R&D Tax Credits for Manufacturing

Published: Jul 26, 2024
By: Timothy Rankins
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For years, the manufacturing industry has reaped the rewards of the research & development (R&D) tax credit. In fact, the credit accounts for over 60% of total credits claimed annually.

The R&D tax credit encourages companies to invest in research and development such as new product development or manufacturing process improvements. In recent years, regulations have extended this credit to include developments costs for software created for internal use. Companies evaluating claiming the R&D credit should carefully consider the following information.

Eligibility

To be eligible for the R&D credit, activities must meet a four-part test, which is both activity and location-based.

Product or Process Improvement
The work must relate to a new or improved product or process and be intended to enhance product attributes such as function, performance, quality, or reliability.

Common qualifying activities include new product development and process optimization. Exceptions exists for reverse engineering, adaptation efforts, and specific customer requests.
Technological Nature
Eligible activities rely on hard sciences, including computer science, biology, physical sciences, and engineering. Social sciences (e.g. market research) are generally not included.
Technical Uncertainty
Companies must face technical uncertainties related to capability, method, or design. This uncertainty is a critical factor in determining credit eligibility.
Process of Experimentation
You must show evidence of a systematic process of trial and error. Organizations often follow a product development lifecycle, which can serve as primary evidence for this requirement.

Specific Considerations for Manufacturing Companies

Once the above tests are satisfied for qualifying R&D activities, there are several developments and key considerations for manufacturing companies to evaluate, such as:

Time and Activity Tracking
All qualifying activities, such as direct support or supervision, should be tracked, along with the time spent on them. While new product development or engineering teams often track their time by project, other support groups (e.g. machine shop, tooling, prototyping, quality assurance, marketing, and administration) may not. Verify that all groups understand the types of documentation available to support their qualified time.
ASC730 Safe Harbor
Large organizations can leverage the ASC730 safe harbor for calculating R&D tax credits. Under this safe harbor, costs booked for financial reporting purposes can serve as the basis for the credit calculation. The safe harbor allows those costs to serve as the basis for calculating the credit and does not require documentation to be accumulated to support the credit claim. This can be an extremely useful tool for large taxpayers that are spending significant time documenting how each project meets the four-part test.
Qualified Small Business Payroll Credit
New businesses (those in existence for five years or less) can use up to $500,000 in R&D credits against future payroll tax expenses. Qualified small businesses are organizations with less than $5,000,000 in gross receipts (including interest income) in their current tax filing year, and zero gross receipts prior to a five-year look-back period. All members of a “controlled group” are treated as a single taxpayer, which may impact eligibility.
IRC Section 174 Pilot Models
Treasury regulations broadly define pilot models and their eligibility under IRC Sec. 174. Manufacturers can qualify significantly more supply costs associated with pilot models. Clearly defining the business component and pilot model is critical to maximize eligible supply costs.
State Credit Incentives
Many states also offer R&D tax credit incentives. Some credits are transferrable, allowing monetization even in a loss position. Be aware of application deadlines in some states where the deadline does not align with your tax filing schedule. States like New Jersey and Massachusetts have recently updated their R&D tax credit to include a simplified credit method.

How Manufacturers Can Maximize R&D Tax Credits

As you can see, manufacturing organizations have a wealth of R&D tax credit opportunities to consider. It is vital to review existing activities if you want to take full advantage of the credit. A good practice would be to engage a professional to perform an analysis or tax study. This not only strengthens your documentation to support an R&D credit, but it also acts as a strong defense if challenged by tax authorities. Reach out to one of our professionals below to get started.

M&D Intelligence - Q2 2019