Chances are that you or companies you know are not taking advantage of a valuable tax credit.
The federal research and development ("R&D") tax credit has been part of the Internal Revenue Code since 1981. However, a large number of manufacturing companies that otherwise could have qualified have not yet taken advantage of this valuable tax credit. Some common misconceptions include:
* "Our product hasn't changed in 50 years."
* "Our products aren't technical in nature."
* "We have been operating at a loss for years."
* "We don't have enough documentation to support the credit."
* "It's probably not even worth taking the time or effort to explore."
Prior to 2003, there may have been some truth regarding the difficulty of qualifying for the R&D credit; however, the final Treasury regulations issued in 2003 make qualifying for the R&D credit much easier. In addition to the federal credit, 38 states including California, Arizona and Oregon have their version of the R&D tax credit, which can provide substantial additional tax benefits. Thus, the time is ripe for your company to claim its share of this valuable tax credit.
The following presents an overview of R&D tax credit, the requirements to qualify for the credit and the computations involved.
Overview of the R&D tax credit
Many taxpayers tend to regard R&D as an activity associated with scientists wearing white coats working for hi-tech, biotech and pharmaceutical companies. Many firms tend to regard their efforts to make new, lighter, stronger, cheaper, more reliable products, or to design more precise, more economical and more versatile products as "just doing my job" when, in fact, they are performing qualifying R&D activities. Although such portrayals might have previously been true in some respects, it is definitely no longer the case. The final regulations make it substantially easier for a broader array of companies to qualify for the R&D tax credit and provide flexibility in certain recordkeeping requirements.
Whereas the former regulations required that a company obtain knowledge that exceeds, expands or refines the common knowledge of skilled professionals, the new regulations adopt a definition of R&D that is broader and, in fact, manufacturing companies in the tooling, mold and die industries are prime candidates to take the R&D credit. Accordingly, the following is a representative list of the manufacturing activities that may qualify for the R&D tax credit:
* Development of new, improved or more reliable products, processes or formulas;
* Development of prototypes or models (including computer-generated models);
* Design of tools, jigs, molds and dies;
* Development or application for patents;
* Certification testing;
* Testing of new concepts and technology;
* Development of new technology;
* Attempted use of new materials;
* Acquiring new equipment;
* Environmental testing;
* Development or improvement of production/manufacturing processes; and
* Development, implementation or upgrading of systems and/or software, among others.
Requirements to claim the R&D tax credit
A manufacturing company, as well as others, may be able to claim the R&D credit if they are conducting research in the United States and satisfy each of the four following criteria:
1. 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 involves significant improvements made to production-line operations. An example of a qualified improvement is the updating of production-line capabilities that ultimately improved efficiency, increased production capacity, and eventually yielded an overall reduction in costs.
2. Elimination of uncertainty: Were the activities conducted 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.
3. Technical in nature: Does the research fundamentally rely on the principals of engineering, physical or biological science, or computer science? Stated differently, products or activities that are predicated upon literary, historical or social sciences do not qualify for the R&D tax credit.
4. 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?
Computing the R&D tax credit
The R&D tax credit is a powerful incentive for taxpayers. Unlike a tax deduction, a tax credit provides a dollar-for-dollar reduction of tax liability. For companies that are in a loss position and do not owe current year taxes, the R&D tax credit can be carried forward up to 20 years to reduce taxes in future years. Taxpayers can claim the R&D credit not only for the current tax year, but also for prior years for which the statute of limitations has not yet expired, which, in general are the three previous tax years, by filing amended tax returns.
Subject to certain limitations that are beyond the scope of this article, the R&D Federal tax credit can result in a cash benefit of up to 6.5 percent of the qualified research expenditures. Qualified research expenditures are wages paid to employees conducting, supervising or supporting qualified research activities. Additionally, qualified research expenditures include supplies used in the research process and costs associated with contract research.
John Williams is the director of tax services for Mark Bailey & Company, a certified public accounting firm in Reno. Contact him at 775-332-4200 or jwilliams@markbaileyco.com.
