By Stephen Stringer, CPA, Director and Amy Sandlin, CPA, Senior Manager at Blue & Co. LLC
News of incredible technological advancement and the rapid pace at which it is changing every aspect of our lives is ubiquitous. It’s hard to imagine an industry that isn’t rethinking its business model in response to the wave of incredible technology available at our fingertips, and manufacturers are no exception.
The reality is that every aspect of your business is evolving, whether you want it to or not. At the same time, recent changes to the tax code increased the cost of innovation. This perfect storm means now is the time to rethink your research and development tax strategy.
The Research & Development Tax Credit
The Credit for Increasing Research Activities was first enacted in 1981. This credit is often referred to as the Research & Development Tax Credit (R&D credit) or the Research & Experimentation Tax Credit (R&E credit). The goal of the R&D Credit is to incentivize companies to invest in innovation to help spur economic activity within the United States.
Many companies, including those in the manufacturing sector, have claimed the research credit since its enactment.
However, there are still costly misconceptions about manufacturers’ qualifications for this federal tax credit.
When most think of research and development activities, they think of the development of a new drug by a pharmaceutical company. However, the R&D credit was designed to encompass far more types of activities and industries, even those that typically don’t come to mind when you think about research and development.
What Qualifies for the R&D Credit?
Many manufacturers engage in activities that qualify for the credit, but they many not know it.
To qualify for the credit, your activities must involve:
- The discovery of technological information useful in the development of a new product, improved product, or process improvement. Process improvement can be related to a new product or an existing product.
- The use of hard sciences which include engineering, manufacturing, computer science, chemistry, biology, and physics.
- Technical uncertainty at the outset of the research activities, and
- A process of experimentation to evaluate the new product design or process improvement to eliminate uncertainties.
The beauty of this credit is that it is designed to reward the activity and not the actual result.
The significance of the activity to the business, or even the success of the research, does not factor into what activities qualify for the R&D credit. If your business activity meets the four criteria above, it is “qualified research” that is eligible for the credit.
Your business is likely undergoing some degree of digital transformation right now, so it is important to note there are limitations to R&D credit claims for software development.
Valuing the R&D Credit
Manufacturers can expect to receive a federal credit of approximately five to eight percent of total QREs.
The credit amount is based on your expenses incurred during the year for qualified research. Eligible expenses are referred to as “qualified research expenses” (QREs) and include wages supplies, and contract research expenses.
Wages
The R&D credit is predominantly wage-driven.
The majority of the expenses that qualify for the credit are the wages of the personnel performing qualified research activities.
Supplies
QREs include the cost of supplies utilized or consumed during qualified research activities. For supply costs to qualify, they must be consumed and not part of the final product or process design.
Common examples include prototypes and other materials used during the research process.
Contract Research Expenses
Expenses of a third party contracted to support qualified research activities are also QREs. These can include the cost of a third party performing testing or other quality measures related to the research activities.
State R&D Tax Credits May Increase the Value of the Credit
Over 35 states offer some form of a research and experimentation tax credit. Each state has its own calculation methodology, but most follow the same activity qualifications used for the federal credit.
Important Reminder for Your R&D Tax Strategy
The qualified research expenses outlined above are generally considered business expenses under Internal Revenue Code Section 174.
However, the Tax Cuts and Jobs Act of 2017 included a provision that required capitalization of all research and experimentation expenses. These capitalized costs must be amortized over five years for domestic expenses and 15 years for foreign expenses.
R&D must be capitalized and amortized regardless of whether the business claims the R&D credit.
Additionally, the types and amounts of R&D expenses that must be capitalized are broader than expenses eligible for the R&D credit.
All research expenses eligible for the R&D credit must be capitalized and amortized, but not all research expenses that must be capitalized are eligible for the R&D credit.
Foregoing the R&D credit to avoid capitalizing research expenses is not a winning tax strategy.
First and foremost, if the activity meets the characteristics of research expenses outlined in IRC §174, it does not matter what you call the expenses or if you claim the credit – the expenses must be capitalized.
Second, the underlying math to forego the credit to avoid capitalizing the costs does not support that approach.
The R&D credit should be viewed as a tax strategy to reduce the cost of capitalizing R&D expenses.
This capitalization provision was included in TCJA knowing there would be time to repeal prior to its effective date, and its unpopularity is bipartisan. Republicans and Democrats are in favor of repealing this provision to support the continued growth and development of our economy. Unfortunately, to date, the two sides have been unable to come to an agreement.
Final Thoughts
Are you already engaging in activities that may qualify, or are considering new activities that may qualify, but you are not taking steps to claim the research credit? An analysis of the benefit should be part of your financial plan for the coming year.
The R&D credit is a vital part of many businesses’ tax strategy, and manufacturers can use it to support economic growth and game-changing innovation.
Blue & Co. has the expertise and experience to help manufacturing companies maximize their tax benefits with defensible credit claims. If you have any questions regarding the R&D tax credit, please contact your local Blue & Co. advisor for assistance.
