For more than thirty years, the federal government has incentivized businesses to increase their domestic research and development. As part of the 1981 Economic Tax Recovery Act, the Credit for Increasing Research Activities—the “research credit” or “R&D tax credit”—was a key mechanism through which Congress tried to stimulate the economy.
As a dollar-for-dollar offset against regular income tax liability, the credit provides additional capital for a company to use on improvements such as hiring more engineers, scientists, and software developers or for buying and using more supplies and materials to develop or improve its products and manufacturing processes.
The Credit for Increasing Research Activities still exists today, as does original the Congressional intent: to keep and increase research, development, and manufacturing in the United States.
Virtually every company that manufactures products in the United States is likely to be performing activities that qualify for the research credit. And the statistics paint the picture: of the more than $10.8 billion in research credits reported during 2012, nearly $6.6 billion were reported by corporations in the manufacturing industry.
Although manufacturers are generally aware of this benefit, many may not be optimizing it.
When a company is evaluating its own R&D tax credit optimization, the company needs to consider what its employees and contractors are doing and whether or not it has adequate support to sustain credit in the event of a tax audit.
Eligible Activities For Qualified Research
The definition of “qualified research” isn’t limited to basic R&D, core engineering or scientific functions. Rather, qualified research can include activities that attempt only to develop or improve existing products, processes, and software, as well as the direct support or direct supervision of these activities.
Generally, the level of technological advancement isn’t necessarily relevant to eligibility. Courts have upheld the evaluation of the efficiency of a third party’s technology to perform within an existing production process; specify and integrate existing components into an overall design for a new system; and additional design and engineering to modify molds purchased from third parties to produce desired components. Moreover, job title or department assignment does not affect eligibility.
R&D Credit To Optimize Adequate Support
To help optimize R&D credit, it is important to assess all employees’ and contractors’ activities.
Tax authorities generally have at least three years to examine a tax return so, it is important to gather and document all employees’ and contractors’ activities in a timely manner after the activity is performed.
While the law doesn’t provide specific guidance about what particular information and documentation to gather, it is recommended that a company record four things in particular:
- The credit calculation and supporting workpapers
- Qualified expenses by department, job title, employee, contractor, supply, and “business component,” i.e., the products, processes, or software you attempted to develop or improve
- Descriptions of the business components and the activities to develop or improve them, more specifically (a) the new or improved functionality, performance, reliability, or quality the activities were intended to develop, (b) technological uncertainties encountered to try to do so, (c) the process by which those uncertainties were intended to be eliminated, and (d) how that process fundamentally relied on the principles of engineering or the physical, biological, or computer sciences
- Documentation regarding these four elements, a-d, e.g., design requirements and specifications documents; prototypical drawings, software programs, models, etc.; test plans and test results; revisions to the drawings, programs, models, etc.
By identifying and accounting for eligible activities and expenses and gathering this kind of information,a manufacturing company can optimize its R&D tax credits, reduce its tax liabilities and tax rates, as well as generate cash.
Material discussed is meant to provide general information and should not be acted upon without first obtaining professional advice appropriately tailored to your individual circumstances.