Manufacturers are currently leveraging powerful tax incentives to the tune of $6 billion a year, yet evidence shows they are still leaving money on the table.
The first step to leveraging these incentives is understanding the two different ways the tax code encourages research. Not only can taxpayers immediately deduct qualified research costs (instead of depreciating or capitalizing them over as many as 39 years), they can also receive a direct credit of up to 20% for increasing qualified research spending over a base period amount. These two incentives together provide a boon to the manufacturing industry.
The most recent IRS data shows that R&D claims are nearing $12 billion annually, and more than half of that total goes to the manufacturing industry. The Joint Committee on Taxation estimates that businesses save an additional $2 billion a year by taking advantage of the ability to expense research costs under Section 174. Despite these seemingly large numbers, it’s clear that manufacturers could be saving much more. The Wall Street Journal estimated that only 5% of qualifying companies claim the credit.
More important, manufacturers are overlooking recent guidance that has expanded their opportunities. New types of pilot models and prototypes can now be expensed (and qualify for the credit), and the IRS has expanded the kinds of IT-related expenses that qualify for the credit.
Expensing Pilot Models
Section 174 allows manufacturers and other taxpayers to immediately deduct the cost of qualified research expenses. Without this provision, many costs would have to be depreciated or capitalized over anything from five to 39 years. Manufacturers often miss research costs that may be hidden as costs of goods sold or treated as a fixed asset for book purposes. This typically includes pilot models and prototypes, which are now easier to expense under IRS guidance.
The IRS made clear that a successful pilot model can qualify even if it would generally end up as a fixed asset or part of costs of goods sold. Pilot models are defined broadly to include any representation or model of a product or process to evaluate and resolve uncertainty during the development or improvement of the product or process.
Fortunately, recent regulations offer new opportunities to claim R&D tax credits for software costs that previously would have been excluded or subject to heightened qualification requirements under the internal use software rules.
This means a large and complete prototype can be expensed as an R&D expense and credit. An airplane manufacturer could include the entire cost of a $5 million experimental airplane built to evaluate and resolve uncertainty and test the appropriate design. The IRS will consider the $5 million as an R&D cost in the experimental or laboratory sense. It doesn’t matter whether the plane is ultimately used as a model or sold, and it can include third-party costs like an engine from a subcontractor. Even better, as long as there are uncertainties surrounding the functionality or interoperability, multiple prototypes can qualify together even if each one is not tested for its own discrete purpose. And expenses after production begins can also still qualify to the extent there is still uncertainty regarding the capability, methodology or design.
The potential benefits are enormous. Most manufacturers customize solutions for production issues by creating new pilot models when standard off-the-shelf solutions are not available.
Traditionally, software developed for internal use has not qualified for the R&D credit, even as it has become a key component of the manufacturing process. Enterprise resource planning (ERP) software in particular is often critical to vendor management, server integration, product logistics and customer relationship management (CRM).
Fortunately, recent regulations offer new opportunities to claim R&D tax credits for software costs that previously would have been excluded or subject to heightened qualification requirements under the internal use software rules. The regulations narrow the definition of internal use to include only software developed for the administrative functions of financial management, human resource management and support services. Any software that is developed to interact with third parties or to allow third parties to initiate functions or review data on a taxpayer’s system is not considered developed for internal use.
Even when software is considered developed for internal use, it can still qualify if it meets a higher standard of innovation. The new regulations even provide examples of how certain aspects of ERP implementations or upgrades can qualify under the higher standard of innovation. Under the examples, the cost to integrate the new system with legacy systems, or to customize certain features or modules, can qualify. Any activities to develop specialized data caching and synchronization software constitute elements of a process of experimentation because the taxpayer identified uncertainties related to the development of such software.
Company management should consider all IT development costs to determine which items may qualify for the R&D credit.
Manufacturers can’t afford to overlook tax opportunities. Tax reform discussions are threatening key manufacturing benefits, and the outlook for manufacturing is complicated by the administration’s trade agenda. The good news is that congressional leaders have signaled a commitment to retaining the R&D credit, which recently became permanent. It’s a great time to take a closer look at investments in infrastructure to confirm if the tax provisions Congress created to help incentivize research may apply.
Dan Mennel is West Region leader, Strategic Federal Tax Services; David Murdock is tax director and Dustin Stamper is director, Washington National Tax Office, for Grant Thornton.