R&D Tax Credit Opportunities
June 06, 2019
By Tim Rankins
The manufacturing sector has long been the largest beneficiary of the R&D tax credit, with the industry accounting for over 60% of these credits claimed yearly. Companies can claim credits for R&D activities such as new product development and manufacturing process improvements. In addition, the relatively recent internal-use software regulations have provided additional opportunities for companies to claim internal software development costs. The following offers insight into some of the key considerations taxpayers should be evaluating regarding the R&D tax credit.
The Basics – Eligibility
Qualifying activities must meet a four-part test, which is both activity-based and U.S.-based. First, the work must relate to a new or improved product or process intended to improve at least one of the following product attributes: function, performance, quality or reliability. This test is typically satisfied with new product development activities, with exceptions for reverse engineering, adaptation or specific customer requests. The other consideration on the R&D test is improving a process toward the product development. In cases where a company incurs R&D spend to improve a process, such may qualify for the R&D credit if it meets the improvement criteria noted above.
The next test is whether the activities are technological in nature – meaning the work relies upon the hard sciences such as computer, biological, physical sciences or engineering. Here, taxpayers must be mindful of social sciences that are not considered qualified R&D – such as market research or cosmetics around a product.
The third test is whether there was a technical uncertainty relating to either capability, method or design. In many instances, this is the critical test of whether the activities will end up qualifying for the credit.
The last test is whether a process of experimentation existed (e.g., a systematic process of trial and error). Companies typically work through a product development lifecycle which can serve as primary evidence this test is met.
Considerations for Manufacturing Companies
Once the above tests are satisfied for qualifying R&D activities, there are several developments and key considerations for evaluation such as:
- Is time being tracked to a project? If so, are all qualifying activities, such as direct support or supervision, being tracked as well? In many cases, the new product development or engineering teams track their time by project. However, support groups such as integrated product teams, or entire departments such as machine shop, tooling, prototyping, quality assurance, marketing and administration will not track their time. Therefore, it’s critical to have an understanding of the types of documentation available to support their qualified time.
- Should the taxpayer use the ASC730 safe harbor as a basis for calculating the R&D tax credit? There is a safe harbor available to large companies that book R&D for financial reporting purposes under ASC730. The safe harbor allows those costs 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 fatigued with spending significant time documenting how each project meets the four-part test.
- Is the taxpayer a qualified small business? For new taxpayers (those in existence for five years or less), there is an opportunity to use the credits against future payroll tax expense. This options can be a tremendous benefit for new start-up companies. Qualified small businesses are companies with less than $5,000,000 in receipts in their current tax filing year; and zero receipts prior to a five-year look-back period. For example, a company filing a 2018 tax return needs to have zero receipts prior to 2014. Receipts include interest in this determination. Further, companies need to be mindful of the control-group rules in determining eligibility.
- IRC Section 174 Pilot Models. The Treasury released regulations broadly defining pilot models and their eligibility under IRC Sec. 174. Consequently, taxpayers have been able to qualify significantly more supply costs associated with pilot models. Defining the business component and pilot model is critical to taxpayers in how much supply costs can be eligible for the credit.
- State Credit Incentives. Many states offer similar R&D tax credit incentives. Some of these incentives are transferrable, enabling taxpayers to monetize the credits if they are in a loss position. Other states use application processes where the deadline does not align with the taxpayers’ tax filing. The New Jersey R&D tax credit was recently updated to include a simplified credit method, for example. Other states have adopted a similar approach in recent years, such as Massachusetts.
In summary, there are several R&D tax credit opportunities and considerations available to taxpayers in this industry. It is vital to review existing activities and ensure you are taking advantage of all the opportunities available. If R&D spend is material, it is a good practice to consider an analysis or tax study performed by a professional. Not only would this be good documentation to support an R&D credit, but acts as a strong defense if challenged by tax authorities.
M&D Intelligence - Q2 2019