By Louis Guay
The federal research tax credit (aka R&D tax credit) under Internal Revenue Code (IRC) Section 41 aims to reward companies for increasing their investments in research and development. This dollar-for-dollar offset of federal income or payroll taxes offers the potential to significantly reduce the cost of these activities. However, many manufacturers don’t realize they have projects that are eligible for the credit or they may assume it requires too much paperwork to be worthwhile.
Any manufacturer that is developing new or improved products or processes, developing or improving software, or conducting research may have a project that qualifies for the R&D tax credit (o known as the federal credit for increasing research activities).
Unlike a tax deduction, which reduces taxable income, the credit reduces your tax liability. Companies typically use the credit to offset federal income taxes owed. Those that don’t have a current tax liability can carry forward the credit for up to 20 years, using it to offset future income tax liabilities. Eligible startups have an additional option: they can use the credit to offset payroll taxes.
Overall, the R&D tax credit’s actual benefits typically represent between 6% and 10% of research expenses that qualify for the credit.
Product, process and software R&D may qualify for research tax credit
Development of new products, proofs of concept, prototypes, and customized products or equipment are Research into improving existing products, experimenting with changes in product input specifications and new materials also often qualifies.
Process- and production-related research and experimentation also often qualify for the research tax credit. This can include development of new or improved manufacturing processes, automation of existing processes and some cost-reduction initiatives. Process and packaging experiments centered around using alternative energy sources, reducing waste, reducing a carbon footprint, or increasing the useful life of equipment or parts may also qualify.
Software development to support your manufacturing processes or improve communication and data transmission may also qualify for the R&D tax credit.
Although the research tax credit can apply to many different types of projects, your work needs to meet certain criteria, defined by the tax code and regulations as “qualified research activities.” The formal qualifications are known as the “four-part test,” and it is applied on a project-by-project basis.
Only costs directly related to R&D qualify for the credit
Costs that are directly related to research and development conducted in the U.S. can be used to ascertain the tax credit. Examples of direct costs include wages for your research and development team, costs of raw materials used in prototypes or full-scale trial runs, and costs of special tools and jigs used to develop or improve products.
Costs that typically do not qualify for the credit include equipment, tangible property that is subject to depreciation, overhead, market research, administrative activity support and any work performed outside the U.S.
Separately, manufacturers should be mindful of recent changes to the way research and experimentation (R&E) expenditures are handled under IRC Section 174. Expenses must now be capitalized and amortized, either over either five years (for expenses incurred in the U.S.) or over 15 years (for those incurred outside the U.S.). Keep in mind that some research and experimentation expenses covered by Section 174 may not be used to calculate the R&D tax credit.
Claiming the research tax credit
The R&D tax credit is claimed on a company’s federal tax return using IRS Form 6765 – Credit for Increasing Research Activities and Form 3800 – General Business Credit.
To successfully claim a credit for research and development expenses, you’ll need to document and substantiate your process of experimentation, the technical uncertainty you faced, your reliance on hard sciences, and when the research and development began and ended. You’ll also need to show how the expenses used to calculate the credit directly relate to qualified research activities.
There are two ways to calculate the credit: the regular research credit method and the alternative simplified credit method. The choice of which to use depends on your revenue, your history of qualified research activities, what types of records you have of previous years’ research expenditures and other factors.
While documentation and substantiation can be a challenge, don’t let it stop you from exploring this lucrative credit. An R&D tax credit professional can help you understand which of the two calculation methods to use, and they can help develop, implement and maintain the documentation and record-keeping required.
This tax credit is a valuable incentive for companies to increase investment in research and development. It can help to offset R&D expenses and boost your bottom line. And like many manufacturers, you may be surprised to discover that activities you’re already engaged in can qualify.
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