Add value to your private equity deals with research tax credits for innovative portfolio companies.

By Mark Dunning and Jamie Overberg

Business transactions involving private equity portfolio companies often trigger complex tax considerations across various disciplines. Advanced tax planning not only creates opportunities but also eliminates unpleasant surprises, increasing the purchase price when taking a company to market for a buyer, especially with the small business payroll cash benefit.

This is especially true when it comes to R&D credits. Motivated sellers can uncover hidden value in the everyday activities of innovative companies, even those with as few as six engineers. Six engineers are all it takes to leverage lucrative R&D credits across industries such as software and technology, manufacturing, automotive and aeronautical, biomedical and medical devices, engineering and more.

The term “#6engineers” highlights the minimum number of engineers or software developers required at a company to generate sufficient expenses – wages, salaries, outside contract and leased computer costs – associated with R&D and achieve a reasonable ROI on R&D credits. These engineers must be actively engaged in improving a product or process. Meeting this criterion is essential for eligibility.

Role of Private Equity Firms

As a PE investor, your role often grants you control over management and operational changes to increase profitability with an eye on a later profitable sale. In this capacity, consider whether your portfolio companies could benefit from federal and state R&D credits to improve cash flow and investment proceeds. Over 20 billion of dollars are distributed to both small and large companies through R&D credits, making it worthwhile to explore this option and file a credit claim, provided the company meets the #6engineers requirement in an innovative field.

To successfully claim R&D credits, several operational tasks must be completed. First, design documents that demonstrate the product’s research must be maintained. Second, a nexus between each associate development activity and the project must be established for claiming the credits.

At the federal level, spending $1 million on research could result in a business receiving a $100,000 credit. However, each of the approximately 38 states offering R&D credits has slightly different criteria and requirements, necessitating a nuanced approach for computation methods and research filings based on the specific state.

Contrary to a common misconception, R&D credits are not solely beneficial to larger corporations. Small companies are eligible as well and can often benefit more by combining federal and state credits.

Recent changes under Section 174 should also be on your radar as a PE firm manager. These changes require companies to amortize Section 174 expenses, typically over five years (or 15 for foreign assets), starting in 2022. This could accelerate amortization and depress income, potentially impacting the short-term sale of portfolio companies. Proactively managing these issues with tax practitioners who understand the intersection of Section 174 and R&D expenses is crucial for preserving valuations.

Justifiable Claims

R&D credit claims require sophistication and expertise and should not be entrusted to subpar market players. Making aggressive or frivolous claims could invite IRS audits and enforcement into your PE deals. R&D credits are not quick or easy and cannot be automated. Beware of vendors who promise a quick estimate of R&D value without delving into project specifics; only experts who examine the details of each ongoing project and R&D subcontract can truly boost business value through R&D credits.

In addition to R&D credits, consider other tax specialty areas during your due diligence, including net operating loss carryforwards, accounting for income tax provisions (ASC 740) when an initial public offering is slated, and state and local tax implications on escrow and purchase price.

Leveraging R&D Credits

The U.S. leads the world in funding for research and development, with annual average spending of 4.3% per year from 2000 to 2017. The right amount of credits to claim is the amount a business can qualify and quantify—nothing more, nothing less. A justifiable R&D study involves creating a new product or process with technical uncertainty and using a process of experimentation based on hard sciences.

The companies nurturing these projects typically combine different manufacturing, medical, and coding disciplines in developing and improving tools, workflows, processes, and testing protocols that bring R&D alive. A great deal of U.S. research comes from software companies, where deploying effective technologies that change how we live and what we see in the digital space happens at hyper-speed especially with the proliferation of machine learning. Many innovative companies, engineering firms, and government entities use unique designs and workflows to create new and improved products, services, and processes. All may be eligible for R&D credits with #6engineers.

Got #6engineers or more? Contact TaxOpsMin to learn more and have a conversation about claiming research credits. 

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