Odds are you’ve heard about it, wondered if your company could take advantage of it, and worried that your competitors are already benefiting from it: the R&D tax credit. A tax incentive offered by the federal government and some states to promote innovation. It allows businesses to receive tax credits for expenses incurred for research and development to create a new product, advance product design or improve production processes. The result is a lowered tax obligation, which translates to increased funds for future innovation.
In other words, it may offer a competitive advantage for the privately held businesses who qualify for it. Is your company one of them?
Part of the federal tax code for more than 70 years, the R&D tax credit became more robustly enacted in 1981 and broadened in 2003. The current guidance indicates that qualified activities no longer need to result in new technological knowledge: They only need to involve the use of technological principles to develop new or improved products or processes. More companies than ever are weighing their ability to claim these credits.
Middle market businesses are gaining particular interest in exploring this incentive since the alternative simplified credit process went into effect in 2007, easing the method of calculating the credit due to them. But the regular credit calculation, a more complex process than the ASC, has the potential to result in a greater credit for the right company. Engaging in an R&D tax credit study is generally the first step taken to explore either option.
Do your research expenses qualify? If your business has engaged in any of the following endeavors, take seriously the R&D tax credit opportunity that the federal code offers. Qualified expenses include wages, supplies and contract research that support:
- Development of new or improved products
- Creation of software applications
- Advancement of your manufacturing process
- Engineering and design of fabrication and/or production equipment
However, the government is certainly not handing these credits out on a silver platter. They have purposely set the bar high. To be claimed, the R&D activities you have funded must pass the following four qualifications with an affirmative answer:
- Are they related to your business component’s new or improved function, performance, reliability or quality?
- Are they meant to eliminate uncertainty? Specifically, are you seeking clarity regarding the capability or method by which you develop or improve a product or process? Are you testing the appropriateness of the product design?
- Are they part of a process of experimentation that includes the evaluation of alternative; the confirmation of hypothesis through trial and error, testing and/ or modeling; and the refinement or elimination of the hypothesis?
- Do they rely on the principles of physical science, biological science, computer science or engineering?
If the above standard can be met, then documentation of your qualifying activity is of primary importance, because it will be needed for your credit application. Keep diagrams, spreadsheets and all notations of experimentation. Your reporting should include the time of any employee actively involved in research and development, down to the project they are working on and when they work on it. As you document your initial activities, simultaneously establish internal procedures that track, record and verify all future qualifying expenses so you can validate future credits.
The R&D tax credit certainly isn’t simple to claim, and it can’t be garnered by every business. But companies in a variety of industries have found that the benefits of tracking the credit study, and the subsequent application process, far outweigh the costs and complication.
Private businesses, in particular, should note the added value that the R&D tax credit can offer during mergers and acquisitions. The credits can be claimed in 1 year and taken in another, making it possible to transfer them to a buyer. They also offer validation of a company’s ability to innovate. Some companies claim the R&D credit annually for the specific purpose of enticing a mergers and acquisitions opportunity. They believe it shows potential buyers or investors that they have an attractive and valuable technology.
The article is reprinted with permission from The Goering Center at the University of Cincinnati Lindner College of Business.