Many taxpayers mistakenly believe that they have to be scientists inventing something completely new or developing cutting-edge technology to qualify for the research and development tax credit.
Or they think they have to be doing “research” as we commonly understand that word.
These do qualify, but there are many other activities that also qualify. The tax definition of “research and development” is quite broad. A dedicated R&D department or laboratory is not required, and it is not necessary to be a biotech, semiconductor, or similar “high-tech” company to be eligible for R&D tax credits.
Most businesses across a broad range of industries are routinely involved in common activities to develop, refine or improve their products and processes to stay competitive, and thus potentially qualify for the incentive.
Regardless of the nature of a business, as long as qualified research and development activities are being performed, there is an opportunity to pursue R&D tax credits.
This credit applies to many businesses, quite a number of which are in the manufacturing field. It also applies to software or technology companies, as well as architectural and engineering firms if they have taken on the economic risk for the project and have met the retention of rights requirements.
Smaller businesses can qualify for the credit in addition to large companies. Many taxpayers have claimed billions of dollars in federal and state tax credits for qualified research expenditures. Qualified research expenditures include costs associated with investments in innovation and improvements beyond just new product development.
The research and development tax credit is available for businesses developing new or improved products. It also can apply to:
- Engineering and designing a new product
- Research aimed at discovering new knowledge
- Searching for ways to apply new research findings
- Designing product alternatives
- Evaluating product alternatives
- Significantly modifying of the concept or design of a product
- Designing, constructing and testing preproduction prototypes and models
- Engineering activity to advance the product’s design to the point of manufacture
- Systems processing modeling
- System and functional requirements analysis
- Integration analysis
- Experimenting with new technologies
- Experimenting with new material and integrating the material to improve manufactured products
- Engineering to evaluate new or improved specification/modifications in terms of performance, reliability, quality and durability
- Developing new production processes during prototyping and preproduction phases
- Research aimed to significantly cut a product’s time-to-market
- Research aimed to obtain more efficient designs
- Developing and modifying research methods/formulations/products
- Paying outside consultants/contractors to do any of the above activities
To determine whether your company qualifies for the tax credit, consult with your tax adviser and consider the following:
1. Is your company discovering some technological information that does not already exist within your company?
2. Is there uncertainty regarding the product or process development?
3. Are the costs your company is expending attributable to a process of experimentation?
4. Does the “research” have a general business purpose?
If you answer “yes” to these four questions, get in touch with your CPA as soon as possible. Your CPA will help you determine whether you are eligible for the tax credit and provide you with an estimate of how much the credit will be.
You can then decide if the benefits of the tax credit are worth the documentation requirements needed to sustain the credit. Under IRS regulations, a taxpayer must retain records in sufficiently usable form and detail to substantiate that the expenditures claimed are eligible for the credit.
To claim the credit, you must clearly establish full compliance with all of the relevant statutory and regulatory requirements. It is imperative to ensure that qualified expenses have been properly quantified and that documentation is properly prepared to support the credit position taken. Failure to maintain records in accordance with these rules is a basis for disallowing the credit, so it is important to consult with your CPA to make sure these records comply with the IRS requirements.
What types of costs qualify for the R&D credit?
The expenditures that may be applied toward the R&D credit include both in-house research expenses and contract research expenses.
The in-house research expenses that can qualify for the R&D credit fall into two categories:
1) Wages paid to company employees for conducting, directly supporting and directly supervising qualified R&D activities
2) The cost of supplies used or consumed in relation to these R&D activities
Contract research expenses are those amounts paid to anyone outside the company performing qualifying research activities on your company’s behalf. The time and effort devoted to conducting research do not necessarily have to be undertaken by your employees. By contracting with outside individuals or companies to conduct these activities on your behalf – provided their contract expenses qualify for the R&D credit – you are improving and advancing your company and, as a result, those expenditures may qualify for the R&D credit.
General business credits can be used up to the full amount of the corporation’s or individual’s tax liability. In addition, credits that can’t be used in the current year can be carried back to any of the previous five years.
It should be noted that, due to legislative changes in 2010, this provision is available for “eligible small businesses.” An eligible small business is defined as one of the following:
(a) A corporation whose stock is not publicly traded
(b) A partnership
(c) A sole proprietorship
To qualify as an eligible small business, average annual gross receipts of the corporation, partnership or sole proprietorship for the three prior tax periods cannot exceed $50 million. Many businesses that qualified for the credit, but could not benefit cash-wise because of AMT limitations, can now get their credits currently versus having to carry them forward.
In addition, the American Taxpayer Relief Act of 2012 extended the tax credit through 2013. The R&D credit has been “temporary“ for many years and its availability subject to many extensions by Congress. Many businesses are lobbying to make the credit permanent, but there are no guarantees.
Additionally, in recent years a few states have added a “refundable R&D credit” to companies that meet their general R&D criteria, but are not yet profitable and operated at a net operating loss for that specific tax year.
To encourage additional development and growth, which would translate to future state taxes, some state legislatures have voted to support state qualified (small) businesses by offering them a refundable credit based on a few additional R&D criteria. Generally speaking, it mirrors their regular R&D credit but requires additional details about the business, etc.
If you are entitled to these credits – take them! In these hard economic times, don’t leave tax dollars on the table for the IRS or states that could be in your pocket.