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Are You Taking Full Advantage of The Research and Development Tax Credit?

August 10, 2012

Tony Switajewski, CPA, MST
Tax Partner

According to IRS statistics, manufacturers have historically claimed approximately 70% of the total amount of research and development tax credits given out by the federal government.  As this statistic shows, manufacturers are the largest industry group taking advantage of the credit. However, we continue to find that many manufacturers are not aware of the credit and those who are aware are not taking advantage, or full advantage, of the credit because of common misconceptions about its applicability to their operations.  Manufacturers who fail to claim the research credit often do so because of misconceptions regarding what activities qualify as research; what expenditures qualify for the credit; what documentation sufficiently supports their research; or that their research activities do not generate sufficient research expenditures to generate a credit. 

This article will summarize the federal research credit eligibility criteria and highlight a fairly new credit computational method.  It will also briefly discuss the credit’s future and recent proposed legislation.  At the end, it will provide some summary thoughts.  It is hoped that by reading this article your misconceptions will be addressed and you will be motivated to explore the credit's applicability to your manufacturing research related operations. 

In General

In addition to a deduction for direct and indirect research and experimental expenditures, a taxpayer is allowed a tax credit for increasing its research activities. The research tax credit is based on a percentage of a taxpayer's qualified “incremental” research expenditures.  In order to take advantage of the research credit, a taxpayer is required to (1) identify its qualifying research activities; (2) identify its qualified research expenditures related to those activities; (3) properly document those activities and expenditures; and (4) elect an advantageous credit computational method.  Each of these requirements will be briefly discussed.

Qualifying Research Activity

The research and development credit is not limited to only those involved in breaking unexplored ground or to those involved in high-tech or scientific industries. That is, a qualifying research activity does not have to result in a product, process or an improvement that is new or innovative to the world at large. The qualifying research activity need only result in a product, process or an improvement that is new to the taxpayer that developed it. In addition, although research activities must rely on principles of physical, biological, engineering or computer sciences, this in no way is intended to include only research intensive industries (e.g., such as biotech, pharmaceutical, medical, engineering, computers and software, etc.) and exclude typical "widget" manufacturers, who may engage in such activities in order to develop a new or improved product or process. 

A qualifying research activity (“QRA”) is one that satisfies the following four-part test as defined pursuant to Internal Revenue Code §41:  

  1. The activity must be undertaken for the purpose of developing a New or Improved Business Component of the taxpayer (i.e., product or process of the taxpayer);
  2. There must be an inherent Uncertainty that the activity is intended to resolve;
  3. A Process of Experimentation must be undertaken in order to eliminate that uncertainty;
  4. The activity must be undertaken to discover information that is Technological in Nature.

As these tests require, a taxpayer claiming the research credit must show that it is engaged in activities that are related to unique challenges in creating a new or improved product or process of the taxpayer.

There are some research activities that are specifically excluded from qualifying for the credit even if they satisfy the four-part test.  These excluded activities include (1) funded research; (2) research conducted outside the U.S.; (3) research related to the duplication of an existing business component (e.g., reverse engineering); (4) certain research conducted after the commercial production of a business component; (5) research related to adapting an existing business component to a particular customer's requirement or need; (6) research not related to function, performance, reliability or quality (such as cosmetics and styling) and (7) certain research related to internal use software. (Please note, this is not an all-inclusive listing.)

To remain competitive, manufacturers are constantly designing new products, improving existing products, or creating new or improved processes for making those products. With proper research credit consultation, many manufacturers learn that they are often engaged in significant qualifying research activities, including activities that they may have previously dismissed as non-qualifying. 

Qualified Research Expenditures

In general, there are three types of qualified research expenditures (“QRE”) that qualify for the credit:

  1. Wages of those involved in QRAs;
  2. Contract research expenditures with respect to QRAs; and
  3. Supplies directly consumed in QRAs.

Administrative and indirect expenditures do not qualify for the federal research credit. 

Generally, the largest research credit expenditure component is the wages of the employees performing qualifying research activities. Determining qualified research wages involves identifying those who are engaged in qualified research activities (including those assigned to the traditional R&D Department as well as those outside the R&D Department that participate in research activities); capturing the amount of time each employee spends performing research; and linking those research activities to the wage expenditures of those involved. 

The second largest research expenditure is often the expense of outsourcing qualified research to a third party (“contract research”).  Many taxpayers believe that they must use their own employees for research activities in order to claim the credit.  However, that is not the case.  Even if a taxpayer does not directly engage in research activities itself, 65% of the expenditure paid to a third party that has been contracted to engage in qualified research on a taxpayer's behalf may qualify for the credit. Identifying and capturing these activities and expenditures involves reading contracts between a taxpayer and its third-party “researcher” in order to determine the nature of the research and whether a taxpayer's expenditures paid to the researcher qualifies for the research credit.

