The research and development (R&D) tax credit offers benefits for a wide range of research activities in a host of industries. This credit is not just for “white coat” researchers in a back laboratory. In fact, entities from manufacturers to technology and other service providers can realize sometimes significant opportunities — if they overcome common misconceptions, such as what actually qualifies and how complex it is to apply.
While we are still awaiting updates on the fate of this credit, which expired at the end of 2013 but is expected to be renewed for 2014, it is a good idea to understand the basics of how the credit may apply to your company so you can be ready.
To qualify, research activities must pass the following three tests:
- Technological Information Test
Research may qualify for the R&D credit if it is undertaken for the purpose of discovering information that is:
- Technological in nature, i.e., it must rely on principles of physical or biological sciences, engineering, or computer science.
- Intended to be useful in the development of a new or improved business component, such as a product, process, computer software, formula, technique, or invention that is intended to be held for sale, lease, or license or used by the taxpayer in a trade or business.
It is important to keep in mind that your research does not have to be successful to qualify.
- The Process of Experimentation Test
Substantially all of the research activities must constitute a process of experimentation, which demonstrates the following steps:
- Identification of uncertainty and of one or more alternatives intended to eliminate that uncertainty;
- Identification of a process to evaluate the alternative; and
- The conduct of the evaluative process, i.e., through modeling, simulation, trial and error, etc.
- The Permitted Purpose Test
The research activities must in some way improve the function, performance, reliability or quality of a new or improved business component. Examples include market driven, cost reduction, satisfying industry/government standards, client driven, competitive advantages, increased efficiency and diversification.
The following activities do not qualify:
- Research after commercial production
- Adaptation or duplication of an existing business component
- Surveys, studies and research relating to management functions
- Acquisition of another’s patent, model, production or process
- Research in connection with social sciences or humanities
- Research performed outside of the United States
- Research relating to style, taste, cosmetic, or seasonal design factors
To help clarify the tests and limitations discussed above, let’s take a closer look at the manufacturing industry as an example of how the R&D credit may or may not apply in different scenarios.
A potential customer asks Company X if they can provide their widget at a lower cost. Using engineering sciences, Company X conducts research to test different materials, designs and manufacturing processes to evaluate if they can manufacture the widget at a cheaper cost. Because cost reduction is a permitted purpose, this research constitutes qualified R&D.
However, Company X also conducts research to determine the best paint and method of application to change the colors of the widgets from blue to orange. Because this is a cosmetic change, this research does not qualify for the R&D credit.
Company Y manufacturers a machine that attaches widgets to different mechanisms. Industry standards recently changed that now require widgets to be larger. Because of this industry change, Company Y has to make improvements to their machine to fit the new, bigger widget. The Company decided that, to do this, they only needed to change one component of their machine. Research and a process of experimentation were used to determine how to change this component. Time is spent to manufacture the machine and develop the new component. The process of experimentation test was only met on the time spent on the new component, so that portion of the project qualifies as R&D. The time spent manufacturing the rest of the machine (which has not changed) does not meet this test, and, therefore, does not qualify.
Company Y must segregate the time spent on only the new component in order to calculate their qualified R&D credit.
Company Z also manufactures widgets. Over the years they have added new pieces of equipment to their shop floor. The Company conducts research to determine if rearranging the equipment would make their manufacturing process more efficient. These types of process improvements meet the three tests and qualify as R&D.
Once you’ve determined that your activities qualify, you can calculate the qualified research expenditures associated with each project. Qualified expenditures include:
Include wages for employees who are:
- Engaging in qualified research, or
- Engaging in the direct supervision or direct support of qualified research.
Indirect and general administration services do not qualify.
Without a project tracking system, determining the amount of time each employee spends on qualified projects becomes more involved. However, there are best practices that your tax advisor can discuss with you on how to calculate this number.
Any tangible property that is used in the conduct of qualified research (other than land and capitalized property).
- 65% of Contract Research (or 75% for qualified research consortiums)
While the nuances of the R&D credit can seem daunting, your tax advisor can help you identify qualifying activities and then calculate the credit to maximize your tax savings.
Please contact a member of your service team, or contact Phil Baptiste at email@example.com for further discussion.
Cohen & Company is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circumstances and current law.