Tax Savings for Innovation: The R&D Tax Credit
by Michael J. Devereux II, CPA, CMP, partner and director of Manufacturing, Distribution & Plastics Industry Services
Most recently, the Protecting Americans from Tax Hikes Act of 2015 (“PATH”) made three significant changes to the R&D tax credit:
- The R&D Tax Credit now is permanent. Taxpayers no longer will have to wait to see if Congress will retroactively extend the credit as part of a tax-extender package.
- Eligible small businesses, defined as those with average sales of less than $50 million over the prior three tax years, will be able to offset both regular income tax and Alternative Minimum Tax (AMT) in tax years beginning after Dec. 31, 2015. Prior to this change, this was a significant hurdle for small and medium-sized businesses to utilize the credit.1 For taxpayers with a Dec. 31 year-end, this break begins in 2016.
- Also beginning in 2016, certain start-up companies will be allowed to utilize the research credit to offset the employer’s portion of payroll tax (i.e., FICA) liabilities.
The R&D tax credit is a dollar-for-dollar credit against the taxpayer’s federal income tax liability. Taxpayers benefit from the deduction in the year the expenditure is paid or incurred and by claiming the credit.2
Approximately 35 states also have incentives for research and development, based upon the federal definition of qualified research. The various state R&D tax credits range from 1.5 percent to 24 percent of the eligible research expenditures, with some states requiring taxable income as a prerequisite for utilizing the credit and others refunding any unused credit to the taxpayer, irrespective of the existence of taxable income. Each state has its own requirements, and state credits only are eligible for research conducted within the respective state.
Eligible research activities and applicability to plastics decorating companies
The R&D tax credit is calculated based upon the expenditures attributed to a taxpayer’s qualified research activities. There are four basic requirements for a qualified research activity. The activities outlined below go beyond the laboratory and R&D departments and demonstrate how companies’ engineering, quality and production departments engage in or directly support qualified research activities. The following overview discusses the requirements and how these activities apply to a typical, custom manufacturer in the field of plastics decorating.
First, taxpayers must be developing a new business component or improving an existing business component that is held for sale, lease or license, or used by the taxpayer in the taxpayer’s trade or business. Business components are defined as products, processes, techniques, formulas, inventions or software applications.
Second, the activities must be technological in nature, fundamentally relying upon the engineering disciplines or chemical sciences. Taxpayers are not required to expand the knowledge in the industry. Rather, reliance upon existing sciences and engineering knowledge to eliminate uncertainty is permitted.
Third, uncertainty with respect to the capability, method or appropriate design must exist at the outset of the research activity. While many in the plastics decorating field generally are confident they can develop the necessary tooling and processing variables to meet their customer specifications, the appropriate design of the tooling and manufacturing process generally is uncertain at the outset of a project and must be solved. Uncertainty may include the evaluation of different design alternatives to determine the best design.
Finally, the design uncertainty must be eliminated using a process of experimentation, which is defined as modeling (including computer-aided modeling), simulation (such as moldflow) and systematic trial and error.
Many of these activities will be performed by engineers or technicians. However, taxpayers may include employees’ time spent directly supervising or directly supporting the company’s research efforts. Expenditures are eligible up until the point that the uncertainty related to the appropriate design has been eliminated. Therefore, it is common to see a company’s production and quality departments directly supporting the efforts of the engineering and technical teams.
Based upon the aforementioned criteria, it would seem that many of those in the plastics decorating field engage in qualified research every day. As noted, employees across numerous departments may be engaging in or supporting qualified research activities. For instance, the following may meet the definition of qualified research activities:
- developing in-mold labeling techniques
- developing new hot stamping techniques
- experimenting with part-specific manufacturing processes
- improving pad or screen printing techniques
- developing new mold designs using computer aided design (CAD) software
- mold flow analysis on new mold designs
- prototyping using 3D printing and/or SLAs
- experimenting with part-specific PLC programming
- improving manufacturing processes through automation
- performing First Article or PPAP inspections on new parts
New, taxpayer-friendly treasury regulations
Moreover, recent treasury regulations clarified that if expenditures meet the definition of qualified research, it is irrelevant whether a resulting product ultimately is sold to a customer or used in the taxpayer’s business. This provision may have tremendous impact for all custom manufacturers. For instance, taxpayers may be able to include labor and supplies (materials) used in the construction of a novel, unique, one-of-a-kind pilot model (i.e., a mold or a prototype) if the design still is uncertain at the time of the tooling or prototype construction.
Documentation is key
Taxpayers claiming the credit must capture information necessary to prove that qualified research is taking place, while connecting the employees that perform qualified research to the activities themselves. Business documents that many taxpayers already prepare as part of the engineering or reporting systems are the best place to begin. Many times, these documents – including, but not limited to, drawings, iterative designs, sample results, pictures, notes, emails and meeting minutes – create nexus to the employees performing or supporting qualified research.
The R&D tax credit may provide a competitive edge to plastics decorators investing significant resources in the development or improvement of products or processes. Taxpayers who have not claimed the credit in the past should review prior years’ tax returns to determine whether amending previous US income tax returns is warranted. Taxpayers already claiming the credit should periodically review their credit methodology, documentation supporting the research expenditures and the underlying activities to ensure they are claiming the proper amount of R&D tax credit. This approach is prudent to ensure that taxpayers are in line with the IRS’ documentation requirements, recent court cases and ever-changing treasury regulations.
1. Generally, taxpayers may not offset the Alternative Minimum Tax (AMT) with their research credits. Rather, they may offset their regular income tax liabilities down to the tentative minimum tax. Exceptions apply, however, with the right facts and circumstances.
2. Depending upon whether the taxpayer claims the credit on its originally filed income tax return, the taxpayer may be required to reduce its research expenditures by the amount of the credit.