As a result of the current state of the economy, companies of all sizes are trying to operate more efficiently and manage cash flow more closely. A provision in the Internal Revenue Code that offers the potential for significant tax savings, and therefore increased cash flow, for manufacturing companies is the Research & Development (R&D) tax credit. However, many manufacturers are still unaware of this benefit, are unfamiliar with how this tax incentive may apply to them or realize that manufacturing companies are excellent candidates for these powerful tax credits.
What are R&D Tax Credits?
The R&D tax credit provides a dollar-for-dollar reduction in tax liability. For manufacturing companies, this means significant cash retained in the business by claiming the credits on originally filed tax returns to instantly reduce taxes, or by amending prior-year tax returns for cash refunds within three years of the original tax filing.
The federal R&D tax credit is based on "qualified" activities undertaken by a company each tax year. There are no requirements to be in a certain industry. The primary requirement for activities to qualify is that they be consistent with the purpose of the incentives: to promote design and development activities within the United States and the subsequent hiring and retention of technical staff to accomplish these tasks.
Expanded Opportunity
Recent changes to the R&D tax credit have expanded the opportunity for more manufacturing companies to qualify for the credit. Prior to 2004, the R&D tax credit was only available to companies that discovered information that was new to the world. This discovery test was eliminated in 2003, and now the information discovered only needs to be new to the taxpayer.
To stay competitive in the marketplace, many manufacturers have changed their existing processes or developed new ones to increase productivity or enable them to produce new or improved products. Therefore, the activities that many manufacturers perform on a day to day basis now qualify for the credit. These activities include, but are not limited to:
- developing a new product or formula
- developing prototypes
- designing tools, molds and dies
- testing new technology
- testing new materials
- developing new or improved manufacturing processes
- developing software
Once it has been determined that a company is performing qualifying R&D tax credit activities, certain costs related to those activities must be identified and allocated to the qualifying R&D tax credit activities. The three areas of qualifying expenses include salaries and wages, supply costs and contract research expenses. The R&D tax credit is based upon a percentage of the qualifying expenses, therefore the larger the allocation of these expenses to qualifying R&D activities, the larger the amount of the credit.
Two other recent law changes that have increased potential utilization of the R&D tax credit include the option to elect the alternative simplified credit calculation and the availability to use the R&D tax credit to offset Alternative Minimum Tax (AMT) for eligible small businesses.
The Alternative Simplified Credit Calculation
Under the regular method for calculating the R&D tax credit, a base period amount needs to be determined to measure the current year's qualifying expenses against. For companies in existence since 1984, this base period is from 1984-1988. However, obtaining information for that time period can be difficult, if not impossible. The Alternative Simplified Credit allows a company to compare the current year's qualified R&D tax credit expenses against the prior three years, thus eliminating the need to gather and document information from 25 years ago.
Offset of AMT for Eligible Small Businesses
In the past, one limitation of the R&D tax credit was the fact that the credit could not be used to offset AMT; however, this changed in 2010 and an eligible small business can now use the R&D tax credit to offset AMT. An eligible small business is defined as a corporation whose stock is not publicly traded, a partnership or sole proprietor and whose average annual gross receipts for the three-year period preceding the tax year do not exceed $50 million.
R&D tax credit claims are extremely complex and are generated using the unique facts and circumstances of each company. In order to maximize available credits, it is recommended that companies seek the assistance of knowledgeable specialists who have technical, tax and legal expertise in this area.
