How to Take Advantage of the R&D Tax Credit
Trying to build a better mousetrap, or better yet, develop a way to snuff out bedbugs? There just may be a tax incentive in the offing that can help you pay for the work.
Momentum is building in Congress behind the idea of extending, and perhaps making permanent, a tax benefit called the Research and Experimentation Tax Credit, or, more colloquially, the R&D tax credit.
First enacted in 1981, the R&D credit in past years has allowed companies that perform technological research a break on the costs of researchers' wages, their supplies, as well as 65 percent of the cost of paying outside contractors, as long as all the work is performed in the United States.
Though the credit has expired, that shouldn't be especially alarming to businesses: It's expired 14 times, and been extended 13 times, often retroactively, over its almost 30-year history. And, like other presidents before him, President Obama has talked about expanding the benefits of the credit -- and even making it permanent.
Though nothing is certain on Capitol Hill (especially this year) experts say it's likely the credit will be extended at least temporarily, given its bipartisan popularity and pro-job appeal. As such, now is a good time for companies, especially those who may not have taken advantage of the credit before, to determine whether they could qualify. In fact, no matter what happens on the federal level, companies should keep in mind that many states offer similar research and development tax credits.
Assess Your Research Activities
The first order of business when trying to figure out if your business qualifies for the R&D credit is to scrutinize the kind of work your company does. Even if you're the smallest of firms, you may still get the credit, as long as the research you do is technological in nature and involves experimentation to develop new or improved products or processes.
'You don't need to be splitting the atom for the first time. If you have a product that has improved performance criteria, then that would be OK,' says Anthony Mondoro, a partner at accounting firm Ernst & Young, who works with clients on federal tax planning. 'The IRS is not looking only for revolutionary, they're looking for evolutionary.'
Count Up Your Costs
The second piece of the puzzle is to see how much you're spending on those qualifying processes and if it measures up to the IRS's criteria. There are two methods for calculating this, both designed to encourage companies to spend more on research and development over time in order to help the U.S. keep pace with other countries' innovations.
The older method of calculation is more complicated, and it involves looking at expenses over a historical period (1984 – 1988), taken as a percentage of revenue, and comparing that to your revenues and how much you're spending now.
There's also a simpler method, aptly known the Alternative Simple Credit, which involves averaging the last three years of R&D costs, halving it to get a base amount, and then taking the tax credit on how much more was spent on research and development over and above that base amount.
The older, more complicated method has a higher rate for the credit – 20 percent -- compared with 14 percent with the Alternative Simple Credit. However, the differences in calculating the base amounts under each method differs so it is important to do the math to see which method is best. If you're a start-up and you don't have a three, or 20-year track record, never fear, the IRS provides methods to take advantage of the credit, even in the first year.
(Of note: President Obama's proposal on September 8 included a change to the simpler calculation method, raising the amount of the credit to 17 percent. The hope is that such an expansion of the benefit will cause more companies to elect the simpler method and companies will get a greater benefit from the increased rate. However, that has made his proposal more expensive. President Obama's proposal would cost the government $100 billion over ten years, as opposed to about $6.5 billion over ten years, as a temporary extension passed by the House late last year estimated.)
Document Your Activities
Think you've found significant qualifying expenses? That's great. But since we're talking about taxes and the IRS, you better be able to prove it.
'If you're a company that hasn't thought about the research credit in the past, because of the fact it's defined so broadly as new or improved products or processes, if you're doing work that's based in the sciences, there's most likely qualified research,' says Mondoro. 'It becomes a question of identifying it, and equally important, documenting it.'
Documentation is critical, emphasizes Kendall Fox, a tax partner who is co-leader of the research tax credit practice for PricewaterhouseCoopers. 'The burden of proof is on the taxpayer," he said.
Companies that use project-based accounting may have an easier time of matching qualifying activities to costs than those using cost-center based accounting. But no matter what, it's a valuable exercise.
"Companies need to look at the way they record expenses, and develop a methodology for quantifying associated costs with credit eligible projects, as well as documenting how the project itself qualifies,' says Fox. 'Then, if the credit is passed, companies will be well positioned to claim it. Waiting until the last minute makes the documentation process more difficult."
Some companies may want to consider surveying their researchers and developers to ask them about their activities this year, or even sitting down and talking to them about what sort of work they are doing, and what sort of records they have.
"What's important here is to examine the nature of the activity, and what the scientists are doing to improve it,' Fox says. 'If it involves experimentation, those activities need to be examined. If it involves a functional improvement to product or process, it may qualify.'