Taking Credit Where Credit is Due
Jerry Schmit, Tax Senior Manager email
In today's competitive and challenging times, businesses are constantly adapting, improving and developing new products to bring to the marketplace. At the same time, businesses are ever-striving to refine and improve the methods and processes they utilize in making these products. Years ago Congress decided to reward these efforts in the form of the research and development tax credit (R&D credit). This credit may reduce a taxpayer's overall income tax liability, and thus trim the cost of the overall research expenditures.
The R&D credit has experienced a turbulent legislative life. While it has been around for nearly 30 years, its availability has been inconsistent. On December 31, 2009, the R&D credit expired; however, it is likely that it will be extended retroactively to January 1, 2010.
Historically, taxpayers have found the R&D credit difficult to use and calculate. In recent years new tax laws and Internal Revenue Service (IRS) regulations have broadened its availability and usability by expanding the permitted expenses and simplifying the calculation.
Several business activities that are considered ordinary functions for operations may qualify as R&D projects. Examples of these activities include the development of a new customer product or manufacturing process, the improvement of an existing customer product or manufacturing process, the creation of prototypes, and the development of software. The new process or product only needs to be new to the taxpayer and not to the industry as a whole. Research expenditures from both successful and failed projects can be used for the R&D credit.
Research projects must meet all three of the following subjectivity tests to qualify for the R&D credit.
Process of experimentation - This is satisfied when there is uncertainty as to whether a product or process can be produced, or when uncertainty exists as to how to accomplish the product or process. The process of experimentation is generally a "trial-and-error" process.
Technological in nature - This requires the use of physical and biological sciences in the project. This eliminates research relating to social science, humanities and economics.
New or improved business component - This criterion is met when the research is focused on developing a new or improved product or process.
Once the research project meets the above criteria, the project costs are further evaluated to determine the qualified research expenses (QREs). QREs include: the wages of personnel involved (engineers, clerical staff, lab assistants, supervisors, etc.), any supplies used in the project and 65 percent of contract research, if certain conditions are met. Examples of ineligible costs include: market and consumer research, advertising and promotion expenses, and ordinary quality control testing.
It is critical for taxpayers to document all QREs. Without any documentation to support the research and related costs the R&D credit is generally disallowed. Documentation should include all test results, the trial-and-error process of testing, changes and modifications made during the process and the product improvements or new product that was developed. It is important to document both successful and failed attempts. Click here for more information on the documentation required by the IRS.
Once the projects are identified and the QREs are determined, the next step is to calculate the R&D credit. Due to recent changes the R&D credit can be calculated multiple ways. The "original" formula requires information from as far back as 1984 and requires an increased level of QREs. While this original method is still available, many taxpayers find the new alternative simplified credit (ASC) calculation to be less complex. Additionally, the ASC method does not require an increase in QREs to receive the credit.
The R&D credit using the new ASC method is calculated as follows: 14 percent of the excess of current year QREs over 50 percent of the average QREs for the previous three years. For example, assume in 2010 XYZ Company incurs $250,000 in QREs. Further, XYZ averaged QREs of $250,000 from 2007-2009. The R&D credit in this situation (no increase in QREs) using the ASC method would be $17,500 [14% x ($250,000 - (250,000 x 50%))].
Taxpayers with no QREs in the previous three years are still allowed an R&D credit if they incur QREs in the current year. The calculation of the research credit in this case is equal to six percent of its QREs for the current year. Using the previous example of XYZ Company with $250,000 QREs in 2010 (and assuming no prior years' QREs), the credit would be $15,000 ($250,000 x 6%), which is just slightly less than the $17,500 credit.
With the variety of activities qualifying for the R&D credit and with the simplification of the credit calculation, the R&D credit is more attractive to taxpayers than in the past. Businesses should analyze their operations to identify R&D projects and the costs associated with these projects to determine the possible benefits of the R&D credit.
If you have any questions, please contact Jerry Schmit.