By Ashley Thompson, BKD, LLP
Companies nationwide have used the research and development (R&D) tax credit to generate tax savings based on the resources expended to develop new or improved products and processes since 1981. During that time, governing rules and regulations have changed significantly. In addition, court cases and other IRS guidance have shaped and reshaped the credit into what it is today. Several common questions surround the R&D credit, including:
• What types of companies qualify?
• How is R&D defined?
• What are the potential tax savings?
The majority of R&D credit claims are made by manufacturers, software developers and tech companies, but the credit applies to any company involved in developing or improving a product, process, technique, formula, invention or software item — there are no exclusions based on industry. The R&D credit is ultimately an incentive for companies to invest in developing new or improved “technology.” If you’re in business today after recent challenging years, you’ve likely innovated successfully to survive or thrive. However, to qualify for the credit, you must have incurred qualified R&D costs in connection with your innovation.
What is R&D?
The value of the R&D credit is driven by wage, supply and contract research expenses related to qualified research activities. For an activity to qualify as research for this credit, it must meet four requirements:
• Research must have been undertaken to discover information, the application of which is intended to be useful in the development of a new or improved business component. A business component is a product, process, technique, formula, invention or software item.
• Research must be technological in nature — it must rely on the principles of the “hard sciences,” e.g., engineering, computer science, biology, chemistry or physics.
• There must be technical uncertainty regarding the development or improvement of a business component at the outset of the project. In other words, is there a risk for failure or are there questions regarding “if” it can be done, “how” to do it or the appropriate design of the solution?
• A process of experimentation must be used to eliminate the technical uncertainties. A process of experimentation often is defined by developing, testing and evaluating new ideas.
Many companies apply an overly narrow definition of R&D and either don’t claim credits or greatly understate the credits they do claim. They might include only engineers’ product development activities or those related to “ground-breaking” discoveries.
The definition provided by the tax code is intentionally broad to reward companies for improvement activities and process-related research. Here are some common examples of qualified research activities:
• Developing a new product
• Improving an existing product, e.g., subsequent software versions or improved performance or function of an existing product
• Developing a manufacturing process, e.g., developing tooling, jigs, fixtures, machine specifications, process parameters or test gages
• Improving a manufacturing process to increase efficiency and throughput or decrease scrap, e.g., automation, tooling redesign or equipment modification
• Developing internal-use software to provide capabilities beyond what is readily available
• Applying existing technologies in new and innovative ways, ways for which they were not originally designed
Taxpayers are not required to “reinvent the wheel” to qualify for the credit; they need only invest internal resources in developing something that is new or improved to them.
What is the Value of the Credit?
Qualified research expenses include wages, supplies and contract research expenses associated with R&D projects that satisfy the above criteria. Qualified wage expenses usually are determined by identifying which employees are involved in research and to what extent. Who performs qualified research isn’t an all-or-nothing prospect. In most organizations — especially small and midsize companies — relatively few people are full-time researchers. Full- and part-time research can be qualified labor expense, so it’s important to identify everyone contributing to the research effort, regardless of department or level.
Qualified supply expenses must be for material used in R&D activities. The Internal Revenue Code defines “supplies” as any tangible personal property, except property of a character subject to the allowance for depreciation. 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.
Contract research expenses are amounts incurred or paid to any person (other than a taxpayer’s employee) for qualified research activities. Examples of contract research include individuals with technical specialties, engineering consultants, design firms, engineering firms, programming services, technical temporary services or PEOs, testing laboratories, validation services and certification services. Remember: Only 65 percent of amounts invoiced for contract research can be included in the credit calculation.
The federal credit generally is 4.5 percent to 6.5 percent of a company’s qualified R&D expenses. So for every $100,000 in qualified research expenses, a company would typically claim $4,500 to $6,500 in tax savings. There are other issues beyond the nature of expenses that also affect the value of the credit to consider, such as prior year expenses. They also should be included in estimates of value before proceeding with a study and claiming a research credit.
The R&D tax credit can provide substantial tax savings for taxpayers in a multitude of industries. It’s important to understand the definition of R&D, the eligible expenses and documentation expectations when analyzing opportunities and applying the R&D tax credit to your specific situation.
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.
Ashley Thompson, BKD, LLP, has 13 years of experience helping clients claim federal and state research credits, and leads BKD’s nationally recognized research and experimentation tax credit practice. He also conducts research credit studies for clients in the manufacturing, software development, food processing and tool and die industries He is a graduate of Wabash College, Crawfordsville, IN, with a B.A. degree in economics. firstname.lastname@example.org