By: Karen J. Koch, CPA, MT
- Many of your longstanding processes and business activities may qualify for valuable research & development tax credits.
- The R&D credit can create immediate cash flow by reducing current year tax liability dollar for dollar.
- Credits not absorbed into the current year can often be carried back for one year and forward for 20 years.
- Additional cash flow can be realized by “looking back” for credit opportunities in any open tax years (currently three years) by filing an amended tax return.
- Real world examples of companies taking R&D credits are included below.
Almost every business in America is wrestling with a painful economic slowdown caused by the coronavirus pandemic. Research and Development (R&D) tax credits can be a very effective and controllable way for businesses to earn a valuable cash infusion to replenish valuable dollars spent on new and innovative products or processes.
Not many people know that the R&D tax credit was introduced in 1981 during another very scary time in our nation’s economic history. The downturn beginning in the early 1980s was triggered by tight monetary policy in an effort to fight mounting inflation. The R&D tax credit program was introduced as an incentive for American businesses to increase technical jobs and to develop innovative products and processes. Fast forward 40 years and we have a different set of challenges that are threatening to bring American business to a grinding halt. Now more than ever, America needs innovation and creative cash flow solutions to keep workers employed and goods and services moving. R&D tax credits can help.
Overview: R&D Tax Credit
The U.S. federal tax law provides a benefit of up to 20 percent–in the form of a non-refundable tax credit– for companies that engage in qualified research and development activities (see list below). The credit, if used, can create immediate cash flow by reducing current year tax liability dollar for dollar. While non-refundable, the credit not absorbed in the current year can be carried back one year and carried forward twenty years. In addition, qualifying activities that can be documented in prior years can create additional cash flow by looking back for credit opportunities in any open tax years (currently three years) by filing an amended tax return.
- Developing New or Improved Product
- Developing New Technology
- Creating a New Production Process
- Improving Current Processes
- Developing or Improving Software
- Developing Prototypes or Models
Why don’t more companies take advantage of R&D Tax credits?
The qualified R&D expenditures are generally found in primary operating expenses such as wages, materials and third-party contractors. All of these expenses are generally fully deductible when determining taxable income. What most companies do not realize is that the R&D credit can be taken in addition to the expenses. The R&D tax credit is calculated as a percentage of the qualified expenditures based on expenses related to R&D activities.
While more than $12 billion in federal and state credits are claimed every year, only 5 to 10 percent of eligible businesses are believed to be applying for the credit. Although R&D credits have been around since 1981, they were only a temporary provision until 2015. That’s when the PATH Act made the credits permanent. The IRS Audit Techniques Guide was published in 2005 as a foundation for guidance. As a result, many companies and their advisors viewed R&D credits as a complex and somewhat risky provision to claim.
Other businesses have shied away from pursuing the credit because the calculations can be complicated. As originally enacted, the Regular Method calculation was complex, and it required companies to have a great deal of historical knowledge about the company. In 2006, another method was enacted called the Alternative Simplified Credit (ASC) method. This simplified method of calculating the R&D credit calculations offers additional flexibility. However, many companies still don’t seek the credit, because they just do not realize they have activities that qualify.
Are you more likely to be audited if you take the R&D credit?
Not necessarily. Just know that the R&D credit can be very significant at both the federal and state level.
Most states conform to the federal credit, but many states have their own specific rules and are often less generous. And keep in mind there are 15 states, including the District of Columbia, that have no R&D credit equivalent to the federal incremental R&D credit. Your provider will be able to work with you to define a scope of benefits based on state nexus.
IRS has guidelines by industry of projected ranges, so it is important to work with a provider that can substantiate the credit.
We have not seen any evidence that claiming the credit directly increases your audit risk–if filed correctly. Just remember that claiming the R&D tax credit must be well-documented to withstand an audit. That’s why many CPA firms partner with independent R&D professional service firms that have the expertise to navigate and document proper record keeping, testing of activities, and to capture all the qualified expenditures to maximize the benefit.
The IRS will look at the overall size of the credit claimed in relation to your industry’s averages. Since companies often amend their returns to claim the credits for prior open years, the amended returns often get an additional look by the IRS.
Bottom line: You definitely do not want to be a do-it-yourselfer here. Make sure you and your tax advisor hire experienced and qualified specialists to help you evaluate, prepare and defend your R&D tax credit claim.
The R&D credit is not only for pharma, biotech and technology companies
Even if you don’t employ scientists in white lab coats, your company may likely be able to take the R&D credit. Some of the industries overlooked for this credit are architecture firms, engineering design firms and software development companies. Start-up companies that do not have an income tax liability yet (i.e. they’re not generating taxable profits) can also take the R&D credit against their employer payroll taxes.
