Although billions of dollars in research tax credits are generated each year, the credit still retains elements of complexity and misunderstanding. Companies often view the efforts of developing new products, improving legacy products, or enhancing outdated and costly processes as merely the cost of doing business. As a result, many businesses may be overlooking a potential tax benefit.
The research tax credit is in addition to the tax deduction for research expenses and results in a dollar-for-dollar reduction of income tax liability.
What is the research tax credit?
The credit was enacted as a provision of the Economic Recovery Tax Act of 1981 as a key component of a multifaceted tax reduction package to ensure future economic growth. The credit offered a financial incentive to profitable U.S. companies of all sizes that were engaged in certain types of product development and process engineering activities. Unfortunately, because of confusion on what qualified research is and how the credit computed, many small and medium size companies have distanced themselves from the credit, and resulting benefit.
What is qualified research?
Claims for the research credit rely on two factors – the definition of qualified research and the expenses eligible for the credit. Qualified research must:
- Involve activities aimed at the development of a new or improved product or process. This includes all technical activities such as analysis, design technical requirements, developing, coding, testing, etc. undertaken from initial design, proof of concept, planning and definition, architecture and detailed design, and development testing.
- Be intended to discover information that is “technical in nature” and useful in the development of a new or improved business product, process, computer software, technique, formula or invention.
- Rely upon a process of experimentation whose ultimate aim is the development of a business component with a “new or improved function, performance or reliability or quality.” These activities generally involve the evaluation of alternatives, trial and error, failures, or other testing methodologies.
Examples of qualifying activities include developing new and improved legacy products, designing and testing pre-production prototypes and models, and developing software applications. By contrast, research conducted outside of the United States, research related to the social sciences, or research funded by the Federal government or a corporate entity is ineligible for the credit.
What expenses are eligible for the credit?
In-house salaries and wages of employees engaged in qualified research, as well as the costs of materials, supplies, and certain time-sharing costs for computer use in qualified research are the only qualified research expenses (“QREs”) included in the credit computation. Additionally, 65% of amounts paid to third-party contractors for conducting qualified research are eligible for the credit.
It is important to understand that certain related research and development (“R&D”) expenses are ineligible for the credit. For example, amounts expended on depreciable property used in qualified research, such as buildings and equipment, are ineligible for the credit. Also, overhead expenses such as utility expenses, rent, and employee benefits are ineligible for the credit.
How is the research credit computed?
For the 2012 tax year, companies have the opportunity to elect one of the two formulas used to compute the research credit: 1) the traditional credit and 2) the alternative simplified credit (“ASC”).
Under the traditional method, businesses receive a 20% tax credit for QREs in excess of a computed base amount. The base amount for any given tax year is determined using the business’ history of QREs and gross receipts (i.e., 1984 – 1988). This methodology is beneficial for companies that have maintained its historical records and whose R&D spending has grown consistently with, or faster than, its revenues.
The ASC is a simplified computation that provides a 14% rate on current year QREs in excess of 50% of a company’s prior three-year average of QREs. The ASC is computed without reference to gross receipts, and utilizes a more current view of a company’s R&D expenses. If a company has no QREs in any of the preceding three years, the credit is equal to 6% of the QREs for the current tax year.
Do the states offer a research credit?
In addition to the federal research credit, approximately 35 states have enacted some form of research credit. R&D activities may also enable a company to qualify for other incentives, such as investment credits, jobs credits, and sales and use tax exemptions. Below is a sample of states that offer a research credit. To learn more about R&D, and whether your state offers a research credit, please contact Fred Lesser at (215) 885-7510 or firstname.lastname@example.org.
Connecticut offers two general research credits:
- Incremental Research Credit. The Incremental Research Credit is equal to 20% of the increase in research expenditures (including both direct and indirect research expenditures compared to the preceding year.)
- Non-Incremental Research Credit. A Non-Incremental Research Credit is also provided to a qualified small business (i.e., $100 million or less in gross revenue) equal to 6% of the current year’s research expenditures.
The Connecticut credit includes all costs incidental to the development or improvement of a product, including any pilot model, process, formula, invention, technique, patent, or similar property. However, overhead and other expenses, such as general and administrative expenses that do contribute directly to the research and development effort do not qualify. In addition, Connecticut allows companies without a current tax liability to monetize their credit at a discounted selling price.
Massachusetts provides a research credit equal to 10% of the excess of qualified research expenses over a base amount. Qualifying research expenditures are similar to research expenditures that qualify for the federal research credit. The base amount computation is similar to the federal methodology.
New Jersey has a comprehensive package of tax incentives for research, including a research credit, an investment credit, a jobs credit, and a sales and use tax exemption. Additionally, certain technology and biotechnology companies may be able to transfer their unused research tax credits and net operating loss carryovers to other New Jersey taxpayers.
Pennsylvania offers a non-refundable incremental research credit of 10% for research activities conducted within the state. The credit is based on the rules set forth in IRS Code section 41. Companies must apply for the credit by September 15 and are notified by December 15 of the approved amount.
How should the credit be documented?
Documentation is essential for receiving and supporting the research credit. It is vital to be able to clearly and completely demonstrate to the Internal Revenue Service (“IRS”), as well as state jurisdictions, that the project work was indeed qualified research. It is also required that QREs be identified by qualified activity. Accordingly, if upon examination an examiner is unable to connect specific research projects and the underlying activities to the qualified expenses, the credit claim will not be sustained.
Contemporaneous books and records are the basis for research credit examinations. In addition, computational work papers, along with the following types of qualitative support, would be helpful:
- Materials explaining the research activities, including the difficulties encountered during the course of the project;
- Project summaries and/or progress reports indicating the issues encountered during the course of the research;
- Minutes of meetings that discuss research activities, including the resolution of uncertainties;
- Complete copies of contracts for research performed by outside contractors.
Is your company a candidate for the research credit?
Any firm with leading edge technology is likely to have qualified research and eligible costs. Companies in the chemical, electronics, manufacturing, medical technology, pharmaceutical, and software industry sectors are candidates for the credit.