Research & Development (R&D) is a key corporate function, whether or not your company has a separate department. Despite this fact, 42% of manufacturers indicated they were not utilizing federal and state R&D tax credits, according to the RSM McGladrey 2007 Manufacturing and Wholesale Distribution Survey. That means there are still thousands of manufacturing companies eligible for the credit that haven't been taking advantage of it.
Various functions fall under the R&D umbrella, including R&D scientists, product designers, plant engineers, software developers -- all perform work to increase revenues, improve margin and deal with competitive pricing pressures.
To promote business innovation, federal and many state tax laws provide a tax credit that reduces income taxes for a portion of R&D expenditures. Many companies have the opportunity to claim this credit but leave a substantial amount of money on the table by assuming that their activities do not qualify.
Companies in a variety of industries qualify for the credit, as long as qualified R&D has taken place. Some questions to ask yourself regarding whether the credit is a good fit for your company include:
- What was uncertain at the outset of a project that required an R&D process?
- What was learned or discovered as a result of the R&D?
- What were the business drivers in performing the research?
- What type of experimentation was used to test and analyze possible alternatives (e.g. modeling, simulation, or trial and error methodology)?
- How were the results recorded and the documentation retained?
"The R&D tax credit helps businesses that are not necessarily 'lab research' environments" said Larry Nealy, Partner with Axiom Solutions. "We recovered over $1 million in credits for a $100 million U.S. manufacturer of switches and connectors. They are competing in a global marketplace and the credit helps them fund additional R&D to maintain their competitive position."
How Does the R&D Credit Work?
The R&D credit was originally enacted by Congress in 1981 to promote innovation, help businesses in the U.S. become more competitive and to encourage companies to keep R&D jobs within the country.
Individual state R&D credits serve the same purposes. While the credit is required to be extended by Congress every year, there has only been one lapse (for 12 months) in its history and there continue to be efforts to make it more generous and permanent.
"The R&D tax credit has provided solid tax benefits and helped us understand our business process more deeply" said Gary Correia, vice president of finance for Taylor Guitars, one of the world's foremost manufacturers of high quality acoustic & electric guitars. "Our future is focused on innovation, and the R&D tax credit provides additional capital to continue to invest in developing new products."
The credit is determined based on a series of calculations which measure the incremental increase in research activities that outpace the growth of the company in terms of revenues. The result of these calculations is a tax credit that directly reduces income tax liability for each year of eligibility. The benefit for many companies can be significantly enhanced by filing refund claims for all open tax years. There are three methods of calculating the credit:
The Standard Incremental Credit
The tax credit equals 20% or 13% (depending on the availability of certain elections) of Qualified Research Expenses (QREs) over a base amount, calculated using historical information.
Alternative Incremental Credit
This method solves some of the challenges created by the incremental nature of the credit. Basically, this method generates a credit as long as QREs exceed one percent of gross receipts.
Alternative Simplified Research Credit
For years ending on or after Dec. 31, 2007, a new method has been made available to further simplify the calculation of the credit by eliminating gross receipts as a factor. The credit equals 12%t of QRE that exceed 50 percent of the average for the three preceding years. In the event the taxpayer doesn't have QRE in any of the three preceding taxable years, the credit is 6% of the current years.
Does my Company Qualify for the Credit?
To qualify for the credit, a company must be engaged in activities that include the following elements:
- Permitted purpose: The activity relates to a new or improved function, performance, reliability or quality of a product, process, software, technique, formula or invention, which is to be sold to customers, or used in your business.
- Elimination of uncertainty: The activity must be intended to discover information to eliminate uncertainty concerning the capability, method or appropriate design for developing or improving a product or process.
- Process of experimentation: The activities must substantially involve the development, evaluation and testing of one or more alternatives.
- Technological in nature: The activity performed must rely on principles of physical science, biological science, computer science or engineering.
"Many U.S. companies are gaining a competitive advantage in creative ways by using software to drive cutting edge manufacturing and service to customers", said Tom Windram, Managing Director with RSM McGladrey. "We identified and qualified over $1.2 million of Federal and California R&D tax credits for an athletic uniform manufacturer. They developed innovative software to design uniforms to customer's specifications entered through their Web site, providing instructions directly to the plant machinery to manufacture them."
If your company is developing new products, enhancing existing products or improving manufacturing processes, then you are likely to benefit from an R&D tax credit study. The IRS recently broadened the potential opportunity by recognizing that many changes in your operations and product lines which are evolutionary rather than revolutionary in nature may qualify for the credit.
How Should R&D Credit Claims be Prepared?
You've heard the phrase "location, location, location" when describing the reason to buy real estate. There's a similar phrase for securing R&D credits -- documentation, documentation, documentation. By documenting, organizing and retaining records from concept through production, you can move closer to turning your R&D activities into tax credits.
Less detailed methods of quantifying costs associated with qualifying R&D activities have come under increased IRS scrutiny, particularly in light of the recent designation of the credit as a "Tier One" audit issue. This designation means that there is a standardized process for auditing claims and a review by the IRS national issue management team. That is why it is important to have a good documentation process in place from the beginning of any R&D activities.
Investing in better documentation provides a payback beyond the R&D credit. By improving your R&D recordkeeping, your company can get a better view of project expenses and realize the true costs and benefits of manufacturing, research and development.
Keith Koland is a director and Upper Midwest R&D practice leader in the Minneapolis office of RSM McGladrey Inc., Tom Windram is a managing director and National R&D practice leader for RSM McGladrey Inc. Nick Kromenacker is chief marketing office for Axiom Solutions LLLP in Denver, Co. Larry Nealy is a partner and National R&D practice leader for Axiom Solutions LLLP. RSM McGladrey is a leading professional services firm providing accounting, tax and business consulting. www.rsmmcgladrey.com. Axiom Solutions (http://www.axiomsolutions.com/) is one of the nation's leading professional services firms specializing in R&D Tax Credits for medium-sized companies.