Are you taking advantage of the R&D tax credit?
A company doesn't have to manufacture a product to qualify for the tax incentive
In 2004 tax regulation changes significantly expanded the credit opportunity associated with the Research & Development Tax Credit. Today the credit is accessible to many small and medium-sized companies whose activities include design, manufacturing, and process improvements.
The Research & Development Tax Credit is a federal program designed for companies that perform manufacturing in the U.S. However, you do not necessarily need to be a manufacturer of an end product in order to qualify.
This program, also known as the Research & Experimentation Tax Credit, is listed under Section 41 of the Internal Revenue Code and continues to be amended on an annual basis as the U.S. manufacturing landscape continues to evolve. To determine if a company qualifies for a tax incentive, the program focuses on its operations and processes. If a manufacturer—or even a metal fabricator—qualifies, it has an avenue to receive tax money back from prior years while also reducing current taxable income on a dollar-for-dollar basis.
The R&D Tax Credit, originally enacted as part of the Economic Recovery Tax Act of 1981, was designed to encourage investment in innovation. The original expiration date for the tax credit was Dec. 31, 1985, but the credit has been extended multiple times in the ensuing years.
In 2004 tax regulation changes significantly expanded the credit opportunity. Today the credit is accessible to many small and medium-sized companies whose activities include design, manufacturing, and process improvements.
Most organizations in the metal fabricating industry don’t have an R&D department and probably don’t consider that what they are doing as R&D. They are making these improvements and changes because they must stay competitive and yet, as the government sees it, R&D is exactly what they are doing. R&D is not just for high-tech and FORTUNE 500® companies.
The federal government recognizes that, by and large, manufacturing companies are in the R&D business even if they don’t have a lab where employees in white coats work. These companies design new products, improve existing products, come up with new processes, or make improvements to existing processes used to make products. They innovate.
Do You Qualify?
Who and what qualify as R&D is much broader than most realize. Activities and costs related to developing or improving a product and/or process often qualify for R&D Tax Credits. Furthermore, engineering, design, testing, and programming are now included as qualified research activities. Companies that most commonly qualify include metal fabricators, engineers, software developers, chemical manufacturers, tool- and diemakers, machine shops, plastics manufacturers, pharmaceutical manufacturers, biotechnology firms, and food and ingredient manufacturers.
Consider, for example, a machine shop with a 20,000-sq.-ft. facility and an annual payroll of about $1.3 million. The shop not only produces metal parts for OEM customers, but also engineers and designs those parts, while occasionally purchasing new machinery to increase its productivity.
Because it was small, the machine shop didn’t believe it would qualify for the R&D Tax Credit. Size wasn’t the important factor, however. The company’s compensation, ownership structure, overall revenue, and project work stood out as the items of note.
After documentation of all projects was reviewed and employee interviews performed, an analysis was completed and submitted to the owners and their outside CPA firm. In the end, the machine shop had successfully generated a benefit of $63,000.
Even a nonmanufacturer has the chance to earn R&D Tax Credit benefits. In this example, an organization is involved in trading stocks and bonds. It has multiple owners, some passive and some active, and rents office space. The company has been profitable in one of the last three years.
The vast majority of the company’s employees are traders, and all are considered “white collar.” On-staff software engineers are used to develop processes to enhance productivity. This software is not resold and used internally only.
Again, a projects review and employee interviews generated a net benefit of $36,000 for the trading firm.
That gives you a better idea as to how companies can qualify for the tax incentive. Now it’s time to ask three questions to see if your company might be eligible:
- Was my company profitable in 2009, 2010, 2011, or 2012?
- Is my company’s average annual payroll for these years in excess of $500,000?
- Is my company structure a C corporation or an S corporation/partnership?
If you answered yes to all of these items, then your company definitely is in a position to benefit from the R&D Tax Credit.
What’s the Next Step?
First off, if company owners or managers think that the company qualifies for the tax incentive, they should not file another tax return or remit the next quarterly estimated payment until they have consulted a specialist in this area. A specialist will be able to provide a solid estimate of benefits.
From there you should have an R&D Tax Credit study performed. Again, a specialist in the area can help because these types of tax incentives are technical and backed by myriad case laws. A certified public accountant may not have the knowledge to fully exploit the benefits associated with Section 41. Additionally, Internal Revenue Service recommendations suggest that these cases need to be supported by engineering-based studies.
What will an R&D Tax Credit study reveal?
- Dollar-for-dollar credit against taxes owed or previously paid
- Tax refund on prior years with interest
- Carry-forward credit for future profitable years up to 20 years
- Immediate increase in company cash flow
This study requires participation of your company’s engineering and financial staff to collect the needed information. Your CPA also needs to be a part of this information-gathering.
If you have never documented employees’ activities or time, this is not an impassable hurdle. Through the interview process, the R&D Tax Credit specialist can collect and document the necessary information required for tax purposes.
What Are the Results?
If you’re going back three years, it may take three to four months after amending returns to receive cash back from the IRS for taxes paid. For the current year, the benefit—a dollar-for-dollar reduction in taxable liability—is realized upon filing.From a macro point of view, economists debate the magnitude of the R&D Tax Credit’s economic effects. However, many agree the credit does increase R&D spending in the U.S. A recent study (“Do Tax Credits Stimulate R&D Spending? The Effect of the R&D Tax Credit in its First Decade”) from Nirupama Rao of New York University suggests that, on average, steps taken to make R&D spending 10 percent cheaper results in a jump in an organization’s expenditures of 11 percent and even larger increases down the road.
While you still may wonder if your company should look into the R&D tax incentive, keep in mind that other organizations aren’t waiting around. An Ernst & Young study (“Supporting Innovation and Economic Growth: The Broad Impact of the R&D Credit in 2005”) released in April 2008 revealed that 17,700 corporations claimed $6.6 billion in R&D Tax Credits on their tax returns in 2005. Approximately 11,300 C corporations and 6,400 S corporations claimed the credit. More than 70 percent of these corporations had a Standard Industrial Classification in some type of manufacturing.
The FABRICATOR is North America's leading magazine for the metal forming and fabricating industry. The magazine delivers the news, technical articles, and case histories that enable fabricators to do their jobs more efficiently. The FABRICATOR has served the industry since 1971.