Research & Development (R&D) Tax Credits
R&D News Alert:Tax provisions attached to the Emergency Economic Stabilization Act of 2008, and signed into law by President Bush on October 3, includes a 2 year seamless extension of the R&D tax credit for 2008 and 2009, and increases the Alternative Simplified Credit rate to 14% in 2009.
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Research Credit Claiming Criteria: The "Four-Part Test"
The R&D Credit has been part of the Internal Revenue Code since 1981; however, a large number of companies have not taken advantage of this provision. In the past, the rules were very confusing. It was hard to determine who qualified, let alone which products or processes might qualify. While the rules are still complex, a company may be able to claim the credit providing that they are conducting research in the US, and if they meet the four following criteria:
- Permitted Purpose: The activity must result in a new or improved process, function, product, performance, reliability, quality, or significant reduction in cost. Probably the most common type of activity overlooked by companies regarding these specific criteria involves significant improvements made to production-line operations. A very common example of this sort of improvement would be the updating of production-line capabilities by a manufacturer that ultimately improved efficiency, increased production capacity, and eventually yielded an overall reduction in costs. An example of this type of activity would be a company that manufactures heavy equipment, and relied upon a labor-intensive approach to production. If that company were to implement improvements in its manufacturing process, by way of automation or some other means that required investment in new equipment for the plant floor, then it’s very possible that the costs associated with the implementation of the new production process could be eligible for the R&D tax credit.
- Elimination of Uncertainty: Were the activities conducted and intended to eliminate uncertainty concerning the development or improvement of a product? This criterion specifically involves the identification of information that is uncertain at the onset of the project or activity. Such uncertainty can relate to the capability of the product, the method used to produce it, or the appropriate design of the product. The examples that we typically encounter when consulting with clients in this arena deal with issues such as: Will the new or improved manufacturing process integrate with our current system, on any level? Will our new product development meet the customer specifications? Will the potential benefits outweigh the potential risks? Or will the new or improved product or activity even work?
- Technical in Nature: Does the research fundamentally rely on the principals of, engineering, physical or biological science, or computer science? This criterion is usually a fairly easy one to deal with. What it really does is eliminate the soft sciences from the formal definition of technology. In other words, products or activities that are predicated upon literary, historical or social sciences do not qualify for the R&D Tax Credit. In all of our experiences, this technology criterion has never been an issue when performing an R&D study for a manufacturing company.
- Process of Experimentation: Does the activity involve developing one or more hypotheses for specific design decisions, testing and analyzing those hypotheses, and refining and discarding the hypotheses? A key factor regarding the Process of Experimentation hurdle was recently crystallized, when Treasury Regulations changed the wording to evaluation of one or more alternatives. Previous language defined the process as evaluation of more than one alternative.
Costs that Qualify for the R&D Credit
Generally, the credit will be 20% (13% net) of qualifying expenditures that exceed a base amount. So, as you can ascertain, the potential for R&D Credits to be large amounts is very reasonable. In fact, it is not uncommon for R&D Credits to be in excess of $100,000 per year. The base-amount calculation is probably one of the more challenging calculations of the entire project. You must be aware that if the company was conducting qualified research, and had qualified expenses and gross receipts from the period 1984 through 1988, then the more complicated calculation in developing a base period amount will result in significantly more R&D Credits than the short-cut technique, Alternative Incremental Research Credit Method. Conversely, if the company did not conduct qualified research until after 1989, then they are deemed to be a startup company, and must calculate their base period amount using the Start-Up Method.
The first step is to determine whether the expenditures fall under the R&D Credit definitions. This determination needs to be made by a qualified, experienced team of accountants and tax experts. If the initial assessment shows potential savings, a complete assessment is conducted. This assessment process normally involves site visits and interviews with financial personnel, product developers, engineers, and IT staff. The process ultimately results in the production of an encompassing R&D Credit Study Report that’s delivered to the company. It captures the information connected to the various qualifying projects.
- All W-2 wages for employees engaged in qualified research activities. This number includes the wages of personnel directly involved in, supervising or supporting research and development efforts. If an individual spends 80% or more of their time working in the R&D area, then 100% of their wages are counted when calculating the R&D credit. If the percentage of time spent is less than 80%, then the actual percentage of time the individual spends in the R&D area is multiplied by his or her salary and allocated.
- Non-capitalizable materials and supplies. Things that don't qualify for the R&D tax credit are things such as capitalizable assets. If a company purchases equipment and depreciates the equipment (which is done almost 100% of the time), then the cost of the equipment does not qualify for the credit computation. Legal fees for new patents may be qualified R&D expenses for the credit. Utilities apportioned to the R&D activity may also be R&D expenses. Equipment leases qualify too.
- Fully 65% of costs of contracted research,
(or 75% of contract research performed by a qualified research group; i.e., a University or consortium). Contract costs may include license fees, outside consultants, professional fees.
The rules for software development are still somewhat complicated, but one recent clarification states that if customized software is developed for sale or lease (not for internal purposes), then it is not subject to the extra hurdles of the High Threshold of Innovation Test. If a company develops internal use software, however, it may still qualify for the R&D Credit, providing that:
- The software is innovative;
- The development involved significant economic risk, and
- A similar product is not commercially available.
If the above three criteria are met, then the cost of developing software for internal use may qualify for the R&D Credit. If any R&D Credits are discovered involving expenditures during the previous three years, you may amend the tax returns of the company or individuals in the case of flow-through entities.
It’s important to note that if your company is considering a R&D tax credit study, one of the previous items in the Treasury Regulations has been changed. Previous law stated that contemporaneous documentation had to be taken at the time the R&D work was performed. Finalization of the regulations has cleared up this issue, however, by eliminating the contemporaneous documentation requirement.