In general, manufacturing companies are great candidates for the various tax credits the Internal Revenue Service (IRS) offers. One of the most popular is the Research and Development (R&D) Tax Credit. This credit can be utilized to reduce tax liabilities, increase cash flow, and add value to profit. Companies that choose to instill these various activities receive a dollar-for-dollar cash savings each year.
RESEARCH AND DEVELOPMENT (R&D) TAX CREDIT
The R&D tax credit was first released in 1981.
It was initially set up to incentivize companies to increase their investment in developing new or improved products or processes. Many of the rules were written expressly for businesses engaged in manufacturing. The IRS incentivized research and development activities because they are essential for the growth of the economy.
A major issue with the R&D tax credit is that many manufacturers either miss a potential savings opportunity altogether or do not utilize a maximum credit due to under allocation of qualified costs. Many business owners are under the impression that R&D activities are performed by technicians in a lab creating new, state-of-the-art products. R&D can exist in many different industries. This article will walk through the logistics of how the credit works and provide opportunities for manufacturing companies operating in the industry today.
WHAT EXPENSES QUALIFY?
- Wages for qualified services, employees paid to/for:
- perform qualified activities
- direct support of qualified activities
- direct supervision of qualified activities
- Supplies used for R&D purposes:
- Can be costs incurred to produce a “pilot model” or a prototype. The “ultimate success, failure, sale, or use of the product is not relevant” to the ability to take the credit. The only requirement in this case is that sufficient uncertainty must exist concerning the prototype’s technical feasibility.
- Qualified supply costs can be claimed for a prototype irrespective of whether it is scrapped or sold to a customer. These supply costs may be used in conjunction with labor used to develop the prototype.
- Tooling and fixturing are a specific type of supplies. They can represent enormous upfront costs when scaling up for production. Creating a new process alone can call for numerous trial-runs and technical challenges. Manufacturers will generally incur tooling costs for specific items and end up retaining the cost even after the order is complete.
- Research expenses paid to a third party:
- Contractors paid to perform R&D activities.
- Research payments to qualified education institutions and various scientific research organizations.
HOW TO DOCUMENT THESE EXPENSES
Documentation is critical with the R&D tax credit. Estimating costs is permitted but providing support to quantify the value of costs incurred is the best approach. Companies eligible for the credit that do not already have a record-keeping system for qualifying expenses may want to consider implementing a plan.
If a tax credit is questioned by the IRS. they will want to see why each cost qualifies for the credit. Standard documents include conceptual designs, design drawings and revisions, prototype results, invoices paid, and emails.
Based on the level of R&D activities, it may be suggested to use an outside organization to determine the costs described above. Professionals in these organizations are fluent in the IRS regulations regarding these issues and can identify eligible costs. They will not keep documentation for their analysis but will identify any opportunities.
WHAT ACTIVITIES QUALIFY?
To qualify for R&D tax credits, an activity must first meet the four-part test set forth by the IRS. Those include:
- The purpose of your R&D must be to create a new product or process, or you must be trying to improve existing ones.
- R&D must use hard sciences.
- You must show that you have attempted to eliminate uncertainty in the development.
- You must also show that you have evaluated other methods for achieving your new product or process.
Some common activities that a manufacturing company will participate in are:
- Developing new products
- Designing tools, molds, and dyes
- Developing models and prototypes
- Developing new processes and technology
- Improving existing processes and products
- Implementing the use of automation to produce more efficient manufacturing processes
- Developing new ways that reduce time for processes and products
HOW MUCH MONEY CAN I SAVE UTILIZING THIS CREDIT?
In general, a company will want to utilize the R&D credit if the savings are from $10,000 to $1 million. The credit size will be based mainly on the size of operations in the company and eligible expenses. The amount of revenue the business generates is not relevant to the amount of credits available. An average percentage of credits available to a company is about 10 percent of the total eligible R&D costs.
HOW DO I TAKE ADVANTAGE OF THIS CREDIT?
Manufacturing companies of all sizes are eligible for the R&D tax credit. The first step is to analyze the types of projects your company is working on to identify eligible activities. Smith Schafer works with R&D tax credit specialists that conduct a study to determine savings. While you may be tempted to calculate the credit on your own, there is expertise required to identify and collect the correct information. An expert will most likely obtain a more considerable tax credit than if you would try to claim this on your own. Also, claiming it incorrectly may result in the loss of credit and possible penalties from the IRS.
Note: If a tax credit specialist prepares an R&D tax credit study, they will provide you with a copy of the Form 6765 to be filed with your tax return. Based on state regulations, your manufacturing company may also be eligible to receive credits at the state level. R&D tax credits are available to be taken on amended tax returns going back three previous tax years.
QUESTIONS ABOUT R&D TAX CREDIT?
We are here to help. Smith Schafer can examine your company’s activities and determine which areas are eligible for the R&D tax credit. We work with approximately 100 Minnesota manufacturing companies to help them grow with accounting, tax, and consulting solutions. Contact us today to schedule a consultation with one of our industry experts.