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Dave Erb

The R&D Tax Credit: You'd Be Surprised Who's Leaving Money on the Table

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Dave Erb, Mike Caouette

Businesses that have historically not claimed R&D credit should take a fresh look at their business activities to ensure they are not missing out on this tax reducing incentive.

This is not your father’s Research & Development tax credit. Available for taxpayers with qualified expenditures since 1981, the activities that gave rise to the credit early on were generally research and development being performed in a laboratory setting. As time passed, manufacturing and other businesses became aware of the applicability and benefits of the R&D credit.  Now, businesses from an increasing number of industries are taking advantage of the R&D credit because:

  • A simplified version of the original credit process (wisely called the Alternative Simplified Credit) substantially reduces the amount of historical data required to qualify.
  • R&D credits can be used to reduce the AMT (alternative minimum tax).
  • Recent court cases have clarified what qualifies as research and design activity and related expenses. This item is what we address in this article.

What kinds of businesses qualify?

You no longer need to conduct lab research to qualify. Most companies that have engineers on staff are likely candidates for R&D credit. However, many companies with no engineers on the payroll may be eligible as well. If your business is engaged in improving existing products in certain ways, ISO implementation, adding or implementing certain kinds of new equipment, or developing prototypes, you stand a strong chance of being able to capitalize on the credit.

Companies in a wide range of industries have gained substantial tax savings from the R&D credit, not just Bio-tech, pharmaceutical, and similar industries. These include small, medium, and large companies in:

  • Architecture
  • Food processing
  • Structural engineering
  • Agriculture
  • Software development

If your business has not claimed the R&D credit in the past, you should take a fresh look at your business activities. The opportunity to gain additional tax savings can be substantial. It may even be applied to prior years. Because it is a tax credit, it can provide dollar-for-dollar deduction in taxes as opposed to a tax deduction which reduces taxable income. 

What kinds of activities and expenses qualify?

In general, your business must have qualified research expenses in order to claim the R&D credit. These include expenditures that are business expenses:

  • performed to discover technological information,
  • useful in the development of a new or improved product, process, computer software, technique, formula or invention, and
  • substantially all of which encompass the elements of a process of experimentation.

For manufacturing businesses, research generally includes expenses related to a new or improved function, performance, or reliability or quality. For example, although the substantial  expense test requires that 80% of the business's research activities expenses constitute elements of the experimentation process, it is possible to qualify for the R&D credit even if the design does not meet the substantial expense test. The design costs for improving the function of an existing product may qualify for the R&D credit if subparts of the design were innovative and new to the overall design.

A recent court decision clarified how design work can qualify as a research and development activity and how the related expenses can qualify for the R&D credit.  The principal question with design work and its eligibility for the R&D credit is whether the design is something that is new or different than what the business has done in the past. This is not an industry test, but rather a business specific test. A design that is inherently complex, with a degree of uncertainty as to how the design will accomplish the goal of the project frequently has some R&D aspect to it.

The degree of uncertainty is a key component of the argument that the design will qualify as R&D. The more uncertainty in a project leads to more experimentation and challenge and thus the case for R&D becomes easier. When a design has only a few minor tweaks and is similar to what the business has already done, the argument for R&D qualification becomes more difficult. 

States get in on the act.

Many states, including Maine and New Hampshire, also provide for a state tax credit related to research and experimentation. Generally, the expenses that qualify for the federal credit will also qualify for a state credit. It’s worth considering what opportunities or savings your business stands to gain if you qualify.

We’d be delighted to help or to answer questions related to your specific circumstance. Contact Mike Caouette or Dave Erb for more information.