The R&D tax credit: All grown up
November 2018 Footnote
The year was 1981. IBM introduced the first personal computer, TV viewers tuned in to the launch of MTV and "Raiders of the Lost Ark" topped the movie charts. Its hero, archaeologist Indiana Jones, wasn't the only one who discovered gold. Technology was changing at a rapid pace, and Congress was about to reward those at the forefront of its development.
As part of the Economic Recovery Tax Act (ERTA) of 1981, Congress enacted the research and development (R&D) tax credit. Companies could recoup a portion of their R&D investment through this valuable tax credit.
The R&D tax credit has proven to be an effective tool at encouraging technological investment, increasing global competitiveness and creating jobs. However, it wasn't until the Protecting Americans from Tax Hikes (PATH) Act of 2015 that the "temporary" R&D tax credit finally became permanent.
Misunderstood and underused
Like a middle child, the R&D tax credit of IRS Code Section 41 has long been misunderstood. Although more than $12 billion in R&D credits are claimed annually in the U.S., more than 80 percent of businesses taking the credit are larger companies with $250 million or more in gross receipts. The credit is underused by small and midsize companies. Why? After 37 years, taxpayers are still confused about what qualifies for the credit.
The Four-Part Test
To better understand the R&D tax credit, let's take a look at the Four-Part Test, which defines qualified research. Activities must:
- Have a permitted purpose. Does the activity relate to a new or improved product or process that improves function, performance, reliability, quality or efficiency?
- Eliminate uncertainty. Uncertainty may relate to production method, product capability, appropriate design or application of product.
- Include a process of experimentation. Did development include evaluation of alternatives through testing, modeling, or systematic trial and error?
- Be technological in nature. Does the activity rely on the principles of physical science, biological science, engineering or computer science?
ABCs of QREs
Three different categories make up the R&D credit calculation. They are called qualified research expenses (QREs).
- W-2 wages. This includes wages of personnel who are directly involved in, supervise or support research and development efforts.
- Supplies. These are noncapitalized materials and supplies. They may include: tooling, prototypes, dies, molds, metals, chemicals, ingredients, etc.
- Contract research. Research performed by a third party on behalf of a taxpayer. Qualified contract research is multiplied by 65 percent.
What about the base?
There are two different credit calculations: the Regular Research Credit (RRC) and the Alternative Simplified Credit (ASC). The RRC hinges on a fixed-base calculation determined by an R&D startup date, which is often difficult to establish.
The ASC is based on increased current spending over the three prior years' QREs. It's a simpler calculation. In 2014, Congress approved the ASC calculation for amended returns. This enabled many companies who didn't qualify for an R&D credit under the RRC to take advantage of it. (You can go back to three open prior years to claim an R&D tax credit.)
What about the 280C?
The 280C election is made on Form 6765 of a timely filed income tax return. It allows the taxpayer to reduce the credit in lieu of adding back the credit to taxable income. Are you considering the R&D credit but are not quite ready to claim one? File a 6765 with $0 credit in the ASC section, and make the 280C election.
Growing pains: R&D milestones
PATH Act of 2015 -- AMT and payroll-tax offsets
An unused R&D tax credit can be carried back one year and forward 20 years. Other than 2010, the R&D credit didn't offset AMT. This was a limiting factor for many companies. And, for startups, an R&D credit wasn't a benefit in an NOL situation. The PATH Act addressed these issues:
- As of Jan. 1, 2016, an eligible small business (ESB) can take advantage of the R&D AMT offset. An ESB must have average annual gross receipts that don't exceed $50 million for the three taxable years preceding the current taxable year. Not in existence for three prior years? Special rules under IRC section 448(c)(3) apply.
- As of Jan. 1, 2016, a qualified small business (QSB) can offset the FICA employer portion of their payroll tax with the R&D credit (up to $250,000 a year). A QSB is a business with less than $5 million in annual gross receipts, and had gross receipts for no more than five years (i.e., for 2018, would not have had gross receipts prior to 2014).
Suder v. IRS
In a landmark case in the R&D world, Suder reaffirmed several critical points:
- Companies don't need to reinvent the wheel to claim an R&D tax credit.
- Evolution, not revolution -- you can build upon existing knowledge.
- Executives and management can have R&D involvement.
- Employee surveys are an acceptable method of substantiating QREs.
In October 2016, the IRS published final regulations regarding internal-use software. When software is considered internal use, it must not only meet the Four-Part Test, but also the high threshold of innovation Three-Part Test:
- Significant economic risk.
- Not commercially available.
The new rules excluded some categories of software development from internal use, which helped lessen the burden of proof required to meet the R&D criteria:
- Internal-use software is developed by the taxpayer for use in general and administrative functions.
- Software that is sold, leased or licensed (includes software as a service (SAAS)) is not internal use.
- Third-party facing software and apps are not internal use.
- Dual function software -- both internal and third-party facing can be segregated, and the appropriate Three- and Four-Part Tests performed.
Supply regulations and tooling costs
In July 2014, the government addressed prototypes and R&D. The costs incurred to construct a "pilot model" are qualified research expenses. It doesn't matter whether the R&D results in a product that is ultimately sold or used in the taxpayer's trade or business.
Recently, the IRS conceded a Tax Court case to TSK of America, an automotive supplier. Initially, the IRS disallowed TSK's claim that tooling costs were QREs, arguing that the tooling was for production purposes. The IRS concession is a huge boost for manufacturers where tooling costs can make up a substantial portion of their R&D QREs.
In response to the Tax Cuts and Jobs Act of 2017, on Sept. 26, 2018, the IRS released draft instructions for a revised Form 6765 (the form on which the R&D credit is claimed). The instructions reflect increased 280C percentages, which deliver higher R&D credits. Blended rates for fiscal year filers are also addressed.
The great state credits -- icing on the cake
Thirty-nine states offer some type of R&D credit or incentive in addition to the federal credit.
Minnesota allows businesses conducting research and development in Minnesota to claim research credits against their corporate franchise taxes or individual income taxes.
Celebrate 37 years
Permanent, beneficial and more inclusive than ever, it's time for you to take another look at the R&D tax credit. For businesses, it's a valuable tool to help fund new product and process development. And, for CPA firms, it's a valuable tool to help maintain and grow your client base.
Ron Antal, CPA, is managing director of RCG Tax Partners, and Marla Schleider is the vice president. For 15 years, their firm has delivered R&D tax credits and cost-segregation studies to clients nationwide. You may reach them at email@example.com or firstname.lastname@example.org, or (330) 689-1778.
THIS REALLY IS R&D
- Developing new or improved products.
- Developing or improving manufacturing processes.
- Creating new or improved formulas.
- Creating prototypes or models.
- Developing software.
- Developing, implementing or improving internal systems.
- Developing mobile apps.
- Product testing.
- Experimenting with new materials.
- Testing new concepts.
- Designing tools, jigs, molds, dies.
- Adding/upgrading equipment.
- Automating processes.
AM I INVITED TO THE PARTY?
- Food processing
- Injection molding
- Oil and gas
- Software development
- Tool and die