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Research & Development Tax Credits — Not Just for Manufacturers
By Steven Everson & Bruce Shapiro
For more than 20 years, our Federal and some state governments have provided tax incentives for technological advancements. Generally, these incentives are in the form of tax credits and are available to companies that invest in new or improved products or processes. While the majority of the companies claiming R&D credits have historically been manufacturing companies, opportunities exist for many other organizations as well. Because both the tax law and how some service companies conduct business has changed over time, the R&D tax credit may afford significant opportunities if your company is providing technical services (such as A&E firms or certain contractors).
When looking at the R&D tax credit, it’s important to realize:
- The IRS’s definition of qualified R&D is usually different than your preconceived idea of what constitutes R&D. The IRS gives four basic criteria you must meet to qualify (discussed on the following page).
- The R&D credit is a tax credit, not an additional deduction. This means that the credit can reduce tax, dollar for dollar, subject to income and alternative minimum tax limitations. If for some reason you cannot use the credit in any given year, it can be carried back one year and forward 20 years.
What Constitutes R&D for Tax Purposes?
The R&D credit is available to any company that invests in new or improved products or processes. A "product" is defined as any pilot model, process, formula, invention, technique, patent, or similar property and includes both products to be used internally, as well as held for sale, lease, or license. Additionally, there are four statutory criteria that also must be satisfied:
- The intent of the research must be to develop new or improved function, performance, reliability, or quality for a product or process. The intended improvement does not need to be successful to qualify.
- The activity must contain a degree of technical uncertainty related to the capability, method, or appropriate design of the product or process. This uncertainty is measured at the beginning of a project.
- The activities must relate to a process of experimentation involving evaluation of alternatives, trial and error testing, and/or modeling.
- The activities must be technological in nature by relying on the hard sciences such as engineering, physical science, biological science, or computer science. Non-qualifying activities include research into style and taste, management studies, market research, and routine data collection.
Lastly, "funded research" does not qualify for the credit. Research is funded if you’re either not economically at risk for the activities or your company does not retain substantial rights in the research. Clearly, if your company charges on a purely hourly rate basis, you won’t qualify for the credit because you aren’t economically at risk. But if you charge on a project basis and payment is contingent on delivery of a "product," then you are at risk and could qualify for the credit.
Potential Benefits
There are several different methods of calculating the credit based on the facts and circumstances of your specific situation. However, these credits can be as high as 6.5 percent of qualifying costs (R&D wages, supplies, and contracted R&D). For example, if you determined that your company had $1,000,000 of qualifying costs in 2007, then the credit could potentially be $65,000 and would offset tax dollar for dollar (subject to limitations). Additionally, credits can be available in prior tax years resulting in refunds for up to three prior years.
A Real-Life Example
Recently we helped a specialized engineering, design, and construction management firm analyze and document qualifying R&D activities that resulted in $340,000 of credits over a four-year period. The documentation process included gaining an understanding of the history and current business practices, conducting interviews to document both departmental and project level qualification, and reviewing all related expenses to maximize the allocation to qualified activities. At the end of the process, we delivered R&D documentation that is designed to support both the qualitative and quantitative aspects of the R&D credit claim.
What Should I Do?
If you think your company is economically at risk for activities that would qualify, please contact us. Our Tax Solutions Group has a team of professionals dedicated to helping our clients with the R&D tax credit.
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