular field of science in which the experiment is conducted and for the type of experimentation involved. For example, in some fields, experiments are recorded in lab books. However, in manufacturing, by contrast, the experiments might be recorded in testing and design verification analyses.
Although enacted on a “temporary” basis and is subject to extension, the R&D credit remains a viable tax incentive for taxpayers for the designated extended period as well as to those taxpayers with open tax return years, which could be a potentially significant financial benefit to business taxpayers to reduce their federal and state income tax liability. In addition, since companies can recover taxes for up to three prior tax years, through the utilization of the R&D credit, the recovered assets could be a great addition to the bottom line.
With the proliferation of technology innovations in equipment and processes, the country’s concentration of manufacturing complexes should benefit from this grand opportunity. American industry and professional associations have demonstrated support of a permanent R&D tax credit. It is perceived that the credit will continue to enable U.S. companies to create and preserve quality jobs for the American worker, develop innovative products and services, and ultimately remain competitive in global markets. Such enablement will continue to fulfill Congress’ initial intent.