R&D tax credit – you may qualify!

By Ashley Thompson | Nov 16, 2015

Manufacturers across the country are making the same big mistake: They assume they don't qualify for one of the Internal Revenue Code's most lucrative tax credits -- and those who do apply often underestimate their tax credit.

The competitive nature of the manufacturing industry means companies need to constantly develop and improve products and production techniques. Enhancements like these are exactly what the research and development (R&D) tax credit strives to foster by offering big rewards.

The tax code leaves the definition of R&D intentionally broad so companies can be rewarded for more than just product development or discovery of information new to the world. In general, R&D efforts must meet four criteria to be eligible for the R&D tax credit:

  1. The intent must be to develop a new or improved business component -- a business component is defined as a product, process, technique, formula, invention or software item. R&D doesn't have to be successful to satisfy this requirement.
  2. The R&D must be technological in nature. This simply means it should rely on the principles of the hard sciences, i.e. engineering, chemistry, physics, biology, or computer science.
  3. It must seek to eliminate technical uncertainty regarding the development or improvement of the business component. Uncertainty exists if, at the outset, information available doesn't establish the capability, method or appropriate design of the business component. (This is also commonly known as the "risk for failure" requirement.)
  4. A process of experimentation must be used to eliminate the uncertainty regarding the development or improvement of the business component. A process of experimentation is the identification and development of one or more alternatives and the use of an evaluative process to test the alternatives. As an evaluative process -- a process of experimentation often involves refining the uncertainty being addressed, modifying the alternatives to eliminate uncertainty or modifying the process of evaluating alternatives.

The federal R&D tax credit generally is 4.5 to 6.5 percent of a company's qualified research expenses, which include wages, supplies and contract research expenditures related to qualified research activities.

Wages associated with R&D often are the largest qualified research expense and include efforts of all employees involved in qualified activities. Who performs research isn't an all-or-nothing prospect; this determination typically includes identifying who is involved and then determining what percentage of time is applicable. There is a "substantially all" rule, wherein 80 percent or more involvement in qualified research activities is considered substantially all and 100 percent of an individual's time can be included in the wage calculation.

Supplies are defined as any tangible personal property, except for property of a character subject to the allowance for depreciation, which is used in the conduct of qualified research activities. Essentially any item considered depreciable property, such as equipment, should be excluded from the calculation. Examples of qualified supplies include components used to fabricate and test prototypes, raw materials used during product or process design, or testing and scrapped material resulting from a failed research and experimentation project. In addition to costs of materials, costs of manufacturing operations performed by vendors to manufacture a prototype product or component, such as coating, heat treating, and machining, also may be considered qualified supply expenses. Tooling developed and sold to customers also may be an eligible expense.

Contract research expenses are amounts paid or incurred to a third party for qualified research. In order to include these types of expenses, the company claiming the R&D tax credit must bear the expense of the research even if it is unsuccessful and retain substantial rights to the research results, e.g. intellectual property developed. Examples of contract research expenses include outside engineering consultants, independent contractors, design firms, and prototype testing. Patent attorney fees and patent filing expenses are not qualified contract research expenses. (Note: Contract research expenses are only eligible at a rate of 65 percent.)

Unfortunately, most companies don't completely understand the credit, how to apply it and which expenses and activities qualify. Many companies apply an overly narrow definition of research and either don't claim credits or greatly understate the credit they do claim. The definition provided by the tax code is intentionally broad to reward companies for a wide array of activities. In addition, the definition sometimes changes as a result of court decisions.

A good next step for most manufacturers is to consult an R&D tax credit specialist to review potential opportunities for their specific facts and circumstances. Most specialists conduct a complimentary review and provide insight regarding the value of a study prior to engaging in a formal study. This provides a method for manufacturers to assess the potential value before incurring significant time and costs.

Reach Ashley Thompson of BKD, LLP at athompson@bkd.com.