How Manufacturers Can Utilize the R&D Tax Credit
by Bradley Rod, CPA
Over the last two years, we’ve all heard about the Tax Cuts and Jobs Act and the business-friendly measures that came with it. But amid the shiny new perks of tax reform, there’s a tax credit that’s still one of the best ways for businesses—including manufacturers—to reduce their tax liability. I’m talking about the Research and Development (R&D) Tax Credit.
The R&D Tax Credit was first enacted into law in 1981 and made permanent in 2015. As a credit, it allows for a dollar-for-dollar deduction from a company’s federal income tax liability and also their state income tax liability in many cases. The (surprising) truth is, many businesses that would qualify for it have yet to take advantage of it.
To keep your business from missing out, here’s how you can take advantage of the R&D Tax Credit.
1. Identify your qualifying research activities
To qualify for the credit, your business must perform “qualifying research activities,” or QRAs. Typical QRAs include the following:
• Developing new or improved products, processes, formulas, or software
• Technical design work, CAD design, modeling, and analysis
• Improving product performance or quality
• Prototyping and 3D-modeling
• Computer modeling and simulation
• Alternative design analysis
• Developing processes to reduce costs
• Developing processes to increase operating efficiencies
• Developing a custom product for a specific application
• Development or incorporation of new technologies
Generally, if a company develops a new product or improves an existing product, it will likely qualify. Nevertheless, for an activity to be considered a QRA, it must pass a four-part test.
2. Pay attention to the four-part test
Internal Revenue Code Section 41 explains that a QRA must pass each part of this four-part test:
- Part 1: Elimination of Uncertainty – The activity must intend to discover information that would eliminate uncertainty concerning the development or improvement of a product.
- Part 2: Technological in Nature – The company engaging in the activity must fundamentally rely upon the principals of the physical sciences, biological sciences, computer sciences or engineering. For example, adding a new color scheme to an existing product may not qualify as R&D; however, relying on the physical sciences to choose a color that would optimize heat resistance might qualify.
- Part 3: The Process of Experimentation Test – The company must utilize a process of experimentation in their effort to eliminate the identified uncertainties. This could include analysis of alternatives, simulations, models, or trial-and-error.
- Part 4: Permitted Purpose – The company must intend to apply the information being discovered to develop new or improved business component of the company. This generally means using the newly discovered information to create a new product or improve an existing product with efforts focused on the products function, performance, reliability, or quality.
3. Identify your qualifying research expenses
Once you’ve determined your QRAs, the next step is to identify your associated qualifying research expenses (QREs) so you can calculate your credit. These are categorized into three buckets:
• Wages for employees who perform QRAs.
• Wages for direct supervisors of other employees who perform QRAs.
• Wages for employees who perform direct support for the QRAs.
• Supplies consumed during the research and development activity. In most instances, this will represent a small portion of the total QRE claimed by the taxpayer.
- Contract research
• Contract research done by a third party (limited to 65% of the amount paid). The taxpayer must own the rights to and be at risk for the results of the research.
Consult with an R&D Tax Credit expert
Determining your QRAs and related QREs can be a challenge—it’s not all cut and dried. There’s risk involved, too. If you were to incorrectly calculate your credit, you could draw the IRS’ attention and possibly miss out on credit altogether. It’s important to get it right. A tax advisor who has a deep understanding of qualifying (and non-qualifying) activities and expenses—as well as of your business—can help you reap the full benefits of the credit. If you’re ready to explore how the R&D Credit could reduce your tax liability, contact us today.