At the end of last year, President Obama signed into law the much-debated Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 (the 2010 Tax Relief Act). This Act contains many important provisions affecting individual taxpayers and businesses, and extends a large number of expiring and expired tax benefits for 2011 and beyond. Among them was the retroactive reinstatement and extension of the Research & Development Tax Credit (R&D tax credit) for manufacturers.
The R&D tax credit allows companies that perform technological research (which has a broad definition) to receive a tax break on certain costs associated with research as long as the research was performed in the United States. The credit is generally equal to 20 percent of the amount by which the taxpayer’s qualified research expenses exceed a specific base amount. It was extended through 2011 for amounts paid or incurred after December 31, 2009.
Often Overlooked in Manufacturing
Manufacturers should look closely at this federal incentive for businesses to invest in research even if, in the past, you have not believed that your activities in developing new products or processes qualified as technological research. And you should not let your size deter you from exploring the credit. While many large companies routinely claim the credit, smaller companies may have much to gain as well.
According to the National Association of Manufacturers, of the nearly 18,000 businesses using the R&D credit, companies with fewer than 500 employees perform 19 percent of the U.S. total business of R&D. And more than 4,500 had assets of less than $1 million in 2006, according to the Manufacturing Council.
The IRS definition of technological research activities has become substantially broader in the years since the R&D credit was first enacted. To remain competitive, manufacturers are constantly designing new products, improving existing products, or creating new or improved processes for making those products. Most do not have what they would consider a traditional R&D department, but even these examples of R&D qualify for manufacturers:
- New product development.
- New process development.
- New line development.
- Ingredient research.
- Recipe blending and formulation.
- Formulating ingredients to achieve pre-determined sensory requirements and specifications, such as flavor, smell, texture or nutritional requirements.
- Shelf-life analysis or testing.
- Packaging design for functional (vs. artistic) purposes, such as shelf life, ergonomics, bacterial prevention or manufacturing compatibility.
- Developing or improving manufacturing and packaging processes.
- Ingredients consumed for sampling and new process initial runs.
How Does the Credit Work?
In order to figure out if you may be able to claim the credit, you must first scrutinize your business, and assess whether or not your company’s activities qualify you to take advantage of it, and earn the potential retroactive and future tax savings. Your first step should be to identify qualifying research activities, and determine that the research you do is technological in nature and involves experimentation to develop new or improved products or processes.
There are four government-specified criteria that are considered when qualifying these activities (the four-part test). Each must meet these four criteria in order to include the associated taxable salaries and wages, supplies and/or contract research in the calculation of the tax credit. These activities must only be evolutionary to your company, not revolutionary to the industry.
- The activity must be technological in nature and be based on the principles of the following hard sciences: engineering, computer science, physical science or biological science.
- The activity must involve the elimination of uncertainty and must explore what was not known at the start of the project. (Capability uncertainty — can we develop it? Methodology uncertainty — how will we develop it? Design uncertainty — what is the appropriate design?)
- The activity must be for a permitted purpose, and must involve the creation of a new or improved level of function, performance, reliability, quality, durability or cost reduction.
- The activity must involve a process of experimentation. Substantially all of the activities must include elements of experimentation: (evaluating one or more alternatives; performing testing or modeling; examining and analyzing hypotheses; and refining or abandoning hypotheses).
Calculating & Documenting Qualifying Activity Costs
Once you have determined that your company is engaged in qualifying activities, you must then calculate costs to see how much you are spending on those activities, document your expenditures and develop a methodology for matching associated costs with projects that may be eligible for the tax credit. Costs that qualify include labor, materials, and supplies used or consumed during the research process, and 65 percent of fees paid to outside consultants.
Appropriate documentation may require some changes to your record-keeping processes since the burden of proof that you have qualifying expenses is on you, the taxpayer. If you use project-based accounting rather than cost center-based accounting, you may find it easier to match qualifying activities to costs.
Also, consider whether you may be capturing relevant expenses in your R&D department, but missing those associated with eligible activities that occur elsewhere in the company. In preparation for claiming the credit, look at how you record expenses and develop a methodology for associating costs with eligible projects.
There are two methods for calculating the credit: a traditional incremental research credit and the alternative simplified credit (ASC). The traditional method involves looking at expenses as a percentage of revenue over a historical period (1984 to 1988), and comparing that to current revenues and expenses. The ASC involves averaging the last three years of R&D costs, halving it to get a base amount, and then taking the tax credit on how much more was spent on research and development over that base amount. Companies who have not claimed the research credit in the past or will have difficulty calculating a historical base amount may find the ASC to be more beneficial.
While claiming the credit does require an investment of time, resources and expertise, it can provide significant monetary and operational benefits to businesses. Even companies currently operating at a loss may benefit since federal R&D credits generated but not used can be carried forward for up to 20 years, and used when the company is profitable. And if the company is acquired in the future, the credits can be considered a valuable future asset when negotiating a selling price for the business.
Baker Tilly Virchow Krause LLP is an accounting firm in Minneapolis, MN. For more information, please call Ebert via 612.876.4500 or email firstname.lastname@example.org.