Depending on the size and breadth of a manufacturer’s research and manufacturing operations, identifying QRAs and computing QREs can become a time-consuming task. However, considering that any QREs captured could provide a tax credit - equal to 14% of the amount of the QREs identified under the Alternative Simplified Method as discussed below (or 20% under the Percentage of Sales Method) - identifying such expenditures should not be ignored.

Documentation Requirements

Documenting research activities and associated research expenditures should not be taken lightly as the research credit is viewed by the Internal Revenue Service as a "Tier I" audit issue.

However, IRS recordkeeping and documentation requirements are fairly lenient. The IRS’s regulations require that a taxpayer claiming a research credit "must retain records in sufficiently usable form and detail to substantiate that the expenditures claimed are eligible for the credit" (Treasury Regulation § 1.41-4(d)).  The intention of the regulation is not to impose unreasonable and cumbersome recordkeeping burdens, but rather requires taxpayers to adequately demonstrate and document a relationship between qualified research activities and expenditures.

Many small- and medium-sized companies may not have the level of supporting research activity and expenditure documentation that a Fortune 500 company may have.  As a result, these taxpayers may be reluctant to pursue the research credit.  However, the IRS regulation, as well as a recent decision by the Appellate Court of the Fifth Circuit, may alleviate some fear surrounding research documentation (U.S. v. McFerrin, Arthur R., (2009, CA5) 103 AFTR 2d 2009-2566, 2009-1 USTC). The Appellate Court instituted the so called "Cohan rule" by looking to testimony and other evidence in allowing and estimating the amount of the allowable research tax credit for a manufacturer. The court held that if a taxpayer can show that its activities are qualified research activities, then the expenses associated with those activities may be estimated so long as there is a reasonable basis upon which to make an estimate. 

BlumShapiro advocates that a company should have contemporaneous written and documentary evidence supporting qualified research activities and expenditures.  However, the McFerrin decision in conjunction with the IRS regulation can provide some substantiation relief and reasonable recordkeeping flexibility in certain situations. Under all circumstances, an identifiable connection must be established between a taxpayer's qualified research activities and qualified research expenditures; the stronger the documentary evidence, the stronger is the likelihood that the research credit will be sustained upon an IRS audit.

Research Tax Credit Calculation

Prior to 2007, the primary method to calculate the federal research credit was based on qualified research expenditures exceeding a certain percentage (i.e., fixed based percentage) of a taxpayer's recent four-year average sales; the credit amount being equal to 20% of such incremental expenses. 

Many manufacturers found that although their research expenditures increased each year, they did not keep pace with the percentage increase in sales.   As a result, although manufacturers incurred significant research expenditures, they were not able to take advantage of the research creditIn 2007, an alternative method of calculating the research credit became available which alleviated this problem for many taxpayers.

Therefore, it is now highly likely that significant research credits can be obtained by many taxpayers, including manufacturers that engage in research under the Alternative Simplified Credit methodology.

The Tax Relief Act and Health Care Act of 2006 greatly simplified the research tax credit calculation and provided the opportunity for more taxpayers to take advantage of the credit.  An elective Alternative Simplified Credit provides that a taxpayer's research credit is equal to 14% of the amount by which qualified (unfunded) research expenses for the tax year exceeds 50% of the average qualified research expenses for the three preceding tax years.

R&D Credit = 14% x {QRE - [50% x Average QRE]}

Under the Alternative Simplified Credit calculation, it is no longer necessary for a taxpayer to have research expenditures that exceed a certain percentage of its average sales nor is it necessary for a taxpayer to increase its research expenditures, from year to year, in order to claim a research credit.  The following example illustrates this:

Example:

Facts: For the tax year ending December 31, 2011, MFG Inc. had average QREs for the period January 1, 2008 through December 31, 2010 of $1,000,000 ((i.e., average of the following research expenditures: $500,000 (2008); $1,000,000 (2009); $1,500,000 (2010)).  Its 2011 QREs were $1,000,000.  The company's average four-year sales were $25,000,000, and its fixed based percentage was 5%. 

Result: Although MFG, Inc.'s 2011 QREs, $1,000,000,  did not exceed 5% of its average sales, $1,250,000, and did not exceed its 2010 QREs, $1,500,000, MFG Inc. is nevertheless entitled to a federal research credit of $70,0009 ( (14% x ($1,000,000 (2011)  - ($1,000,000 (prior three-year average)  x 50%)) under the elective Alternative Simplified Credit Calculation.

As this example illustrates, as long as the current tax year qualified research expenditures exceed 50% of the average annual research expenditures in the preceding three tax years, a credit may be claimed.  The Alternative Simplified Credit can provide a significant opportunity for taxpayers to take advantage of the research credit which may be nonexistent under the percentage of sales methodology.

As a result of the simplified and beneficial method to calculate the credit, we are finding that more manufactures are able to capture significant research tax credits, whereas in the past they were not able to.  This has greatly enhanced a manufacture’s ability to plow otherwise tax dollars into further research or into other needed investments.

