Manufacturers across the country are making the same big mistake: They assume they don’t qualify for one of the most lucrative federal income tax credits, and those who do apply often underestimate their tax credit.
In fact, the current competitive nature of the manufacturing industry creates a constant need for companies to develop new, improved products and faster, cheaper production techniques. Enhancements like these are exactly what the research and experimentation (R&E) tax credit strives to foster. Unfortunately, most companies lack a solid understanding of the credit, how to apply it and/or what expenses and activities qualify—but who can blame them? While the R&E credit is three decades old, governing rules and regulations have changed many times. Several court cases and other IRS guidance have shaped and reshaped the credit into what it is today. Without some knowledge of its history, it is virtually impossible to apply correctly.
The majority of manufacturers BKD has contacted about the R&E tax credit simply assume they don’t qualify, which potentially leaves a lot of money on the table. Some assumptions can be costly:
“Credits Are Intended for High-Tech Research Firms Where Most People Work in White Lab Coats” – This is partially correct. Companies with white lab coats hanging in the break room typically do qualify for the credit. However, manufacturers with only an occasional need for a slide rule or pocket protector also can participate.
“Product Improvements Don’t Qualify” – In addition to making products look better, design engineers generally can improve the way a product works; however, improvements in appearance or style are specifically excluded from R&E credit.
Allowable time is that spent improving a product’s functionality, usability, reliability, performance and/or quality, including brainstorming and developing new ideas and hypotheses.
“Manufacturing Process Improvements Don’t Qualify” – This is a common misconception among manufacturers. However, process-improvement activities and the associated costs are allowable and can greatly contribute to qualified research expenses. Such improvements include time and resources allocated for experimental design improvements to manufacturing equipment and changes to existing equipment to increase efficiency and throughput or to decrease scrap.
“Unsuccessful Projects Don’t Count” – Wrong. The credit doesn’t require you to have offsetting income; it is designed to encourage and foster experimentation and research. Successful and unsuccessful efforts count equally for R&E tax credits purposes.
“Only Really Big Improvements or New Products Qualify” – Not true. The tax credit doesn’t define thresholds for project size or scope. In fact, many small improvements to either your processes or product(s) can have a significant effect when added together.
“Research Scientists’ & Engineers’ Wages Are the Only Qualifying Salary Expenses” – The tax code does not limit salary expenses to specific members of your team; it includes everyone who contributes to the project, e.g., team members from quality control, production, tooling, maintenance, management and administration.
The cost of employee time is the largest contributor to most credit amounts.
How Do Your People Spend Their Time?
Answering this question is one of the best ways to determine if your company qualifies for the R&E tax credit.
Check all that apply from this list of possible answers:
· Design & test new products
· Use CAD to draw, design & model new products or improvements
· Perform design simulations & analyses, e.g., FEA, CFD, FMEA
· Design & test new processes
· Improve product designs
· Improve machine speeds
· Improve process yields
· Improve production quality
· Improve jig & fixture designs
· Modify equipment designs
· Develop new equipment
· Develop innovative tooling designs
· Perform other related activities
Investigate any items you checked; this will help you determine if your company qualifies for R&E tax credits you may have overlooked.
The federal credit generally is 4.5 percent to 6.5 percent of a company’s qualified research expenses. In addition, you may qualify for state tax credits for the same expenses.
R&E Credit Expires
The R&E credit expired December 31, 2013. This means qualified research expenditures incurred after that date are not eligible for the credit; however, qualified expenditures incurred on or before December 31 remain eligible. Historically, the credit has been extended, and legislative efforts are underway to extend it once again. BKD is closely monitoring these efforts. Though we cannot affirmatively state that the credit will be extended, it has substantial bipartisan support.
The R&E credit is complex, with a history of changes. BKD’s experienced research credit professionals work extensively with the credit’s laws and rulings to help you analyze your situation. They can help you identify, quantify and document qualified credits for a refund application.
Ashley Thompson, athompson@bkd.com
Herb Hanselmann, hhanselmann@bkd.com
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This article is for general information purposes only and is not to be considered as legal advice. This information was written by qualified, experienced BKD professionals, but applying this information to your particular situation requires careful consideration of your specific facts and circumstances. Consult your BKD advisor or legal counsel before acting on any matter covered in this update.
Article reprinted with permission from BKD, LLP, bkd.com. All rights reserved.
