The R&D Tax Credit has been a part of the United States tax law since 1981 and is the incentive most frequently utilized by manufacturing companies, according to the RSM McGladrey 2008 Manufacturing and Wholesale Distribution National Survey.
Despite its apparent popularity, 40 percent of the survey’s manufacturing respondents reported that they are not taking advantage of the credit. There are literally thousands of manufacturing companies that are eligible but have not been profiting from this opportunity.
The credit is required to be extended by Congress every year or two. Both houses of Congress are working on extending the credit retroactively for 2008 and are working towards resolving the revenue offsets necessary to pay for it.
The credit is derived from a series of calculations that measure the increase in current R&D activities over a historical base level of R&D as a percentage of revenue. If your company’s increase in R&D outpaces the growth in revenues, you will generally be able to take full advantage of the credit.
A manufacturing company will likely benefit from the R&D tax credit if it engages in one or more of the following activities:
- Development of new or improved products
- Development of new or improved manufacturing processes
- Design and fabrication of tools and dies
- Development of production equipment
- Development of new or improved software used in the production process.
Based on final IRS regulations, changes in your operations and product lines which are evolutionary rather than revolutionary in nature can also qualify for the credit.
Companies in a variety of R&D-intensive industries may qualify for the credit; however, manufacturing companies make up the largest portion of businesses claiming the credit. The most R&D-intensive manufacturers include makers and processors of pharmaceuticals, biotechnology, medical devices, computers and peripherals, equipment and component parts, chemicals, food, aerospace and defense contractors.
Why, then do we have this gap between the thousands of manufacturing companies performing R&D and those that actually claim the tax credit? One obvious reason is that some companies have not been eligible for the research credit due to one or more of the computational rules.
For example, a manufacturing company may be performing R&D, but its R&D activities have not been increasing, so it does not have enough qualified research expenses to exceed the base amount.
Another reason is that the rules are complicated. Companies don’t normally keep their records in a way that makes it easy or practical to extract data that can accurately measure costs under the tax definition of R&D. Many small and mid-sized manufacturers don’t have the in-house expertise or manpower to apply these complex rules and do the recordkeeping necessary to quantify the qualified activities and related costs.
Moreover, it is a very specialized area of tax law and only the larger CPA firms and some specialized boutique firms have the expertise and experience required to help companies set up an efficient process for capturing qualified R&D expenses.
Last but not least, the IRS has found the R&D credit a difficult area to audit and their resources have had trouble keeping up with the prior years’ refund claims filed.
In response, they have designated the R&D credit as a “Tier One” issue, which means that there is a standardized process for auditing credit claims in order to reach the program’s goal of ensuring that the issue is identified, developed and resolved in a consistent manner across all cases that involve similar taxpayers.
Examining agents are trained to focus on documentation created at the time the research was performed (i.e., contemporaneous) and to view estimates and testimony prepared several years later with skepticism.
How should claims be prepared?
Despite the new IRS audit approach, the R&D credit continues to be a significant tax benefit for manufacturers. What has changed is that it has become increasingly important to develop a consistent process for documenting R&D activities and costs.
In addition, refund claims for prior years are getting more scrutiny due to historical methods of estimating prior years’ activity for companies that did not maintain project accounting records. Prior year refund claims are still viable, but some changes to historical methods have become necessary.
It is recommended that companies take the following approach to document, claim and sustain R&D credits:
Project Qualification
- Identify R&D projects and initiate a project accounting process as soon as possible.
- Establish and retain project files outlining R&D processes and results. It is important to document the journey as well as the destination.
- Track key milestone dates, from project concept to commercial production.
- Supplement contemporaneous documentation with narratives addressing the R&D qualification criteria for each project based on interviews conducted by R&D tax credit experts.
- If there are too many projects to document, then a statistical sample will be required. The IRS does not accept judgmental sampling.
Wages
- Set up a project accounting system to track employee hours and activities to specific projects.
- Supplement time sheet entries with contemporaneous documentation such as calendars showing scheduled project meetings and e-mails discussing project issues.
- For prior year refund claims for years prior to setting up a project accounting system, have employees estimate qualified research hours by project and within each project, by qualified activity.
Supplies
- Identify supplies consumed in the R&D process for each specific project.
- Include supplies in the project accounting system and segregate supplies used in R&D in a separate general ledger account.
Contract Research
- Develop a vendor list to keep track of services performed in each R&D project.
- Obtain contemporaneous documentation from contractors that documents the work performed and the R&D activities. This may be in the form of work orders, statements of work and/or itemized invoices.
- Keep copies of each R&D contractor agreement/contract on file.
- Address which party has the financial risk and retains the intellectual property rights. Both are required to claim the R&D credit.
Less detailed methods of quantifying costs associated with qualifying R&D activities have come under increased IRS scrutiny, particularly in light of the recent designation of the credit as a “Tier One” audit issue.
Following the processes outlined above puts companies in a much stronger position to sustain a larger portion of the claimed research credits in an IRS exam. Investing in better R&D recordkeeping provides a significant payback in terms of increased R&D credits and decreased cost of IRS audit defense.
Tom Windram is a managing director and National R&D practice leader for RSM McGladrey Inc. For more information visit http://www.rsmmcgladrey.com/