The federal government, and most states, provide lucrative economic incentives in the form of research and development (R&D) credits to reward companies for fostering innovation and advancing technology on U.S. soil. These credits cover qualified expenses for companies developing new, improved, or technologically advanced products or trade processes, lowering the net cost of investment and keeping technical jobs here in the U.S.
These highly nuanced credits are tied to a stringent set of rules and criteria requiring both qualitative and quantitative analyses in advance of successfully claiming the credits. Taxpayers that design, develop, or improve products, processes, techniques, formulas, and software may be eligible for research credits. Below you?ll find answers to the questions we get asked the most about these underutilized credits.
Who can claim the research credit?
Any taxpayer that is performing qualified research on U.S. soil.
What type of expenses qualify for the credit?
In general, only wages (Box 1 W2), direct supplies and outside contract associated with qualified research. Leased computer costs or cloud computing costs for development platforms can also qualify. Indirect expenses such as rent, travel, education, taxes or utilities are generally not includable. For supplies, it is tangible property that is not land or subject to depreciation. Typically, these qualified supply expenses are used within twelve months.
What is “research”?
Technical development to create a new product or process where uncertainty exists at the outset and a process of experimentation is undertaken.
What if I receive money for funding?
If you receive federal funding from a grant program, you must net those proceeds against your expenses. If you receive compensation from a customer, it’s possible that you can claim all the expenses still as a credit. The determining factors are rights and risk. You must maintain rights to the intellectual property and be at risk for the costs.
I heard claiming the research credit triggers an audit. Is that true?
If a taxpayer claims a refund due to research credit on an amended return, there will be a coordinated audit. The audit is conducted by a local agent under supervision of a national team from DC. If it placed on an original return (extended or not), there is not an automatic audit.
What is the 280C on the credit?
Section 280C was enacted to raise taxes by decreasing the benefit amount for many different credits. A taxpayer must make an M-3 adjustment by adding back the Credit amount as if it were income (a negative deduction) basically taxing the credit amount or elect to make the 280C reduction to the actual credit. The net tax benefit of the credit is the same. We recommend electing the 280C reduction as it is administratively easier by eliminating the M adjustment, causing no change to taxable income. An additional benefit is that if a credit were to change under IRS examination, then there would be no change to taxable income easing the burden of amending state tax returns which typically begin with federal taxable income.
What is process development?
Process development is where you are improving the method in which you make your product. It can be enhancements to your production line that reduces waste. It could be updating your equipment because a new raw material or new technology is being used. The process must be better than the old, you must have uncertainty as to the appropriate design and you must follow of process of experimentation that assists you in determining the best design. Here is an example from the IRS regulations:
Example 3. (i) Facts. X is engaged in the business of manufacturing food products and currently manufactures a large-shred version of a product. X seeks to modify its current production line to permit it to manufacture both a large-shred version and a fine-shred version of one of its food products. A smaller, thinner shredding blade capable of producing a fine-shred version of the food product, however, is not commercially available. Thus, X must develop a new shredding blade that can be fitted onto its current production line. X is uncertain concerning the design of the new shredding blade, because the material used in its existing blade breaks when machined into smaller, thinner blades. X engages in a systematic trial and error process of analyzing various blade designs and materials to determine whether the new shredding blade must be constructed of a different material from that of its existing shredding blade and, if so, what material will best meet X’s functional requirements.
(ii) Conclusion. X’s activities to modify its current production line by developing the new shredding blade meet the requirements of qualified research as set forth in paragraph (a)(2) of this section. Substantially all of X’s activities constitute elements of a process of experimentation because X evaluated alternatives to achieve a result where the method of achieving that result, and the appropriate design of that result, were uncertain as of the beginning of the taxpayer’s research activities. X identified uncertainties related to the development of a business component, and identified alternatives intended to eliminate these uncertainties. Furthermore, X’s process of evaluating identified alternatives was technological in nature and was undertaken to eliminate the uncertainties.
For software, do bug fixes count?
Unfortunately, no. The IRS considers bug fixes as postproduction error fixing. They are essentially mistakes from a prior release that you are correcting.
What are some engineering costs that do not qualify?
Research after commercial production or sustaining engineering, reverse engineering, and work performed outside the United States or its territories. Not qualified postproduction work includes preproduction planning for a finished business component; tooling-up for production; trial production runs; trouble shooting involving detecting faults in production equipment or processes; accumulating data relating to production processes; and debugging flaws in a business component.
We are developing an enhancement on our product based on a customer?s request. Does that qualify?
An example is a modification on a filtration system for a particular customer’s needs. If you roll out that modification to other customers, you can include those design efforts and costs if you otherwise followed all the R&D requirements. If it is used only on one customer, you may not include because the work is considered an adaption for only that one customer and not for the benefit of others.
What does substantially all mean?
If eighty percent or more of your research activity measured on a cost or other consistently applied reasonable basis constitute elements of a process of experimentation for a qualified purpose, then you can include 100% of the cost associated with that activity. It also applies to an individual’s wages. If eighty percent or more of an engineer’s time is spent on qualified activities, you can include all of the individual’s wages.
What about research in the pursuit of exploration of raw materials?
If the exploration is solely for the extraction of materials, it is not a qualified activity. This activity is simply deemed as not qualified in the law. Furthermore, exploration does not meet the process of experimentation test; it is simply a technical search for materials. If you are developing a new method or equipment for exploration, that activity could be included.
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Mark Dunning, managing partner at TaxOps Minimization, and Jamie Overberg, partner, implement tax saving strategies for dynamic companies. Reach out to Mark firstname.lastname@example.org and Jamie at email@example.com.
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