According to IRS statistics, manufacturers are the largest industry group receiving research tax credits. However, many manufacturers may not be aware of the credit and those who are aware may not be taking full advantage of the credit because of common misconceptions about its applicability to their operations. It is hoped that by reading this brief article your misconceptions will be addressed and you will be motivated to explore the credit's applicability to your company.
In General
In addition to a deduction for research expenditures, a taxpayer is allowed a tax credit (i.e., $ for $ reduction of the tax liability) for increasing its research activity and expenditures. The tax credit is based on a percentage of a taxpayer's incremental research expenditures. In order to be allowed the credit, a taxpayer must engage in qualifying research activities and incur qualified research expenditures.
Qualifying Research Activity
A research activity does not have to result in a product, process (including a manufacturing process) or an improvement that is new or innovative to the world at large. It need only result in something that is new to the taxpayer. In addition, although research activities must rely on principles of physical, biological, engineering or computer sciences, this in no way is intended to include only research intensive industries (such as biotech and pharmaceutical) and exclude manufacturers who engage in these disciplines.
A qualifying research activity ("QRA") is one that satisfies the following four-part test:
The activity must be undertaken for the purpose of developing a Newor Improved Business Component (i.e., product or process) of the taxpayer;
There must be an inherent Uncertainty that the activity is intended to resolve;
A Process of Experimentation must occur; and
Information that is Technological in Nature must be discovered.
However, there are some research activities that are specifically excluded from qualifying for the credit, even if they satisfy this four-part test. These excluded activities include, but are not limited to, (1) funded research; (2) research related to the duplication of an existing business component; (3) certain research conducted after the commercial production of a business component; (4) research related to adapting an existing business component to a particular customer's requirement or need; and (5) research not related to function, performance, reliability or quality (such as cosmetics and styling).
Qualified Research Expenditures
There are three types of research expenditures that qualify for the credit:
Wages of those involved in QRAs
Contract research expenditures with respect to QRAs
Supplies directly consumed in QRAs
Administrative and indirect expenditures do not qualify for the federal research credit.
Generally, the largest research expenditure component is the wages of the employees performing qualifying research activities. Determining qualified research wages involves identifying those who are engaged in qualified research activities and linking those activities to their wage expenditures.
Even if a taxpayer does not directly engage in research activities itself, 65% of the expenditure paid to a third-party that has been contracted to engage in qualified research on a taxpayer's behalf may qualify for the credit.
Documentation Requirements
The IRS’s regulations require that a taxpayer claiming a research credit "must retain records in sufficiently usable form and detail to substantiate that the expenditures claimed are eligible for the credit." The intention of the regulation is for taxpayers to contemporaneously document a relationship between its qualified research activities and expenditures.
Research Tax Credit Calculation
The primary method to calculate the federal research credit is based on qualified research expenditures ("QRE") exceeding a certain percentage of a taxpayer's four-year average sales; the credit is equal to 20% of that excess amount. Many manufacturers find that although their research expenditures increase each year, they do not keep pace with the percentage increase in sales. As a result, although manufacturers may incur significant research expenditures, they may not able to take advantage of the research credit under the percentage of sales method. However, an alternative method of calculating the research credit may alleviate this.
An electiveAlternative Simplified Credit allows a taxpayer to claim a research credit that is equal to 14% of the amount by which the taxpayer's research expenses for the year exceeds 50% of the average research expenses for the three preceding years.
Research Credit = 14% x {QRE - [50% x 3-Year Average QRE]}
Under this calculation, it is not necessary for a taxpayer to have research expenditures that exceed a certain percentage of its sales nor is it necessary for a taxpayer to increase its research expenditures, from year to year, in order to claim a research credit.
The Federal Research Tax Credit’s Future
The federal research credit has been available to taxpayers since 1981, on an extended "temporary" basis. As of today, the research credit has expired and is not available for research expenses paid or incurred after December 31, 2011. Although Congress has not yet extended the credit into 2012, based on the federal government’s continuing desire to incentivize research within the U.S., it is likely that they will.
Summary Thoughts
Taxpayers who are not taking full advantage of the research credit are unnecessarily paying taxes; dollars which can otherwise be invested and improve their profitability, cash flow and capital. In summary, following are few things to consider:
Explore your prior year(s), as well as your current year’s, research activity and expenditures. Unclaimed research credits could warrant a tax refund claim.
Determine your eligibility for state tax credits. Massachusetts provides generous research credits.
Don't just focus on the immediate utilization of the research credit. A research credit not immediately utilized may provide long-term tax reductions during its carry-forward period (often 20 years).
This article is intended to only provide general tax information.
Tony Switajewski is a tax partner at BlumShapiro, the largest regional accounting, tax and business consulting firm based in New England, with offices in Connecticut and Massachusetts.
According to IRS statistics, manufacturers are the largest industry group receiving research tax credits. However, many manufacturers may not be aware of the credit and those who are aware may not be taking full advantage of the credit because of common misconceptions about its applicability to their operations. It is hoped that by reading this brief article your misconceptions will be addressed and you will be motivated to explore the credit's applicability to your company.