Unclaimed Research & Development Tax Credits

The following article was written by Chuck Bennett who is a Director with Tax Projects Group, LLP, a national tax consulting firm that specializes in performing R&D Tax Credit Studies.

Unclaimed Research & Development Tax Credits

Manufacturing companies often qualify, but don't get the "credits" they deserve.

Since 1981, the Research and Development (R&D) Tax Credit has been part of the U.S. law. Unfortunately, because of its complexity, many businesses, particularly small and mid-sized, have failed to take advantage of it; as it is a common misconception that R&D is performed exclusively by scientists in laboratory settings. However, once companies understand what constitutes as R&D, they typically find that activities performed during their day-to-day operations will qualify. This often includes the development of new products, enhancements to existing products or improvements to a manufacturing process.

The R&D credit was enacted as an incentive by congress in an effort to maintain a competitive balance for U.S. based companies within the global marketplace. It's an incentive designed to reward companies for developing new and better products and methods of manufacturing in order to compete against foreign competition that has the ability to produce and manufacture product at significantly lesser costs.

The guidelines outlining what type of activities qualify for the R&D credit have changed considerably throughout the past 20 years, and recent changes have broadened the scope of what type of activities qualify for the credit. As such, firms should not underestimate or trivialize the product or process improvements they undergo on a daily basis.

In order for an activity to qualify for the R&D credit it must comply with the following four-part test:

1. Technological in nature: The activity performed must fundamentally rely on the principles of physical science, biological science, engineering or computer science.
2. Permitted purpose: The activity must relate to a new or improved business component or to its new function, performance, reliability or quality.
3. Process of experimentation: Many of the activities must be elements of a process of experimentation involving evaluation of alternatives, confirmation of hypotheses through evaluation, testing and/or modeling or refining or discarding the hypothesis.
4. Developmental Uncertainty: Uncertainty surrounding the best technical approach needed to achieve the desired outcome.

Calculating the credit

Once qualifying R&D activities have been determined, the R&D tax credit calculation can begin. The credit is comprised of three specific areas of cost that coincide with the qualifying R&D activities. The IRS has provided a set definition as to what constitutes qualified research expenses:

1. Wages of employees who work on or supervise the development of projects or manufacturing staff who are supporting the experimentation process
2. Supplies used in the research or experimentation process, including raw materials, prototypes, test beds, tooling, etc.
3. Contract research expenses paid to outside consultants to help develop or test new products or improvements.

Documenting qualifying activities

Retaining records and documentation of R&D activities is critical in the case of an IRS audit. If audited, the IRS will look to see two types of documentation:

1. Documentation relating to the credit calculation: W-2 information on salaries will be examined. Also helpful, but not essential, are time cards that may identify hours, days, weeks or months that employees have spent performing R&D.
2. Contemporaneous documentation: This must relate in a meaningful way to the course of the experimental development work performed. This requirement can be fulfilled with a variety of contemporaneous documentation, including but not limited to, notes, test results, CAD or paper drawings and patents.

Chuck Bennett is a Director with Tax Projects Group, LLP, a national tax consulting firm that specializes in performing R&D Tax Credit Studies (email: chuck.bennett@taxprojectsgroup.com).