Research & Development (R&D) Tax Credits
R&D News Alert: The R&D tax credit has been extended through 2007. The 109th Congress passed H.R. 6111,The Tax Relief and Health Care Act of 2006, that included a retroactive extension of the R&D tax credit from January 1, 2006, through December 31, 2007. Also included is language to strengthen the credit with a new credit formula called the Alternative Simplified Credit that would be effective January 1, 2007 through December 31, 2007. The legislations was signed into law December 20, 2006 by President Bush.
Summary of the R&D Tax Credit
The legislation extending the R&D tax credit thru 2007 was passed by congress and signed it into law by President Bush on December 20th. The Bill provided a seamless extension of the R&D credit, which was retroactively restored to the beginning of 2006 along with some other popular tax incentives.
The new law extends the R&D credit to amounts paid and incurred in 2006 and 2007. For 2007, the new law also makes two enhancements that could make the credit more valuable for many businesses. The research credit is generally equal to 20% of the taxpayer’s “qualified research expenses” that exceed a base amount. However, a taxpayer may elect to take the alternative incremental research credit (AIRC). The AIRC uses a “stated percentage” of qualified expenses that exceed a taxpayer’s average research expenditures over four years.
Increase in stated percentage
The new law increases the “stated percentage” beginning in 2007. The amounts are:
2.65 percent (increasing to 3 percent in 2007) of qualified research expenses between 1 and 1.5 of average annual gross receipts.
3.2 percent (increasing to 4 percent in 2007) of qualified expenses between 1.5 and 2 percent of average annual gross receipts; and
3.75 percent (increasing to 5 percent in 2007) of qualified expenses exceeding 2 percent.
Taxpayers on a fiscal year will take into account the percentage that applies to each calendar year.
Alternative Simplified Credit
The new law also creates an Alternative Simplified Credit for 2007. Under the simplified method, the credit is 12 percent of the qualified research expenses that exceed 50 percent of the average qualified research expenses for the 3 preceding years. If the taxpayer has no qualified expenses in any one of the preceding 3 years, the credit is 6 percent of the current qualified research expenses.
R&D Tax Credit Frequently Asked Questions (FAQ)
- How Does the Alternative Simplified Credit Work? The alternative simplified credit equals 12 percent of the excess of current-year qualified research expenses ("QREs"), as defined under section 41(b), over 50 percent of the taxpayer's average QREs for the prior three years. For start-up taxpayers, the credit would equal 6 percent of current-year QREs.
The election could be made for taxable years ending after the date of enactment, and would apply to that taxable year and all subsequent taxable years unless revoked with the consent of the Secretary of Treasury. Taxpayers that have previously elected the AIRC could apply the new computational rules or to continue to calculate the credit under the AIRC rules.
- Who Would Benefit from the Alternative Simplified Credit? The credit would be utilized by many companies performing significant amounts of R&D in the United States that are unable to claim the regular credit because of changes in business models and economic circumstances. For example, many taxpayers are no longer able to qualify for the regular credit because their R&D spending relative to gross receipts has not kept pace with the ratio set in the "base period" that governs eligibility for the regular credit. This can happen, for example, where a company's sales increase significantly in the intervening years, where a company enters into an additional line of business that generates additional gross receipts but performs little R&D, or where a company spends less to perform the same amount of R&D because it becomes more efficient in its R&D processes.
A wide variety of industries would utilize the alternative simplified credit, including the automotive industry, chemical manufacturers, aerospace and defense companies, telecommunications, and information technology companies, among others.
- Why is More than One Credit Mechanism Needed? For many companies, the regular credit is operating to provide a strong incentive to increase R&D activities in the United States. For others, a new credit calculation is necessary to account for different business structures and changing economic circumstances. A "one-size-fits-all" approach would have the effect of discouraging continued U.S. R&D investment by some companies and industries.
- Does the Alternative Simplified Credit Provide an Incentive to Increase U.S. R&D Spending? Yes. The credit will provide a higher effective credit rate for taxpayers increasing R&D spending from year to year.
- How Will the Alternative Simplified Credit Improve U.S. R&D Incentives Relative to Those of Our Trading Partners? The United States is engaged in a global battle to attract R&D investment. Canada, France, the Netherlands, Australia, Japan, and the United Kingdom are among the countries that offer richer incentives for R&D investment than the United States. Canada, for example, provides a 20-percent flat credit for R&D spending (including not only wages but also capital expenditures) in Canada.
The alternative simplified credit will provide a meaningful incentive for many companies to perform R&D activities in the United States as opposed to other countries that provide more substantial incentives for such activities. Increased R&D activities in the United States will have a positive impact on U.S. jobs. Maintaining U.S. technology ownership also will foster U.S. competitiveness and strategic interests.
Research Credit Claiming Criteria: The "Four-Part Test"
The R&D Credit has been part of the Internal Revenue Code since 1981; however, a large number of companies have not taken advantage of this provision. In the past, the rules were very confusing. It was hard to determine who qualified, let alone which products or processes might qualify. While the rules are still complex, a company may be able to claim the credit providing that they are conducting research in the US, and if they meet the four following criteria:
Four Part R&D Tax Credit Test: - Permitted Purpose: The activity must result in a new or improved process, function, product, performance, reliability, quality, or significant reduction in cost. Probably the most common type of activity overlooked by companies regarding these specific criteria involves significant improvements made to production-line operations. A very common example of this sort of improvement would be the updating of production-line capabilities by a manufacturer that ultimately improved efficiency, increased production capacity, and eventually yielded an overall reduction in costs. An example of this type of activity would be a company that manufactures heavy equipment, and relied upon a labor-intensive approach to production. If that company were to implement improvements in its manufacturing process, by way of automation or some other means that required investment in new equipment for the plant floor, then it’s very possible that the costs associated with the implementation of the new production process could be eligible for the R&D tax credit.
