You May Qualify for the R&D Tax Credit
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Despite the significant dollars available via the R&D tax credit, many companies have not taken advantage of these benefits. The profusion of changes in the R&D tax credit throughout the years and the continual cancellations and reinstatements of the credit has led many taxpayers and their representatives to view the potential credit negatively and simply disregard any potential benefits. Surprisingly, the numerous changes have made the credit more readily available to companies of all sizes.
Ask these questions to determine your qualification for the credit and how to obtain it:
• What costs qualify for the credit?
• What costs do not qualify for the credit?
• What records are needed?
• How much is the credit and how is it calculated?
• How can we claim the credit?
• What IRS audit techniques are associated with the credit?
What Costs Qualify for the Credit?
Generally, qualifying costs include those undertaken for the purpose of discovering technical information with research intended to be useful in development of a new or improved business component. Substantially all research activities must constitute experimentation for the purpose of developing or improving that business component.
A prototype department, new tooling methodology, engineering design for new products, certain software applications and process improvement projects might all qualify as R&D costs for a metalformer. Additionally, much of the technical staff employed for these activities might also qualify.
Specifically, the costs will include:
• Wages of those employees directly involved in the R&D activity, limited to gross wages as per Form W-2;
• Supplies consumed in the activity;
• Contract expenses paid to outside contractors and others limited to 65 percent of cost;
• Wages of senior executives and technical sales personnel who directly participate with customers and staff in producing design alternatives, reviewing results, supervising staff in technical activities and consulting with customers on design requirements (allocations are permitted);
• Adaptation of an existing product to a particular requirement or customers need would qualify only if there is uncertainty as to the capability or method of accomplishing the adaptation; and
• Validation testing to ensure that a design or process meets its objective.
As an underlying premise for costs to qualify for the credit, the company must be at risk for the success of the project. There is no requirement that the improvement or initiation of a product or process be significant or successful to qualify as an R&D expense.
Importantly, if 80 percent of an activity constitutes a process of experimentation then 100 percent is eligible for the credit even if the remaining 20 percent does not qualify. This could mean that a design department working primarily on new products could qualify for 100-percent inclusion for the credit although other company departments do not qualify.
What Costs Do Not Qualify for the Credit?
Costs for the following activities do not qualify for the R&D tax credit:
• Ordinary testing or inspection of materials or products for quality control;
• Surveys, management studies, advertising or promotions;
• Research in connection with literary or similar projects;
• Research conducted outside the United States;
• Acquisition of another’s patent, model or production process;
• Administrative costs;
• Costs for the acquisition of depreciable property;
• Wage fringe costs such as payroll taxes, vacation or holiday pay, deferred compensation, insurance, etc.;
• Any ordinary production activity; and
• All costs of selling.
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What Records are Needed?
The taxpayer should maintain records to substantiate the credit claimed. These records should include a detailed technical description of the activity underlying the claim for credit. This description should address all aspects showing how the activity satisfies the cost criteria addressed above.
The technical description can best be supported by time records of the involved employees. In many instances, particularly when a taxpayer applies for credit for prior open tax years, time records might not be available to the extent claimed, thereby accentuating the importance of the written technical description. Taxpayers would be wise to maintain time records in greater detail in subsequent years in an attempt to validate prior years’ claims. When applying for credit by amending prior years’ returns, documentation might be more sketchy than currently available. Hence, subsequent records might help prove prior year’s assertions.
In addition, invoices for supplies and for contracts with outside suppliers should be readily available and retained for all open years.
How Much is the Credit and How is It Calculated?
The credit is stated as 20 percent of R&D eligible costs. However, taking the 20 percent requires the taxpayer to reduce expenses by the credit amount in order to obtain the benefit. Presuming a 35-percent corporate tax rate, the tax cost of the expense reduction of 7 percent (35 percent by 0.2) produces a 13-percent effective credit.
An election is available to reduce the claimed credit from 20 to 13 percent, negating any reduction of expenses. Claiming the 13 percent also permits the taxpayer to eliminate the requirement to add the expense reduction to taxable state income, thereby increasing state-tax liability. As a result, other than in special circumstances, 13 percent is the effective credit before limitations.
The credit is calculated on the lower of 50 percent of qualifying costs or the product of a fixed base percentage of average annual gross receipts. For example, if qualifying costs were $2 million and 50 percent of that amount was lower than the gross receipts product, then the credit would be $130,000 ($2 million by 50 percent by 13 percent).
The base-year calculation is dependent upon the age of the company. The law also permits an Alternative Incremental Credit and an Alternative Simplified Credit after December 31, 2006. Both of these methods generally produce lower credits than that produced by the Regular Credit method.
How Can We Claim the Credit?
The credit is claimed on Form 6765, Credit for Increasing Research Activities, attached to the applicable tax return. Unused credits can be carried back to all open years and carried forward for the next 20 years. Generally, the three years prior to the current year are open for amendment by the taxpayer or the government. The credit is used as a reduction of any corporate tax due for a C corporation and for cash refunds to shareholders of an S corporation, subject to alternative minimum tax limitations. R&D credits flow through to S corporation shareholders and beneficiaries of trusts or estates.
What IRS Audit Techniques are Associated?
In the event of an audit, IRS agents will first examine the underlying expenses and then the underlying technology. They will examine work documents and determine whether alternative documentation is available. They will review the written descriptions of the project. They also will ask for the company’s instructions to employees and directly inquire of employees as to why certain costs are included as R&D and how that was determined. They might also ask for job descriptions, organizational charts, and materials and brochures promoting R&D activities to potential customers. The agent will determine if the activity meets the general criteria and will search for activities claimed that do not comply.
In the foregoing example, R&D costs of $2 million generated a credit of $130,000. Had the company then amended returns for the prior open three-year period and the current year, it would have generated credits totaling $520,000 ($130,000 by 4). That is serious money. It should not be a complex matter for any company to estimate its potential cash benefit from an R&D credit and proceed accordingly. MF
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