Each year, large corporations save billions of dollars through the federal Research and Development (R&D) Tax Credit—yet common misconceptions prevent smaller and mid-sized businesses from pursuing this valuable incentive. Created in 1981 with the goal of encouraging innovation and technological progress in the U.S., the R&D Credit has since been expanded to reward businesses in a variety of industries for developing new or improved products, processes, or software.
For manufacturing and product engineering companies, the R&D Credit offers a lucrative, but often overlooked, opportunity to drastically reduce their tax burdens.
For many years, the R&D Credit was not a permanent part of the tax code - it typically expired at the end of each year and was subject to renewal by Congress. However, the Protecting Americans from Tax Hikes (PATH) Act of 2015 expanded the credit and permanently added it to the tax code, enabling businesses to rely on this incentive as they formulate their tax strategies for current and future years. In light of these changes, now is an opportune time to review the facts behind some of the pervasive myths that keep manufacturers, product engineers and many other business taxpayers from seizing the R&D Credit.
Myth: The R&D Credit is only available to companies that perform high-tech or scientific research.
Fact: The words “research and development” evoke images of test tubes and scientists in white lab coats—leading many businesses to erroneously believe that they do not qualify for the R&D Credit. In reality, the credit is available for a wide array of activities routinely performed by businesses in several different industries, including manufacturing and product engineering. Businesses do not even need to conduct “research and development” in the traditional sense. To be considered eligible for the R&D Credit, activities must involve each of the following:
- Permitted purpose. The purpose of the activity must be to create new or improved functionality of a business component, such as a product, process or software program.
- Elimination of uncertainty. The business must attempt to eliminate uncertainty about the project’s capability, design, cost or method of completion.
- Process of experimentation. In seeking to eliminate the uncertainty, the business must conduct a systematic process of experimentation that evaluates one or more alternatives. This process may consist of informal trial and error, computational analysis or modeling.
- Technological in nature. Although the activity itself does not need to be scientific or technological, the process of experimentation must rely on the principles of engineering, computer science or the physical or biological sciences.
Myth: A company must develop a revolutionary new product or process in order to qualify for the R&D Credit.
Fact: A business only needs to develop a product or process that is new or an improvement for that business—not necessarily for the industry. For manufacturing and product engineering companies, the following activities are a few examples of those that may qualify for the R&D Credit:
- Developing a new manufacturing process or improving an existing one in order to boost efficiency or yield better results.
- Evaluating different materials, such as those that are more durable or environmentally friendly.
- Evaluating new design concepts.
- Improving or developing new equipment, tools, or machinery for use in the manufacturing process.
- Designing or evaluating prototypes.
- Constructing or improving manufacturing facilities
Myth: Only large companies with substantial income tax liabilities would benefit from the R&D Credit.
Fact: The credit is available to businesses of all sizes, and in recent years, it has become more valuable for smaller and newer businesses. The PATH Act allows businesses to apply up to $250,000 of R&D Credits per year against their FICA payroll tax liabilities if they have been in operation for less than six years, have gross receipts of $5 million or less for the current tax year, and had no gross receipts in the past five years. Credits received may not exceed the company’s payroll tax burden for a given quarter, but excess credits may be carried forward to future quarters.
In addition, recent changes to tax law have reduced alternative minimum tax (AMT) limitations for many businesses and individuals. The AMT traditionally prevented taxpayers from taking full advantage of credits and deductions by requiring them to pay tax at a certain rate regardless of available incentives. However, with the newly reduced AMT limitations, taxpayers have more flexibility when claiming the R&D Credit.
Myth: Preparing the paperwork to claim the R&D Credit is too time-consuming and not worth the effort.
Fact: To claim the credit, businesses must provide substantial documentation of qualifying activities, including payroll records, a project list, and state and federal tax returns. While gathering these items may be time-consuming, the amount that most businesses are able to save in taxes through the R&D Credit more than justifies the time and expense. Even smaller and mid-sized businesses may be eligible for a dollar-for-dollar, six-figure tax reduction through this credit alone.
Myth: Businesses can only use the R&D Credit to offset their federal tax burdens.
Fact: Numerous states offer their own R&D Credits, which may be even more generous than the federal credit. Most states follow the same requirements for qualified research as dictated by federal law, so businesses located in these states may be able to substantially increase their tax savings without having to put forth much additional effort.
The amount of federal R&D Credits that a company receives is based on the company’s qualified research expenses (QREs). These expenses include wages paid to employees and amounts paid for supplies used in qualifying activities, as well as amounts paid to contractors who performed research. The federal R&D Credit may equal up to a net 13 percent of a company’s QREs.
With the R&D Credit now a permanent part of the tax code businesses should consult a tax professional and review their activities to determine whether they qualify for this incentive. The tax savings that may be available based on routine business activities represent a powerful opportunity to boost a company’s bottom line, fueling future growth and innovation.
Since 2004 Capital Review Group (CRG) has been applying their knowledge of federal and state incentive tax law to help clients unleash powerful savings opportunities. Over the years, the CRG team has cultivated wide-ranging expertise by maximizing tax savings for businesses in a variety of industries, including architecture, engineering, manufacturing and hospitality, as well as commercial building owners. Capital Review Group is based in Phoenix, Arizona.