The credit for increasing research activities, commonly referred to as the research and development (R&D) credit, is one of the biggest and best tax breaks available to manufacturing companies. Unlike a deduction, a credit is a dollar-for-dollar reduction of a business’s tax liability. Plus, there’s no limit on the R&D credit amount for a particular tax year and excess credit can be carried back one year and forward up to 20 years.
Unfortunately, many manufacturers overlook this high-impact credit because they erroneously assume they don’t qualify for it. If this is your thought, a word of advice: Take a closer look. You may be able to claim a credit worth thousands of dollars.
How to Qualify
The federal R&D credit is available to businesses that increase their qualified research and development expenditures. It can be claimed by manufacturing companies that are developing new products and processes — including prototypes, software and patents — that meet certain objectives. This is not only a federal credit, as many individual states also offer tax benefits for R&D development.
Under current federal regulations, companies need to meet the following requirements:
- Research must be performed to create a new or improved business component resulting in a new or improved function, performance, reliability, or quality. A business component can be a product, process, software application, technique, formula, or invention relative to manufacturing.
- The business must demonstrate it has attempted to eliminate uncertainty about the development or improvement of a business component. Generally, there would be uncertainty if the available information doesn’t “establish the capability or method for developing or improving the product or the appropriate design of the product.”
- The company must show through models, simulation, trial-and-error, or other methods that it has evaluated alternatives for achieving the desired results. For instance, a manufacturer may demonstrate efforts to develop software that improves the functionality of the goods it produces.
- Finally, the research process must be “technological” in nature. This means it relies on sciences such as engineering, physics, chemistry, biology, or computer science.
Many manufacturers overlook the R&D credit due to four widespread misconceptions:
- You need a research department. You don’t need a formal research department or must be a “high-tech” business. Your company simply must satisfy the rules outlined above.
- You must have scientists and engineers on staff. Although employees with degrees and expertise in scientific research often make research easier to conduct, they aren’t necessary to qualify for the credit. Eligible R&D can be performed by employees or third-party contractors with nontraditional backgrounds.
- Start-ups don’t qualify. Due to recent legislation, new companies may apply up to $1.25 million of the R&D credit against payroll taxes over a five-year period (up to $250,000 a year). To be eligible, your company must have less than $5 million in gross receipts for the year the credit is claimed or zero gross receipts or interest income for any of the previous five years.
- The research must be “new.” Qualified research doesn’t have to be unique to the world or even to the industry so long as it’s new to your company.
Calculating the Amount
Generally, manufacturers are allowed to claim a credit equal to 20% of qualified R&D expenses over a base amount. For this purpose, the base amount is a fixed-base percentage (not to exceed 16%) of average annual receipts from a U.S. trade or business, net of returns and allowances, for the four years prior to the year of claiming the credit. The percentage can’t be less than 50% of a company’s annual qualified research expenses. Thus, the minimum credit is equal to 10% of qualified research expenses.
Sound complicated? It is. A “simplified credit” is available. It’s equal to 14% of the amount by which a company’s qualified research expenses for the year exceed 50% of its average qualified research expenses for the preceding three tax years. For example, if your business has an average of $100,000 in qualified expenses for the prior three-year period, 50% of that amount is $50,000. If you incur $125,000 in qualified expenses in 2021, the simplified credit for the year is 14% of $125,000 minus $50,000 — or $10,500.
Note that although some estimates are allowed, your company must be able to document its claims. Hold on to payroll records, general ledger entries. project lists and notes, laboratory results and emails.
Reporting the Credit
Prior to the 2021 tax year, businesses were simply able to report the calculation methods listed above on a form 6765, Credit for Increasing Research Activities, to claim the credit. As of January 10, 2022, the IRS is requiring much greater detail be provided. Form 6765 must now be accompanied by a written statement detailing the following:
- Listing of research activities performed
- Individuals who performed in each research activity
- All the information that each individual sought to discover
More changes?
Think the changes stopped there… well, you’re wrong! The way all research and development expenses are deducted, in accordance with IRC Section 174, will be changing starting in tax year 2022. Research and development expenses ordinarily deducted will now be required to be capitalized and amortized over a five-year period, if research is conducted in the United States, or a fifteen-year period, if research is conducted outside of the United States.
What does that mean for the R&D credit? Ultimately this change will not affect R&D credits. Do note though that a taxpayer’s research & development expense listed on their tax return is generally required to be reduced by any R&D credit claimed. Now that these expenses are required to be capitalized and amortized, if the credit claimed exceeds the amount allowed as a deduction in the given year, the excess is still claimed as a credit, but the taxpayer must reduce any amount set to increase the capitalized amount for that period. Luckily, taxpayers can always avoid this headache altogether by making an irrevocable election to reduce the research credit claimed by 21%, or the maximum corporate tax rate, of the total credit claimed, rather than reducing any research and development expenses listed on the tax return for that year.
Give Yourself Credit
For additional information or guidance related to this article, contact Courtney Venard at cvenard@vlcpa.com or 800.887.0437.
