In recent years, the IRS has scaled back several restrictive R&D Tax Credit regulations. Historically, these tax credits primarily benefited Fortune 500 companies, but now apply to a broad range of small to medium sized businesses, primarily in the manufacturing, engineering, architecture, medical science, and information services industries. Businesses in these industries and their CPA firms should consider the following highlights of the R&D tax credit changes to avoid leaving significant money on the table.
1. The R&D Tax Credit is more accessible than ever before.
Prior to 2001, taxpayers had to comply with rules for the research credit that were difficult to meet. New taxpayer-friendly rules were proposed in 2001 and finalized in December 2003, making it much easier for taxpayers to qualify for the credit. These new rules drop certain requirements that were onerous at best and imposed tests that few could pass.
2. Product or process improvement is key.
Activities that qualify for the credit must relate to a new or improved function of a process or product. Eligible business components are defined by the Tax Code as products, processes, computer software, techniques, formulas, and inventions, whether held for sale or lease by the taxpayer or used in the taxpayer’s trade or business. To the extent a taxpayer’s development activities constitute qualified research, they may be able to claim a research credit based on their costs for developing and improving such business components. Examples of a company’s activities that qualify for the credit include efforts to make new, lighter, stronger, cheaper, and more reliable products, or development of more precise, economical, or versatile processes.
3. Eliminating uncertainty is the focus of improvement.
The old rules required that taxpayers undertake research for the purpose of discovering information that exceeds, expands, or refines the common knowledge of skilled professionals in a particular field of science or engineering, i.e. "the Global Discovery Test." Many said this rule went beyond the intent of the Tax Code. More importantly, this was an impossible test for the credit, since a taxpayer often could not prove that discoveries exceeded, expanded, or refined common knowledge.
This test has now been completely eliminated and replaced by the simple requirement that research be "for the purpose of discovering information which is technological in nature." Expenditures represent research and development costs if they eliminate uncertainty concerning the development or improvement of a product. Uncertainty exists if the information available to the taxpayer does not establish the capability or method.
4. A process of experimentation is the vehicle to remove uncertainty.
To qualify as an expense, expenditures qualify as research and experimentation if either the capability or method of improving a product, or the design of the product, is uncertain. Under the old "process of experimentation test", research to design a product did not qualify if a taxpayer was certain it could improve a product, but was uncertain about the final product design.
Under the new regulations, requirements for the process of experimentation test for the credit are the same as those for an expense. Therefore, "a process of experimentation may exist if a taxpayer performs research to establish the appropriate design of a business component when the capability and method for developing or improving the business component are not uncertain."
5. R&D efforts must be technological in nature.
Research is considered technological in nature if the process of experimentation used to discover such information fundamentally relies on principles of the physical or biological sciences, engineering, or computer science.
6. Recordkeeping requirements have been eased.
Previous regulations required documenting the principal scientific questions to be answered and the information the taxpayer sought to obtain. The new rules eliminate these special "speculative" recordkeeping requirements for the research credit. The previous regulations were criticized as overly burdensome and requiring unnecessary records. This does not mean taxpayers can avoid having to keep records. The new regulations provide that a taxpayer must retain appropriate records in sufficiently usable form and detail to substantiate that the expenditures claimed are eligible for the credit.
7. Qualified expenditures may include salary and wages, supplies, and contractor fees. The focus of the tax credit covers expenses where a new business component was developed or an existing business component was improved. The expense categories of salary and wages, supplies, and contractor fees typically constitute the bulk of R&D expenditures and represent a significant credit opportunity for eligible businesses.
8. Subjective definitions in tax code suggest using an engineering approach.
Taxpayers and tax practitioners may be challenged to interpret "records in sufficiently usable form and detail to substantiate that the expenditures claimed are eligible for the credit." Unlike other areas of the Tax Code that provide more guidance for deductibility of certain items, the Tax Code does not provide much definition for the qualitative aspect of the credit.
Both CPA firms and the IRS realize that an engineering approach is required to recognize the qualitative aspects of the credit, and identify records in sufficiently usable form and detail to substantiate the credit.
9. Specialized expertise offers the best path to recognize the credit.
The R&D tax credit can translate into a significant impact to cash flow, but recognizing the credit often requires significant expertise along with time, energy and money. CPAs often partner with specialists in R&D credits to deepen their expertise in this specialized area. Factoring the numbers can challenge even the most sophisticated businesses and their CPA firms, creating the demand for more specialized tax credit services firms who bring extensive technical and practical engineering experience to the credit recovery process.
10. Impact on the bottom line can be significant.
R&D credits may apply not only to the current tax year, but can also generate significant refunds of previously paid federal income taxes for open tax years. The tax savings can not only boost the cash flow for a single tax year, but can also provide a financial planning roadmap for future filings as well.
The intent of the modifications to the tax law is to help stimulate financial performance in small to medium sized businesses. If you would like explore how your business can substantiate projects that qualify for R&D Tax Credits, contact Axiom Solutions at http://www.axiomsolutions.com.
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Nick Kromenacker is Chief Marketing Officer at Axiom Solutions, a provider of tax credit services and cost management solutions. He can be reached at [email protected].
