Sometimes the Internal Revenue Code (IRC) giveth more than it taketh. Section 41 of the code created a research and development tax credit designed to be your tax pal and reward you for improving your business within the United States. But he’s a complicated fella.
The Federal Research and Experimentation Tax Credit was added to the IRC in 1981 to incentivize companies to increase their research activities. It enables businesses to apply for a reduction of taxes for qualified expenditures related to virtually everything they do to modify and improve their products and processes.
Large corporations most often take advantage of this credit, but small- and medium-sized companies also are eligible. It is available to every type of entity, including an S or C corporation, limited liability company, partnership, etc.
One of the reasons section 41 is such a good tax friend is that he enables you, as a business owner, to get two tax advantages—a deduction and a credit—for a single expenditure. For example, say you spend $1,000 for wages on a
qualified R&D project. First, you get a $1,000 deduction, then you use the same $1,000 to make a calculation that gives you a credit that can be deducted dollar-for-dollar to reduce your income tax liability.
In addition, many states also have joined the tax-saving fun, awarding their own R&D credits toward state income taxes.
The R&D tax credit is not just for new inventions. In a nutshell, the credit can be taken advantage of by any company that develops, makes or improves products, software and/or processes—not just scientists or engineers in a lab who are inventing new things.
When you consider pursuing an R&D credit, you must assess two factors: 1) Do you conduct “qualifying activities/projects” and 2) What amount of “qualifying expenses” do you incur?
Your company is in a position to take advantage of the credit if you do any of the following:
• Develop/improve/test new concepts and/or technology
• Conduct certification testing
• Manufacture products
• Create new, improved or more reliable products, formulas or processes
• Create prototypes or models, including computer-generated models
• Automate, streamline or improve internal processes
• Develop or improve production, manufacturing processes, software or hardware
• Add or improve equipment
• Try using new materials
• Design new or improved tools, dies, molds or other devices.
If your company doesn’t undertake any of these activities in house, but you hire outside consultants or contractors to do any of the above, you are still eligible for the credit.
It’s quite a lengthy list of projects. If you have an R&D product development or design department, or provide engineering, design or testing services for your customers, qualifying activities are likely taking place within your business.
Once qualifying activities/projects have been identified, you must accumulate certain qualifying expenses to determine your R&D credit. Internal labor (i.e., salaries, wages, bonuses), costs of supplies consumed and third-party consultant/contractor expenses are the primary qualifying expenses. These expenses normally are incurred in many different areas of your business, not just in your R&D or engineering departments.
Of course, you must properly document any of these expenses in case of an IRS audit. It is essential to retain in an organized system such items as product and/or project specifications, descriptions or proposals; technical reports/test reports and results; patent applications and results; contractual agreements with consultants; and other documents that support your qualifying activities and expenses.
Maximizing Your R&D Credit
Naturally, you want to maximize your R&D credit, and you most likely will need professional help. Think of building a new plant or warehouse. You would not even think of doing so without hiring an experienced architect and general contractor. This tax incentive can benefit your company, but it also is complex. If you have been doing your R&D credit planning internally, you probably have been leaving money on the table.
The rewards of the R&D tax credit will be easy to recognize. The table below offers real examples of tax benefits realized by clients of Scott Schmidt, principal of the Black Line Group. Scott, considered a guru in the R&D tax credit area, provided most of the information for this article.
|Type of Business||Federal/State Credit -2011||Total Credit for All Years|