- Elimination of Uncertainty: Were the activities conducted and intended to eliminate uncertainty concerning the development or improvement of a product? This criterion specifically involves the identification of information that is uncertain at the onset of the project or activity. Such uncertainty can relate to the capability of the product, the method used to produce it, or the appropriate design of the product. The examples that we typically encounter when consulting with clients in this arena deal with issues such as: Will the new or improved manufacturing process integrate with our current system, on any level? Will our new product development meet the customer specifications? Will the potential benefits outweigh the potential risks? Or will the new or improved product or activity even work?
- Technical in Nature: Does the research fundamentally rely on the principals of, engineering, physical or biological science, or computer science? This criterion is usually a fairly easy one to deal with. What it really does is eliminate the soft sciences from the formal definition of technology. In other words, products or activities that are predicated upon literary, historical or social sciences do not qualify for the R&D Tax Credit. In all of our experiences, this technology criterion has never been an issue when performing an R&D study for a manufacturing company.
- Process of Experimentation: Does the activity involve developing one or more hypotheses for specific design decisions, testing and analyzing those hypotheses, and refining and discarding the hypotheses? A key factor regarding the Process of Experimentation hurdle was recently crystallized, when Treasury Regulations changed the wording to evaluation of one or more alternatives. Previous language defined the process as evaluation of more than one alternative.
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Costs that Qualify for the R&D Credit
Generally, the credit will be 20% (13% net) of qualifying expenditures that exceed a base amount. So, as you can ascertain, the potential for R&D Credits to be large amounts is very reasonable. In fact, it is not uncommon for R&D Credits to be in excess of $100,000 per year. The base-amount calculation is probably one of the more challenging calculations of the entire project. You must be aware that if the company was conducting qualified research, and had qualified expenses and gross receipts from the period 1984 through 1988, then the more complicated calculation in developing a base period amount will result in significantly more R&D Credits than the short-cut technique, Alternative Incremental Research Credit Method. Conversely, if the company did not conduct qualified research until after 1989, then they are deemed to be a startup company, and must calculate their base period amount using the Start-Up Method.
The first step is to determine whether the expenditures fall under the R&D Credit definitions. This determination needs to be made by a qualified, experienced team of accountants and tax experts. If the initial assessment shows potential savings, a complete assessment is conducted. This assessment process normally involves site visits and interviews with financial personnel, product developers, engineers, and IT staff. The process ultimately results in the production of an encompassing R&D Credit Study Report that’s delivered to the company. It captures the information connected to the various qualifying projects.
- All W-2 wages for employees engaged in qualified research activities. This number includes the wages of personnel directly involved in, supervising or supporting research and development efforts. If an individual spends 80% or more of their time working in the R&D area, then 100% of their wages are counted when calculating the R&D credit. If the percentage of time spent is less than 80%, then the actual percentage of time the individual spends in the R&D area is multiplied by his or her salary and allocated.
- Non-capitalizable materials and supplies. Things that don't qualify for the R&D tax credit are things such as capitalizable assets. If a company purchases equipment and depreciates the equipment (which is done almost 100% of the time), then the cost of the equipment does not qualify for the credit computation.
- Fully 65% of costs of contracted research,
(or 75% of contract research performed by a qualified research group; i.e., a University or consortium).
The rules for software development are still somewhat complicated, but one recent clarification states that if customized software is developed for sale or lease (not for internal purposes), then it is not subject to the extra hurdles of the High Threshold of Innovation Test. If a company develops internal use software, however, it may still qualify for the R&D Credit, providing that:
- The software is innovative;
- The development involved significant economic risk, and
- A similar product is not commercially available.
If the above three criteria are met, then the cost of developing software for internal use may qualify for the R&D Credit.
If any R&D Credits are discovered involving expenditures during the previous three years, you may amend the tax returns of the company or individuals in the case of flow-through entities.
R&D Case Study #1: Elimination of Uncertainty
R&D Case Study #2: Improving Manufacturing Processes
It’s important to note that if your company is considering a R&D tax credit study, one of the previous items in the Treasury Regulations has been changed. Previous law stated that contemporaneous documentation had to be taken at the time the R&D work was performed. Finalization of the regulations has cleared up this issue, however, by eliminating the contemporaneous documentation requirement.
Listen to our R&D Tax Credit Radio Commercial: 
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R&D Tax Credit Contacts:
Freed Maxick & Battaglia, CPAs is Western New York's largest public accounting firm and a Top 100 Public Accounting Firm in the U.S. With over 200 professional and administrative staff, Freed Maxick has the resources to work with companies nationwide to claim the R&D Tax Credit. Richard Wright, CPA is responsible for managing the firm’s research & development tax credits service area. He assists manufacturing, technology and software companies in New York and nationally to successfully reduce their tax liabilities by uncovering R&D credits. Mr. Wright has had articles published nationally on R&D tax credits in Manufacturing & Engineering Magazine, the publication of the Society of Manufacturing Engineers (SME) and Leading Edge Magazine, the Magazine of the Leading Edge Alliance, which is a peer group organization of over 50 progressive public accounting firms in the U.S. Additionally he is a member of the American Institute of Certified Public Accountants (AICPA) and the New York State Society of Certified Public Accountants (NYSSCPA). To see if your company qualifies,
Contact us Via the Web or Toll Free: 1-800-777-4885
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| Richard Wright, Jr., CPA | Sean Govern, CPA |
