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How to Make Sure You’re Taking Advantage of R&D Tax Credits

When you think of Research & Development, we bet that it conjures up imagery of people in white lab coats looking intently at beakers or making notes on clipboards. However, we find that many companies in the manufacturing, distribution and wholesale sectors complete qualifying R&D activities that they may be unaware of, which can result in significant tax savings. As the tax credit was recently made permanent by Congress, businesses are now in the position to strategically plan R&D projects for the future knowing they will be able to take advantage of the credit against current or future profits. Make sure you’re not missing out.

What do we mean by R&D?

The IRS defines research activities that are qualified for the credit as research activities related to the development or improvement of a business component. On its own, this is a very broad statement. Let’s look further into the four criteria that must be met, as set forth within the Tax Code, in order to achieve the standard of “qualified research” that will be eligible for this credit.

Technical in nature

According to the regulations, the research must be undertaken for purpose of discerning information that is technical in nature, and the application of which is intended to be useful in the development of a new or improved business component of the taxpayer. Most often people think of physical or biological science as technical, but it also includes engineering and computer science which are two areas that may have the most relevance to companies in the manufacturing, distribution and wholesale sector.

Qualifying purpose - create new functionality, performance, reliability or quality

This research must be used to create new functionality, performance, reliability or quality of a business component. Within the Tax Code, a business component is defined as any product, process, computer software, technique, formula or invention which is to be held for sale, lease or license, or used by the taxpayer in a trade their trade or business.

Activities that generally qualify for the credit include:

  • New product development
  • Improved manufacturing processes
  • Improvements in automation technology
  • New or Improved packaging
  • Reducing scrap or increasing quality

Elimination of uncertainty

According to the Tax Code, uncertainty exists if the information available to the taxpayer does not establish the capability or method for developing or improving the business component, or the appropriate design of the business component.  The taxpayer must exhibit that the changes or improvements of the business component are more than for mere aesthetic purposes.

Process of experimentation

A systematic process of experimentation must be completed to evaluate one or more alternatives to achieve a result where the capability or the method of achieving that result, or the appropriate design of that result, is uncertain as of the beginning of the taxpayer’s research activities. However, there is no requirement that you must finish the experimentation in the same year to be eligible to claim the tax credit. If you have experimentation that lasts across many years, make sure you have documentation of the qualifying activities undertaken during each respective year that you are claiming the credit. You will be able to claim the credit for each year that the experimentation and documentation exists, regardless if the experimentation is still in process or has been finalized.

How big of a tax credit could it be?

The calculation of the actual tax credit is complex, but the potential tax savings can be bountiful.   It is important to understand what qualifies for the credit, which include the following:

  • Wages paid to employees engaged in, or directly supervising, qualified research
  • Amount paid for supplies used during the qualified research
  • If there are any outside contractors used as a part of fulfilling any of the requirements above, you can deduct 65% of the expenses paid to them.

Additionally, internally developed software can qualify for the credit if supplementary requirements are met.  Make sure to talk to your tax professional if this applies to you.

What should I do next?

First and foremost, to make sure you’re taking full advantage of your R&D costs, talk to your tax professional.  Next, determine if your business is undertaking qualifying research that could qualify for the credit that you may not be claiming currently.   To ensure that you’re claiming all possible qualifying expenses, consult your accounting personnel or employees on the floor that have a deep understanding of your day to day processes. These personnel are often a wealth of knowledge that should be tapped in to, in order to help recognize and identify qualifying activities currently being carried on by your business.

The R&D Tax credit can have a very positive impact on your company’s bottom line. If you are not currently generating taxable income, you can carryforward the credit for up to 20 years, and can be utilized to offset taxable income in future periods.  Make sure your business is taking advantage of this tax credit and talk to your tax professional ahead of your next filing deadline.