Does your company qualify for an R&D tax credit?

Does your company spend time and resources in the development and/or improvement of a product, process, formula, technique, software or invention? If so, you should consider taking advantage of both federal and state research and experimentation tax credits.

Also known as the “R&D” or “research” tax credit, its purpose is to encourage innovation and provide a powerful incentive for businesses to continue to invest in people and technology. By tracking the expenditures associated with activities that meet a four-part test, your company may be able to achieve significant tax savings.

Evolution of the R & E Tax Credit

Although first enacted in the 1980’s, the R&E tax credit has evolved substantially since then, with significant changes and clarity coming from sources including the US Treasury Department, the judicial system, and Congress.  Many of these changes have been taxpayer friendly.

The biggest change occurred with the issuance of Treasury Decision (TD) 9104 in 2004.  Previously, a discovery test required the research to expand or refine knowledge within the industry. TD 9104 removed the discovery test language, effectively lowering the “innovation bar” to where it only had to be new to the company.

“Research” defined

“We don’t have scientists wearing white lab coats using beakers and test tubes.  Improving our products and processes is a normal part of our company culture.  How can this be research?”  When evaluating research activities as possibly qualifying for the tax credit, the U.S. Tax Code’s current requirements have a unique definition of research and experimentation.

The concept of experimentation is evidenced by a variety of everyday activities within various industries. For example, companies that develop and/or improve proprietary products, but outsource the manufacturing of these products, can claim the credit for the product development portion.  Conversely, many contract manufacturing and “job shop” companies do not design the products they produce, but use trial and error to develop or improve the process needed to meet their customers’ specifications on a part or component to be manufactured.

The ultimate success or failure of the project is not a requirement.  In fact, projects need not to have been awarded to your company. Therefore, projects that were lost in the bidding process may qualify for the research credit if they involve significant up-front design time.

Expenses that may qualify for the credit include in-house wages, supplies, as well those for contract research, which are costs incurred for third-party services that would have been qualified had they taken place within the company.

Four-part test

A four-part test must be satisfied for projects and activities to be eligible for the research credit.  

The first references the six project types – product, process, formula, technique, software, or invention.   

The second requirement requires the existence of uncertainty in one of three categories:

1. Capability (can we do it?)

2. Method (how do we do it?)

3. The appropriateness of the design (what will it look like?)

The third requirement is that the research must be technological in nature, fundamentally relying on the principals of the physical or biological sciences, engineering or computer science. 

The final requirement calls for the existence of a process of experimentation, which can include modeling, simulation, or a systematic process of trial and error. 

How much?

The net benefit of the federal R&E tax credit is approximately 6% of the qualified expenditures.  Therefore, for every $100,000 in qualified wages, supply costs, and contract research, the company (or its owners in the case of flow-through entities) receives approximately $6000 in dollar for dollar reduction in tax.  The gross Colorado credit is 3% of the qualifying expenditures.  There is a pre-certification requirement, with limitations on how much can be claimed in a single year.  These credits can be included on the originally filed tax return, and also can be captured by amending the returns still within statute (typically three years).  

Why now?

If your company has not taken advantage of the research credit in the past, now is a great time to review your activities to determine if you are eligible. There have been many changes with the R&E tax credit in the last year. If you have taken the credit in the past, you will want to make sure you are in compliance with all recent changes and that you are maximizing the credits available.