Even today, many manufacturing companies are not taking advantage of the federal and state Research and Development (R&D) tax credits available to them. In a time when demand for manufacturers to deliver the "next big thing" is at an all-time high, the R&D tax credit can be the positive boost needed to make innovation possible.
The R&D credit is available to taxpayers who are developing new or making improvements to their products and processes. For most companies, there are development efforts for both products and manufacturing processes. The development of new products or the improvement of existing products determines whether a manufacturer will remain competitive in marketplace. Likewise, companies need to continuously improve upon their manufacturing processes to ensure efficiency.
The R&D tax credit has been around since the early 1980s, but many companies are not taking advantage of the credit simply because they do not believe that they qualify for the credit. There is a four-part test that activities must satisfy to qualify for the credit:
- Are you developing a new or improved product or process that relates to function, performance, reliability, quality, or for significant cost reduction purposes?
- Are you utilizing a type of hard science, such as industrial engineering or computer science, in your R&D efforts?
- Is there a technical uncertainty?
- Do you implement a process of experimentation in your R&D efforts?
If you answered yes to all of these questions, then your company may be eligible to take advantage of the R&D tax credit. The incentive is a federal income tax credit based on the amount of expenses attributable to qualified R&D activities, including:
- Wages paid to employees who are directly involved with, supervise or support qualified R&D activities
- Supplies used in the research process
- Amounts paid to third parties for contract research and development activities
The federal R&D credit can be as much as 6.5 percent of qualified research expenses.
In addition, many states also have available R&D tax credits that can be used along with the federal credit. Most state R&D tax credits can only be used to offset state income tax, but select states — like Georgia, for example — allow the credit to be transferred, sold, or used against other types of tax, including state withholding tax.
Recent regulations have enhanced the ability for startup and small businesses to utilize their R&D credits and have made the credit permanent.
First, startups with less than $5 million in gross receipts and in their first five years can use the credit to offset the employer portion of FICA payroll tax, at up to $250,000 each year. This enables taxpayers to monetize the credit even if a company is not in a taxable position. Second, small businesses with less than $50 million in average gross receipts can utilize the credit to offset Alternative Minimum Tax (AMT). This benefit is especially key for owners of pass-thru companies who may have been limited in utilizing the credit in the past.
An important part of claiming the R&D tax credit is substantiation of the activities qualifying for the credit. There needs to be substantiation to support which activities qualify, why they qualify and the expenses associated with each.
The process begins with gaining an understanding of the business as a whole, the products manufactured, the processes used and the activities performed by each department within the company. Interviews are conducted with personnel to determine activity qualification and to substantiate those projects that are determined to qualify. Internal documentation maintained during the research process is collected as additional substantiation.
In order to calculate the credit, a review of financial information is required to determine qualified research expenses. There are two calculation methods available to taxpayers. An evaluation of both calculation methods should be made based on available financial records. Taxpayers have the ability to amend previously filed tax returns (typically three years) in order to claim the R&D credit.
If you have not claimed the credit in the past or believe that you have not claimed the appropriate amount of credit, you can gain additional value by having your outside provider complete a multi-year R&D study and amend previously filed tax returns to claim the benefit. The calculation and substantiation of the R&D tax credit can be a large undertaking and most companies decide to utilize outside providers to prepare the necessary calculations and documentation.
Betsi Barrett is a partner in the Credits and Incentives practice at Bennett Thrasher LLP (Atlanta).