When you think of Research & Development (R&D), you might conjure up an image of people in white lab coats looking intently at beakers or diligently taking notes on clipboards. However, we find that many companies in the manufacturing sector may unknowingly perform qualifying R&D activities—activities that can result in significant tax savings. Businesses are in the position to strategically plan R&D projects for future endeavors, knowing they will be able to take advantage of the credit against current or future profits. Make sure you’re not missing out.
How Does R&D Tax Credit Work?
The Tax Code defines activities that are qualified for the credit as research efforts 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 in order to achieve the standard of “Qualified Research” that is eligible for the R&D tax credit.
Technical in Nature
According to the regulations, the research must be undertaken for the 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 businesses in the manufacturing sector.
R&D Tax Credit Qualified Activities
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 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 demonstrate that the changes or improvements of the business component are more than for merely 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 experimentation in the same year to be eligible to claim the tax credit. Also, a taxpayer may claim the credit regardless of whether it succeeds or fails in achieving its desired objective.
If you have experimentation that lasts 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 occurs, regardless of if experimentation is still in process or has been finalized.
How to Account for R&D Tax Credits
The calculation of the actual tax credit is complex, but the potential tax savings can be bountiful. It’s important to understand what qualifies for the credit, including:
- 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 claim 65% of the expenses paid to them
Additionally, internally developed software can qualify if supplementary requirements are met. Make sure to talk to your tax professional to see if this applies to you.
What Should I Do Next?
First and foremost, talk to your tax professional to make sure you’re taking full advantage of your R&D tax credits. Next, determine if your business is performing research that could qualify for the credit that you may not be currently claiming. 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 can often help your team recognize and identify qualifying activities currently being performed by your business.
The R&D tax credit can have a very positive impact on your company’s future. If you are not currently generating taxable income, you can carry forward the credit for up to 20 years, and it can be utilized to offset taxable income in future periods. Make sure your business is taking advantage of this credit and talk to your tax professional ahead of your next income tax filing deadline.