Research and Development Tax Credit Opportunities for Manufacturers

For years, the manufacturing industry has reaped the rewards of the research and development (R&D) tax credit. In fact, the credit accounts for 60% to 65% 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, companies have invested significant resources and capital towards AI adoption within their businesses. Many of these investments fit within the scope of the R&D tax credit and can enhance tax savings. Companies evaluating whether to pursue the R&D credit should carefully consider the following information.

Key Takeaways

• The R&D tax credit is majorly beneficial to the manufacturing industry.
  • The credit encourages companies to invest in research and development, such as new product development or manufacturing process improvements.
• Eligibility depends on meeting a four-part test that must involve:
  • A business component being improved/created
  • Technological nature – reliance on hard sciences
  • Technical uncertainty related to capability, method, or design.
  • A process of experimentation (systematic trial and error)
• Special opportunities exist for smaller/newer businesses and for some states.
• Maximizing the R&D tax credit may require engaging a professional to conduct an analysis or tax study. This both strengthens your documentation to support an R&D credit and serves as a strong defense if challenged by tax authorities.

Eligibility

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

1. Business Component 

   The work must relate to a new or improved business component and be intended to enhance product attributes such as function, performance, quality, or reliability. A business component is any product, process, technique, software, formula, or invention.
   
   Common qualifying activities include new product development and process optimization. Exclusions apply for reverse engineering, adaptation efforts, and specific customer requests.
   
   

2. Technological Nature

   Eligible activities must rely on hard sciences, including computer science, biology, physical sciences, and engineering. Social sciences (e.g., market research) are generally not included.
   
   

3. Technical Uncertainty

   Companies must face technical uncertainties related to capability, method, or design. This uncertainty is a critical factor in determining credit eligibility.
   
   

4. 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 key considerations for manufacturing companies to evaluate, such as:

1. Time and Activity Tracking

   All qualifying activities, such as direct support or supervision, should be tracked, along with the time or hours 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.
   
   

2. ASC730 Safe Harbor

   Large organizations can leverage the ASC 730 safe harbor to calculate R&D tax credits. Under this safe harbor, costs booked for financial reporting purposes can serve as the basis for calculating the credit. The safe harbor allows Book R&D 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 who spend significant time documenting how each project meets the four-part test.
   
   

3. 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.
   
   

4. IRC Section 174 Pilot Models

   Treasury regulations broadly define pilot models and their eligibility under IRC Sec. 174. Manufacturers can qualify for significantly lower supply costs associated with pilot models. Clearly defining the business component and pilot model is critical to maximize eligible supply costs.
   
   

5. State Credit Incentives

   Many states also offer R&D tax credit incentives. Some credits are transferable, 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 to take full advantage of the credit. A good practice is to engage a professional to conduct an analysis or tax study. This not only strengthens your documentation to support an R&D credit but also serves as a strong defense if challenged by tax authorities. Reach out to one of our professionals below to get started.