Misconceptions about the Research & Experimentation Tax Credit
by Sarah Russell, CPA, MBA, Shareholder
Clayton & McKervey Posted 08/30/2018
In 2018 we are trying to figure out the extent of the impact from the Tax Cuts and Jobs Act. One thing we know is that the Research & Experimentation (R&E) Tax Credit remains intact. Additionally, as manufacturing companies put more emphasis on Industry 4.0, each current process may change and become even more automated and accessible, which will allow a greater amount of companies to qualify for the R&E credit.
The research and experimentation (commonly known as the research and development) tax credit is a tax incentive that can provide tax benefits for companies investing in R&E. Only 5% of companies with qualified research activity are currently utilizing this tax incentive to the fullest extent. This article outlines what is considered qualifying activity and highlight the areas most often overlooked when calculating the credit.
What Type of Activity Qualifies?
There are three prongs to the definition of the term qualified research. Qualified research includes:
- Research expenditures which may be treated as deductible expenses under the provisions of the tax code
- Research that is undertaken for the purpose of discovering information which is technological in nature and, the application of which, is intended to be useful in the development of new or improved business component
- Substantially all the activities that constitute elements of a process of experimentation for a functional purpose
What Exactly Does This Mean?
The most common misconception regarding the credit is that you must be inventing something entirely new or groundbreaking to qualify for the credit. However, in 2003 the IRS loosened qualifications: under the current regulations, development efforts only need to be evolutionary to you. In other words, if employees in your organization are spending time to discover technical information through research and experimentation, with the intention of developing or improving products or trade processes using the principals in Industry 4.0, those expenses will generally be qualified research and development costs for purposes of the credit.
Research expenditures are defined in IRC §174 and generally include costs incidental to the development or improvement of a product, process, formula, invention, technique, patent or similar property.
The discovery requirement is satisfied if the research is “intended to eliminate uncertainty concerning the development or improvement of a business component.” The test is taxpayer focused, rather than industry focused, which means it does not matter if another company has developed the product or process. If there is an element of uncertainty in the activity you are engaging, it may be qualifying activity. Eligibility does not depend upon the ultimate success, failure, sale or use of the product. Typically, costs are eligible until the element of uncertainty is eliminated.
The process of experimentation test requires a facts and circumstances analysis, however the IRS has provided three core elements needed to satisfy this test:
- Identifying uncertainties
- Identifying alternative solutions
- Evaluating the identified alternative
If your process includes all three steps, it is likely a qualifying activity.
Identifying Research Expenditures
Many companies aren’t aware that a product or process merely needs to be evolutionary to them in order to qualify. In addition, we have encountered many companies who are utilizing the credit, but not to the fullest extent.
Identifying qualifying expenditures is usually an area most taxpayers misunderstand. Costs incurred in the development or improvement of a plant process, a product and a technique are all qualifying expenditures. To put that into context, a system integrator often improves a product or technique for each automation cell produced. In that regard, the costs incurred to engineer and test a cell would be qualified expenses. If the cell is duplicated, only the costs incurred for the first cell would be qualified; however, most cells have a unique component.
If you drill down even further and question what type of costs are considered research costs for purposes of calculating the credit, you would find that many supply costs are also included in the definition of qualified expenditures. We have found supply costs are often an overlooked expenditure for purposes of the credit calculation, and often these are the largest costs incurred in the development of an automation cell.
How Much Is the Credit?
Typically the credit will be about 6.5% of qualified research expenditures. The credit may be carried back one year and carried forward 20 years.
If you think you may qualify for the credit, or may not have utilized the credit to its fullest extent in prior years, there may an opportunity to amend returns and apply for a refund or credit carryover. Contact Clayton & McKervey Shareholders Sarah Russell or Tim Finerty for a free assessment to determine your potential R&E credit.