Enacted in 1981 to encourage innovation, Congress introduced the Research & Experimentation Tax Credit (R&D Credit) for companies that incur research and development costs in the United States. Originally introduced in the Economic Recovery Tax Act of 1981, this credit has since expired eight times and been extended 15 times.

For the past 35 years, this government-sponsored benefit has been one of the most valuable tax credits for manufacturers. While the credit is equal to a percentage of qualified expenditures incurred in the research and development of qualified activities, many manufacturers do not take full advantage of this tax incentive due to fallacies on claiming the credit. Some of these common misconceptions include the credit only being available to large companies or only available for innovations created in a science lab with test tubes.

Neither of these are true and with recent changes to the tax credit, there are more opportunities for manufacturers to claim the credit than ever before.

Recent Changes

The Protecting Americans from Tax Hikes Act of 2015 (PATH) included three key taxpayer-friendly changes to the R&D Credit:

  • Permanent – The R&D Credit is no longer an annual credit, but one that is here to stay. With the credit being renewed continually during its thirty-five-year history, the cyclical uncertainty of its future made it difficult for businesses to plan around. Now, the permanency of the credit eliminates that uncertainty and allows businesses to strategically tailor R&D endeavors to maximize the credit.
  • Offset Against AMT – PATH also removed one of the biggest limitations that prevented certain small and medium-sized business owners from taking full advantage of the R&D Credit. Beginning in 2016, “eligible small businesses” (defined in the PATH Act as a business with average gross receipts less than $50 million for the prior three years) will be able to use the R&D Credit to offset their AMT liability.  Additionally, partners of a partnership and shareholders of an S corporation need to meet the same $50 million gross receipts required to offset their individual AMT with the R&D credit.  Credits generated prior to 2016 may not be used to offset AMT and must still be carried forward.
  • Startups – For years, new emerging manufacturers were unable to benefit from the credit since startups traditionally do not generate enough income to have a federal income tax liability. Beginning in 2016, startups that have annual gross receipts of less than $5 million and no gross receipts in any of the last five tax years are eligible to take the credit against their payroll taxes (i.e. FICA) up to $250,000.

Qualifying Activities

Generally, when manufactures hear R&D they think of the activities with lab coats, test tubes, and safety goggles. In truth, when it comes to tax purposes, R&D has a much broader definition. For activities to qualify for the R&D Credit they must pass a four-part test:

1. Create a new or improved product or process that adds new functionality, performance, or quality of a business.

2. Be technological in nature; use a process of experimentation governed by physics, biology, engineering or computer science (though not required to be in a lab).

3. Aim to eliminate uncertainty; seek information currently unknown, whether a project succeeds or not.

4. Be experimental; evaluate one or more alternatives using a systematic process, including a hypothesis and testing.

Manufacturers are constantly improving or creating new products. These activities, including those for unsuccessful product development, may qualify for the research credit. Some activities that would qualify to meet the 4-part test include:

  • Designing, developing, or formulating new and/or improved products, processes or formulas
  • Developing products using computer-aided design tools
  • Testing, evaluating, or improving materials
  • Developing new software, hardware or technology
  • Developing and designing the implementation of the Industrial Internet of Things for operations
  • Designing and developing product samples, prototypes, and models
  • Streamlining or improving production or manufacturing processes

Qualifying Expenditures

There are three types of qualifying expenditures that qualify for the credit:

1. Wages paid to those involved, including supervision, in qualifying activities;
2. Supplies used in the development of qualifying activities; and,
3. Contract research paid to any person for services related to qualifying activities.

It is important to note that certain costs do not qualify for the credit, including purchases of depreciable property.

The IRS does require documentation of all qualifying research activities and their corresponding expenditures. In recent years, regulations and court cases have helped eliminate the administrative burden on businesses seeking to claim the credit. For example, a questionnaire tracking time spent on qualified research wages would be sufficient documentation, which is a much easier task compared to historically tracking research labor through precise timesheets.

State Credits

Beyond the federal R&D Credit, some states also offer a credit to promote innovation within their state. While the definitions of what activities qualify generally follow the federal regulations, credit computation varies from state to state. For example, Ohio provides a non-refundable credit against the Commercial Activity Tax equal to 7% of the increase in qualifying expenditures.

Take Advantage of the Benefits

With the modifications of the PATH Act, the R&D credit is now a reliable resource for long term tax planning for businesses to improve their cash flow.   Manufacturers should take a closer look at the federal and state benefits of their research activities. Now is the time to maximize the permanent benefit. Let the benefits of the research credit help change the competitive landscape in your favor.

If you’d like to discuss how the R&D Credit can benefit your business, please contact us.

About the Authors

John E. Jenkins
CPA
Partner, Taxation Services

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