When you think about research and development, what images come to mind? Do you think about rows of lab tables surrounded by lab personnel in white coats? Maybe you see little dollar bills floating out the window as you think about the cost of R&D. Perhaps very little comes to mind because you believe your company does not engage in R&D activities. At one time, just about all of these images would have been valid for many of us in business, but times have changed – for the better!
With those changes, the Federal income tax credit for increasing research and development costs became available to more businesses than ever before. The credit, which at one time was available only to companies that spent massive amounts of money looking for “new” information, was made available to a vast array of businesses in December 2001. It was then that the Internal Revenue Service issued regulations that significantly broadened the definition of qualified research expenditures. The regulations became final in December 2003.
In general, the credit is equal to 20% of the increase in qualified research and development expenditures over a base amount. The base amount is calculated by reference to prior year expenditures and its computation is complex, thus we won’t be discussing how the base amount is derived in this article.
A four-part test is used to establish whether expenditures qualify for the credit. The first part requires that your research activities be for a permitted purpose. This means your work must be undertaken to create a new or improved process, product, function, or quality OR achieve a significant reduction in cost. One example might be the improvement of a production line to enhance efficiency and capacity, thereby significantly reducing costs. Another example might be the in-house development of software to improve some aspect of your business.
The expenditure must also be technical in nature. To qualify as a research and development activity, your work must include engineering, computer, biological or physical sciences (the hard sciences). If your company is primarily involved in manufacturing, you are likely conducting activities that would qualify as research and development actions. By eliminating activities based on soft sciences like literature, social, or historical sciences, the purposes of the credit were made clear – to help U.S. businesses compete effectively in the international marketplace.
A third requirement is that the research must be undertaken to eliminate uncertainty. Are you trying to determine the proper design of a product or perhaps how to best produce it? Are there quality control issues you are trying to address? If you develop a new manufacturing process, how will it integrate with your current methods? All of these questions and more are examples of ‘uncertainty’.
Any owner knows that running a business includes the process of eliminating uncertainties on a daily basis. Whether your costs associated with addressing those uncertainties qualify as research expenditures depends on their ability to meet all four parts of the IRS test.
Finally, the actions you undertake to eliminate the uncertainty must involve a process of experimentation. You must be able to demonstrate that your activities involve the development of a hypothesis and the design and implementation of tests to prove or disprove the hypothesis. This does not mean you have to evaluate more than one alternative. Treasury regulations specifically define the process of experimentation as involving the evaluation of one or more alternatives.
Assuming you are engaged in R&D activities, you then need to determine if you can benefit from the credit. Since the credit is not refundable, if your company is presently in a net operating loss position, its availability may be a moot point - unless you foresee profitable operations in the near future. The credit may be carried back for one year and forward for twenty years.
Even if your company is in a profit position, the utilization of the credit is not assured. The credit cannot be used to reduce your income tax liability below your alternative minimum tax. The rate differences between the alternative minimum tax and regular tax for C corporations make it very likely that such companies can benefit from the credit. On the other hand, companies that pass through their tax attributes to owners (partnerships, sole proprietorships, S corporations) are not as lucky. The rate differential between the alternative minimum tax and regular tax at the individual level are not as great and could operate to make the credit useless to such owners.
Even if you cannot benefit from the R&D Tax Credit at the Federal level, you might still benefit from the credit on a state level. Some states allow companies to sell credits to other taxpayers and this can be a source of needed capital to some businesses.
While it is not a certainty that your company would qualify or benefit from the Research and Development Tax Credit, the potential tax savings make it important for you to consider the possibilities. Even if you think there is only a remote possibility the credit would be available to you, give us a call. You may just have a hidden asset that will boost your bottom line.
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