An Introduction to R&D Tax Credits
Many industries and US-based companies can take advantage of tax credits for activities relevant to research and development, or R&D. In 2015, the Protecting America from Tax Hikes Act (PATH) expanded and made permanent federal R&D tax credits. Today, more companies than ever before can use these credits to lower their tax liability.
While most CPA firms are aware of R&D tax credits, they don’t have the expertise or employee bandwidth to help their clients obtain these credits. In most cases, it is more cost-efficient for CPA firms to outsource tax credit studies to a knowledgeable expert.
R&D tax credits give you an excellent opportunity to offer additional, valuable services for your clients. CPAs who understand how to qualify and obtain R&D tax credits can help their clients get the max ROI while maintaining IRS compliance.
Partnering with an R&D expert means you can offer this additional service while protecting your staff from engaging in labor-intensive documentation required to obtain the credits. This guide will give you step-by-step instructions on expanding your firm’s offerings with R&D tax credits.
Our guide covers:
- R&D Tax Credit at a Glance
- History of R&D Tax Credits
- Who Qualifies for the R&D Tax Credit?
- What Qualifies as a Qualified Research Activity?
- What are Qualified Research Expenses (QRE)?
- Exclusions With Qualifying Follow-up Questions
- Building a Business with R&D Tax Credits
- Working with an R&D Tax Credit Expert
- How Can Cunningham and Associates Help
The R&D Tax Credit at a Glance
Only 1 in 20 eligible companies take advantage of R&D Tax Credits. With the broadened definition of R&D, more companies are eligible than ever before. Additionally, now that R&D offsets AMT there are no longer the limitations we have faced in the past.
What is the R&D Tax Credit?
R&D Tax Credits are a Federal (and many states) tax incentive put in place to promote domestic innovation and production. This tax incentive provides many organizations with an additional dollar-for-dollar tax deduction for innovation, process improvement, and the adoption of new business components.
Common Qualifying Activities
- New Product Development
- Process Improvement
- New Software Implementation
- Outside Services / Consultant
- Custom Tooling
- Bringing on New Business Component
- Product Customization
- Monetizing the R&D Credit is streamlined so any qualifying business can now take advantage.
- $1.5MM- $3.0MM Annual Revenue – Explore
- $3.0MM – $8.0MM Annual Revenue – Most Likely
- $8.0MM + Annual Revenue – Highly Likely
Common Qualifying Expenses
- Wages and Self-Employment Earnings
- 65% of Subcontracted Expenses
- Supplies – Non-depreciable Property
Timing, Cost & ROI
- The total project timeline is 4-10 weeks, depending on scope.
- Typical costs are usually less than one year’s credit.
- The first year the taxpayer can apply the study to all open tax years. Initial 60-day return on investment is often 3:1 – 20:1+, plus long-term returns.
- Quarterly / annual services are recommended for contemporaneous documentation requirements.
History of the R&D Tax Credit
The R&D tax credit (known previously as Research and Experimentation or R&E) was instituted in 1981 as part of the Economic Recovery Tax Act. The credit was created as an incentive for US companies to maintain their technological competitiveness. However, due to extremely strict requirements and the high threshold of innovation only large corporations were able to utilize the credit (Guenther 2005).
In 2001, President Bush and his administration reviewed the utilization of the credit and discovered that small and mid-size companies were not taking advantage of the credit. This prompted a change in the regulations that removed the high threshold of innovation and allowed the threshold of innovation to be relative to the individual company and not the industry (Rivera 2011).
In 2008, Congress passed The Emergency Economic Stabilization Act of 2008, which retroactively extended the credit and increased the Alternative Simplified Credit rate to 14 percent. In 2010, President Obama signed into law the Small Business Jobs Act of 2010, which eliminated the 2010 AMT restrictions on sole proprietorships, partnerships and non-publicly traded corporations with $50 million or less in average annual gross receipts for the prior three years (Titan Armor 2010)
On December 18th of 2015, President Obama signed into law a sweeping $1.14 trillion-dollar funding bill that kept the federal government operating through September 30th of 2016. In connection to the tax aspects of this comprehensive and pivotal legislation, the Protecting Americans from Tax Hikes Act of 2015 (hereinafter the “PATH Act”) accomplished considerably more than the typical tax-extenders legislation passed in previous years and truly signifies a dynamic paradigm shift as the PATH Act makes permanent over twenty leading tax incentives while extending other tax incentives over either a five-year period of a two-year period.