The Federal Research Tax Credit’s Future

The federal research and development tax credit has been available to taxpayers since 1981, on an extended “temporary” basis. As of today, the research credit has expired and is not available for otherwise qualified research expenses paid or incurred after December 31, 2011.  Although Congress has not yet extended the credit into 2012, based on the federal government’s continuing desire to incentivize research within the U.S., we have no reason to believe that they will not.  In fact, Congress is currently agreeing to extend expiring tax incentives, including the research credit.  In addition, following up on the Small Business Jobs Act of 2010 (which, in part, allowed eligible small businesses beneficial research credit treatment), Congress has introduced the Startup Innovation Credit Act of 2012 to expand the research and development credit to companies that are less than five years old and have less than $5 million in gross receipts.  Under this legislation, a start-up company that does not incur a federal income tax liability may be able to utilize the tax credit against its employment taxes.

State Research Tax Credits

In addition to the federal credit, some states offer research credits similar to the federal research credit. State research credits can be more lucrative than the federal credit because states often provide generous research credits to encourage taxpayers to perform research and other business activities within their states.  For example:

Connecticut offers two general research credits: (1) Incremental Research Credit and (2) Non-incremental Research Credit.  The Incremental Research Credit is equal to 20% of the increase in research expenditures (composed of both direct and indirect research expenditures compared to the preceding year.)  A Non-incremental Research Credit is also provided which is equal to 6% of the current year’s research expenditures (in the case of companies with over $100 million in gross income, the credit rate is generally 1%).

Massachusetts provides a research credit that is equal to 10% of the excess of qualified research expenses over a base amount.  Qualifying research expenditures are similar to research expenditures qualifying for the federal research credit.  The base amount calculation is similar to the federal percentage of sales methodology.

In addition to offering a research credit, some states may allow an entity in a loss position (i.e., without a current tax liability in which to utilize the credit against) to immediately monetize their credit (i.e., “cash-in” the credit at a discounted selling price) with the state (e.g., Connecticut) or transfer it to a third party that may be able to utilize it (e.g., New Jersey), rather than carry it forward to a future year when a company has a tax liability to utilize it against.

Summary Thoughts

We continue to find that many manufacturers are either not claiming the research credit or if they are, are not taking full advantage of the credit. As a result, these manufacturers are unnecessarily leaving significant tax dollars with the federal and state government, dollars which can otherwise be invested and improve their profitability, cash flow and capital. 

  • If you believe that you are not taking full advantage of the federal and/or state research tax credits, we recommend that you explore your prior year tax year(s) as well as your current tax year’s eligibility for the credit. Unclaimed credits identified in prior tax years could warrant a tax refund claim (or generate carryforwards).    
     
  • You also may be entitled to state research tax credits. These credits are often more generous than the federal credit and in some states can be immediately monetized. 
     
  • You should not just focus on the immediate utilization potential of the research credit. A federal (or state) research credit identified, but not utilized, may provide you with significant long-term tax reductions during its carry-forward (or carry-back) periods. Any unused federal research tax credits may generally be carried forward 20 years (and back one year), with any unused credit being deductible in the 21st tax year.

Often times a research credit study is necessary in order to identify qualified research activities; link qualified research expenditures to those activities; adequately document the research activities and expenditures; and calculate the research credit.  BlumShapiro would be happy to discuss the research credit with you further and provide any research credit study assistance we can in order for your manufacturing company to maximize this tax credit for your business and its owners.   Please feel free to call one of our tax professionals to discuss how we may be able to help you.

Tony Switajewski is a tax partner at BlumShapiro, the largest regional accounting, tax and business consulting firm based in New England, with offices in Connecticut and Massachusetts. The firm, with nearly 300 professionals and staff, offers a diversity of services which includes auditing, accounting, tax and business advisory services. In addition, BlumShapiro provides a variety of specialized consulting services such as succession and estate planning, business technology services, employee benefit plans, litigation support and valuation and financial staffing. The firm serves a wide range of privately held companies, government and non-profit organizations and provides non-audit services for publicly traded companies.

 

Under U.S. Treasury Department guidelines, we hereby inform you that (1) any tax advice contained in this communication is not intended or written to be used, and cannot be used by you, for the purpose of avoiding penalties that may be imposed on you by the Internal Revenue Service or State Tax Authorities, (2) no part of any tax advice contained in this communication is intended to be used, and cannot be used, by any party to market or promote any transaction or matter addressed herein without the express and written consent of Blum Shapiro & Company, P.C., (3) Blum Shapiro & Company, P.C. imposes no limitation on any recipient of this tax advice on the disclosure of the tax treatment or tax strategies or tax  structuring described herein, and (4) any fees otherwise payable to Blum Shapiro & Company, P.C. in connection with this written tax advice are not refundable or contingent on your realization of tax benefits from the advice contained herein.

 

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