Whether you are a small or large business, you may be eligible for the credit if you engage in activities such as these:
- You develop or design new products or processes.
- You enhance existing products or processes.
- You develop or improve upon existing prototypes and software.
In 2003, the “Discovery Rule” was removed. That was a big milestone because it meant that a company’s research activities no longer had to be “new to the world.” The activities only had to be “new to the taxpayer” to qualify for the R&D credit–a standard that is much more favorable to companies.
In 2015, the Protecting Americans from Tax Hikes (PATH) Act made the R&D Tax Credit permanent—which motivated many more companies to include the credit in their long-term tax planning strategies. Also, the PATH Act modified the credit for the benefit of small and mid-size businesses, including startup companies. Startups and small businesses may qualify for up to $1.25 million (or $250,000 each year for up to five years) of the federal R&D Tax Credit to offset the Federal Insurance Contributions Act (FICA) portion of their annual payroll taxes. NOTE: There are certain criteria you need to meet in order to be able to claim the credit against payroll taxes. Make sure you are planning from the inception of the business.
Additionally, as part of the PATH Act, small businesses (defined as non-public companies with less than $50 million in average annual gross receipts for the previous three years) can permanently use research credits generated after January 1, 2016 against both regular tax, and AMT.
Example 1: 2017 startup company using R&D credits against payroll taxes
This company develops software to create virtual reality experiences that educate, motivate and activate healthy behavior change.
Source: Bedford Cost Segregation
The payroll credit can apply to payroll reports filed after the company’s tax return is filed to validate the credits. In this case, the company elected to use $18,000 toward future payroll expenses. The 2017 credit must be carried forward for use against future tax liability. This is a good example of why you want to involve your provider earlier to use the credit now rather than in the future.
Example 2: Lookback study of a 30 year-old food manufacturing facility
This company spends a significant amount of time “researching” new products and adding efficiency to its manufacturing processes. Until our firm was enlisted, the company’s management was not aware of R&D tax credits or that it might qualify for them. After performing a “lookback” study covering a four year period here is what we uncovered:
Source: Bedford Cost Segregation
Architecture and construction firms often overlook R&D credit opportunities
Like many industries, architecture and construction continues to change with both technological and competitive growth. Unlike some of the other industries well known for R&D tax credits, many times only a portion of the project’s activities result in qualified research.
Below are some examples of the types of projects most likely to contain qualified research:
- Green building design/LEED certification.
- Energy efficiency design or improvement.
- Structural engineering to withstand earthquakes, hurricanes, fire and other disasters.
- Experimenting with alternative material combinations.
- Dew point analysis to determine location and type of vapor barrier for walls, roofs & floors.
- Foundation engineering to mitigate the effect of unstable soil or sand.
- HVAC system design for airflow and energy efficiency.
- Electrical system design for efficient power usage.
- Plumbing system design for efficient water usage.
- Lighting system design for energy efficiency.
And many more.
Projects involving the use of advanced modeling software to develop and test virtual mock-up designs, as well as significant work that’s being done to test the applicability of new materials or methods are good candidates for R&D tax credits (see below):
Example 3: Company that qualifies for both federal and state credits–Architect & Engineering Firm
This firm specializes in large mixed-use projects that require special design in multiple areas ranging from geographical to sustainability, with rendering capabilities from concept to final design. Their work includes testing of materials and structural designs that allows it to develop sites in difficult urban areas.
Source: Bedford Cost Segregation
Don’t confuse innovation with “new and improved”
“New and improved” refers to how we define new products or new features of an existing product. True innovation generally includes the improved product, but also the process and a solution that may even include the impact of the product, process or solution on people.
Does my business (or client’s business) qualify
Check all criteria below that apply:
If you have checked off one or more of the criteria above, then you may qualify for the R&D Tax Credit for past, current, or future years. Don’t leave this valuable tax savings opportunity on the table.
Any business that is currently improving or creating new or improved products, processes, or technology has can potentially take advantage of the R&D credit– one of the most beneficial federal tax credits currently offered. The R&D tax credit is both a federal and state incentive, with roughly 70 percent of states offering it.
The first step to taking advantage of this tax strategy is to determine the areas of opportunity you might have within your business operations. For a complimentary feasibility analysis, please contact me any time at firstname.lastname@example.org.
About the author
Karen J. Koch, CPA, MT, is a Partner of Bedford Cost Segregation, located in Louisville, Kentucky. Karen is a recognized professional in tax treatment of fixed assets for commercial real estate, tax incentives for energy efficient buildings, and research and development tax credits. Combining her many years of experience in public accounting and her many years with Bedford, Karen has worked with local, national and international clients providing them with unique planning strategies to produce immediate and recurring financial benefits.