In particular, the PATH Act meaningfully enhanced the R&D Tax Credit Program (hereinafter “RTC program”) on a myriad of levels. As an overview, the RTC program was initially added to the U.S. Internal Revenue Code (hereinafter the “Code”) in 1981 through the Economic Recovery Act of 1981 as a temporary provision of the Code. The RTC program had most recently expired on December 31, 2014. A tremendous paradigm shift to the RTC program was made possible through the PATH Act,
which not only renewed the RTC retroactively for all calendar year 2015 but most importantly made the RTC program permanent. In addition, the enhanced RTC program has been considerably restructured to:
- Allow eligible small businesses (i.e., $50 million or less in gross receipts) to claim the credit against the Alternative Minimum Tax (hereinafter “AMT”) for tax years beginning after December 31, 2015;
- Allow eligible startup companies (i.e., those with less than $5 million in gross receipts and earning revenue for less than 5 years) to claim up to $250,000 of the credit against the company’s federal payroll tax for years beginning after December 31, 2015; and
- Allow Alternative Simplified Credit (hereinafter “ASC”) filers an increase from 14% to 20% in benefit.
On December 22, 2017, the Tax Cuts and Jobs Act was signed into law by President Trump. The Research & Development tax credit survived this major reform and was identified as a priority tax credit by the administration. Taxpayers now are able to take a long-term view when evaluating annual R&D Credit benefits.
Who Qualifies for the R&D Tax Credit?
Your client’s employees do not have to wear lab coats and run a microscope to qualify for the credit. Despite its name, research and development as it applies to the tax credit covers a broad range of activities.
Any business that conducts activities that develops or improves:
Can qualify for the research tax credit. Engaging in these activities must require some level of technical experimentation to determine improvements or appropriate designs and creations to qualify.
The business type or the industry doesn’t exclude an enterprise from obtaining the credit. But the nature of the activities may mean some businesses are more qualified for the credit than others.
What Qualifies as a Qualified Research Activity?
There is a common misconception in the market about what activities qualify for the R&D Tax Credit. We often say the activities don’t need to be revolutionary to the industry, just evolutionary to the business.
The IRS utilizes a “Four-Part Test” to define qualified research activities.
Part I: Permitted Purpose
The activity must relate to new or improved business components in one or more of the following areas:
The term “business component” means any product, process, computer software, technique, formula, or invention, which is to be held for sale, lease, or license, or used by the taxpayer in a trade or business of the taxpayer.
SPECIAL RULE FOR PRODUCTION PROCESSES
Any plant process, machinery, or technique for commercial production of a business component shall be treated as a separate business component (and not as part of the business component being produced).
Part II: Technological in Nature
The activity performed must fundamentally rely on the principles of:
- Physical science
- Biological science
- Computer science
Part III: Sense of Uncertainty
The activity must be intended to discover information to eliminate uncertainty concerning the capability or method for developing or improving a product or process, or the appropriateness of the product design.
Part IV: Process of Experimentation
Substantially all the activities must be elements of a process of experimentation involving:
- Evaluation of alternatives
- Confirmation of hypothesis through trial and error
- Testing and/or modeling
- Refining or discarding of hypotheses
Qualified Activities Examples
This list isn’t exhaustive. But the following activities can qualify an organization for the R&D tax credit:
- Inventing or designing a product to market
- Optimizing an existing products functionality, reliability, quality, or performance
- Evaluating alternatives to existing processes and products
- Testing different product prototypes
- Researching solutions for reducing time-to-market for a product
- Developing a manufacturing process to mass-produce something
- Improving an existing manufacturing process, partially or totally, to improve automation, efficiency, or throughput, or to reduce cost, waste, bottlenecks, etc.
- Developing or improving a technical process such as engineering or drilling
- Developing software to sell, lease or license
- Developing software to facilitate a service or to bridge or interface between outside parties (B2B or B2C) or internally within different channels
- Developing and experimenting with formulations
- Improving existing techniques
- Developing something patentable
- Hiring outside consultants to conduct any of these listed activities
What are Qualified Research Expenses (QRE)?
Qualified Research Expenses are outlined under IRC §41(b)(1) as amounts paid or incurred by the taxpayer during the taxable year in carrying on a trade or business relating to: (1) in-house research and (2) contract research.
In-house research is the sum of all amounts paid or incurred for wages, supplies, and amounts paid or incurred to another person for the right to use computers to conduct qualified research.
Any wages paid or incurred to an employee in the performance of qualified research activities can be included in the credit computation. The term “wages” generally holds the same meaning as provided under IRC §3401 (base wages, direct bonuses, non-qualified stock options, etc.). If an employee performs both qualified and non-qualified activities, only the qualified wages will be considered.
The appropriate method of apportioning wages to the qualified activities is multiplying an employee’s total wages for the year by a fraction, with the numerator consisting of the annual qualified activity hours and the denominator representing total annual hours worked in all activities.
If the above apportionment calculation shows that the employee’s qualifying percentage is at least 80%, then all of the employee’s wages for the year will qualify for the credit computation.
Qualifying services, which are required in determining wage payments available for the credit include the services engaged in qualifying research, direct supervision of qualified research activities, and direct support of qualified research activities.
Supplies are defined as any tangible personal property (other than land, improvements, or property subject to the allowance for depreciation) directly used in the performance of qualified research.
