Many businesses focus their efforts on developing new products. To accomplish this, companies must keep up with their competitors by investing in new technologies. Those that don’t risk being left behind.
As it may seem, some companies are often unaware of the tax benefits they can receive when investing in new product development. These businesses might be entitled to a tax credit at both the federal and state levels for their research expenditures. Federal and state tax incentives serve to reduce the after-tax cost of amounts spent on research and are best known as Research & Development (R&D) tax credits.
Background on the R&D Credit
R&D credits can reduce the tax liability of a company and its owners on a dollar-for-dollar basis. The credit is a tax incentive designed to encourage businesses in many industries for their efforts to research and develop new products and processes. For instance, manufacturers and technology businesses are well suited for this credit, as competition in the marketplace forces them to continually look for ways to improve their products and become more efficient. They often need to invest in research efforts, and the R&D credit is therefore a bonus for their investment.
Identifying Qualified Research Activities
The tax law indicates that to be eligible for this credit, qualified research must satisfy the following four criteria:
- Permitted Purpose – The research must be related to the development of a new or improved product or process for the company. Improvements can relate to efforts to enhance the quality, performance, reliability, and functionality of the product or process for the company, and it can also result in reduced costs. As part of developing a new product or process, it is important to be able to quantify and document these improvements.
- Technological in Nature – The research activities must be based on the physical sciences, such as engineering, metallurgy, material science, chemistry or computer science. It cannot be related to the social sciences.
- Process of Experimentation – The research activities must include the evaluation of various design alternatives through the development, refinement, revision and testing different options. This process must include technical risk – a chance that the project may not be successful. It is essential to document any failures that occur in the experimentation process as well as the successes.
- Elimination of Uncertainty – The activities must aim to discover information and eliminate technical uncertainty (e.g., determining the optimal design or process).
Capturing Qualified Research Expenses
Qualified research expenses include in-house costs for the company’s own research; covering the salaries and wages of the personnel involved in the research activities (including employees directly supervising the researchers, as well as clerical support); supplies consumed in the research activities; plus 65% of the amounts paid for outside contract research. Foreign research, research in the social sciences, arts, or humanities, or funded/subsidized research does not qualify.
Claiming the Research Credit
The amount a business can claim of its research credit involves a complicated formula with several limitations. The research credit varies from one company to another, but it generally produces a credit of between 5 to 10% of the qualified research expenses incurred in the year. Once calculated, the research credit is available to taxable C Corporations and pass-through entities (S Corporations and Partnerships/LLCs). In addition, owners of eligible small businesses can claim the research credit against the Alternative Minimum Tax (AMT). Unused research credits can be carried back one year and forward 20 years.
Badger, Inc. is a manufacturer of high-tech widgets. It focuses on research and design of new products to keep up with its competitors. For the current year, it incurred $600,000 of employee wages for engineers and technicians involved in qualified research activities. In addition, Badger incurred $270,000 of supplies used in the research efforts and had $200,000 of qualified “contract research” with outside parties. The amount spent on research activities was up over prior years’ expenditures. Their current year’s research tax credit (using the “Alternative Simplified Calculation”) is determined as follows:
Current Year Qualified Research Expenses:
Contract Research at 65%
Total Qualified Expenses (A)
Total Qualified Expenses in Three Prior Years:
2nd Prior Year
3rd Prior Year
Average Expenses of Prior Three Years
50% of Average of Prior Three Years (B)
Excess of Current Year over 50% of Average of Prior Years (C) (A – B)
Research Tax Credit for Current Year 14% of Excess (D) (C @ 14%)
Badger, Inc. would qualify for an R&D credit of $84,000.
Documenting & Optimizing the Research Credit
The expenses incurred in qualified research must be documented along with the test results of these experiments. Without proper documentation, any claimed credits are potentially reduced or eliminated upon a tax audit. A Research Credit Study, conducted by specially trained engineers, provides the support to defend the credit upon audit, identifies qualifying activities and captures all types of expenses eligible for the research credit. Even with a Research Credit Study, the amount of the credit could be reduced by the IRS upon audit – however, without a study, the full amount of the research credit is at risk.
Research credits can be claimed for the current tax year up until the tax return is filed and involves specific tax forms to be filed. Many states, such as Wisconsin, also offer research tax credits, which would be identified during a study. Sikich tax professionals are familiar with the R&D Credit, as well as the Research Credit Studies, and can assist you in evaluating the need for a study. Please contact your Sikich tax advisor or one of the below professionals with any questions you have on the R&D Credit.