Any contract research paid or incurred by the taxpayer to another person, excluding employees of the taxpayer, to perform qualified research for the taxpayer qualifies for the credit. 65% of contract research expenses are considered QRE.
The summation of qualified wages, supplies, and contract expenses is referred to as total “qualified research expenditures” or “QRE”.
Exclusions with Qualifying Follow-up Questions
Certain activities, which appear to meet the above requirements, may still be statutorily excluded from qualified research. Following are the statutory exclusions. If the answers to any of these exclusions are yes, then the activities do not qualify (IRS 2008).
Research after commercial production – “Was any research conducted after the beginning of commercial production of the business component?”
Adaptation of existing components – “Was any research related to the adaptation of any existing business component to a particular customer requirement or need?”
Duplication of existing business components – “Was any research related to the production of an existing business component (in whole or in part) from the physical examination of the business component itself or from plans, blueprints, detailed specifications, or publicly available information with respect to such a business component?”
Surveys, studies etc. – “Was research related to any efficiency survey, activity relating to management technique, market research, testing, or development (including advertising and promotions)?”
Computer Software – Computer software developed by or for the company primarily for internal use will only qualify if (a) the computer software is created for use in an activity, which constitutes qualified research, (b) the computer software is created for use in a production process, or (c) the computer software meets three specific internal use software tests. In order to meet the three specific internal use software tests, the software must be innovative, created at significant economic risk and not commercially available. Traditionally this excludes off-the-shelf software costs.
Foreign research – “Was any research conducted outside the United States?”
Social Sciences, etc. – “Was there any research in the social sciences, arts, or humanities?”
Funded research – “Was any research to the extent funded by any grant, contract, or otherwise by another person?”
Building a Business with R&D Tax Credits
When you own or manage a CPA and business advisory firm, you offer services intended to help your customers lower their tax burdens and grow their businesses. R&D tax credits offer a unique opportunity that can help grow your business while continuing to provide those primary benefits to your clients.
When your customers can get credit for activities they’re already engaging in, they can take those dollars saved on taxes and invest them back into their companies. If you’re the one who helps them obtain these increased tax-savings, you’re going to build more trust with your clients, increase your referrals, and get new customers in the door.
R&D tax credit studies can make a major difference in your firm’s growth and in your clients’ profitability too. By offering additional R&D tax credit services, your firm can identify other avenues for generating non-traditional revenue.
Among CPA firms, there’s increased competition to offer R&D tax credit services. You want to get in on the ground floor while the opportunity is still relatively new. By offering these services now, you sharpen your competitive edge and can give your clients alternative saving methods they may not have heard of before.
Also, if you offer services that people don’t get from their current CPA, you can attract new prospects, convert them into full-service clients, and grow your firm’s customer base.
Working with an R&D Tax Credit Expert
Unfortunately, we see way too many firms offering internal R&D tax credit services when they don’t have the knowledge and expertise required to apply for them correctly. As a result, they’re unable to help their clients because they quickly realize that obtaining R&D tax credits requires much more experience and nuance than they’d initially thought.
That’s why we highly recommend that CPA firms partner with an expert to manage R&D tax credit studies for their customers.
R&D Credit Management Services
First Class Service for Less
Cunningham & Associates
Percentage based fee arrangements, which may be excessive and may skirt IRS laws governing practitioners.
We are a fixed fee firm. We get paid based on deliverables, which saves our clients 25%-60%+ in overall costs.
Many studies we review are based on the same boilerplate language and allocations.
While you may not be a unicorn, your company is different! Those unique attributes typically help us increase your credit by 10%-35%.
Most national firms require 9-10+ months before providing year-end documentation. Many times, this delays filing or forces practitioners to amend tax returns.
Because we actively manage our clients, our average tax documentation timeline is 3-months. This helps clients and practitioners plan and file timely.
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You are a small fish in a large ocean. Many larger firms view your account as merely a name on an invoice.
100% of our accounts are assigned a Partner for management and review. We work closely with our clients to save you time and streamline communication.
How Can Cunningham and Associates Help CPAs with Determining R&D Tax Credit Eligibility and Filing?
At Cunningham and Associates, we offer our CPA partners an unparalleled combination of R&D tax credit expertise and resources. As such, we make it easy for you and your clients to obtain these tax credits with a streamlined, predictable, and reliable service you can count on.
We’ll collaborate with you throughout the entire process and strategize with you for the most effective ways to take advantage of the R&D tax credit scheme.
In addition, we also maintain close ties with federal, state, and local government agencies. This enables us to keep our thumb on the pulse of any changes in legislation and compliance requirements as they happen. The information we provide is accurate and current.
We also provide ongoing audit support, and we’ll defend the credits under IRS or state tax authority audits.
Are you ready to grow your firm, make your company more competitive, and help your clients save even more money on their taxes? Reach out to us today at (508) 687-6329 for a free consultation and let’s partner up.
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