The tax rules governing research and development are complex, but they can yield significant benefits for a broad range of companies, not just those involved in scientific research.
Developments in the tax benefits of R&D are such that all CFOs, controllers, tax directors, and accounting managers need to have a perspective on when and how the rules affect them.
The R&D credit was made permanent in 2015, and President-elect Trump plans to retain this incentive. An important liberalization of the R&D credit rules aimed at benefiting small- and medium-sized businesses began in 2016, and also this year the IRS issued final R&D regulations for internal-use software.
Deduction or Amortization Incentives
In general this topic is about engineering and science, and perhaps patent law. For example, marketing and tax research are not R&D items, for our purposes.
The rules can sanction immediate deductions, amortization over 60 months, and a write-off more than 10 years.
The tax incentives may focus on the multi-degreed scientist in a white coat, but they also apply to the blue-collar machinist finding improvements, technology and software developers, and certain work in architectural or engineering design.
Qualifying efforts here include designing manufacturing processes; designing molds, dies, or work related to process improvements; and qualifying work related to all-new products.
A general definition is that such efforts involve R&D costs “in the experimental or laboratory sense.” (CFR 1.174-2(a)(1))
The R&D credits we’re about to discuss are even more involved and time-intensive in terms of measuring and supporting the credit, but they may also be more valuable than the R&D deduction.
New, Enhanced Incentives for SMBs
There are major new developments that have made the R&D credit more readily available in 2016 to small and start-up companies. Specifically, the credit can now be used to offset payroll taxes of up to $250,000 and to grant relief from the alternative minimum tax.
The AMT relief is for companies with revenue under $50 million. The payroll tax credit is specifically aimed at start-ups. To claim this relief, the taxpaying company must have received revenue for five years or fewer, and its revenue must be $5 million or less in 2016 and each year the credit is claimed. These new incentives were effective Jan. 1, 2016.
Final Regs on Internal-Use Software
Not all internal software development costs are subject to the internal-use rules. Some software development costs qualify under general R&D rules.
The internal-use criteria subject the costs to a narrower corridor leading to a credit. These additional requirements fall into the category of general and administrative —specifically financial management, managing the human resource function, and support services. The preamble to the new regulations says the scope is “back office” regardless of industry, so the topic is of interest to almost any business.
For the efforts related to internal-use software to qualify, the general criteria are that the work must be “innovative,” involve significant economic risk, and not be commercially available. “Innovative” does not look to whether the work is unique or novel but rather whether the result would be cost reduction, improvement in speed, or other measurable improvement that is significant, if successful.
Basics of the R&D Credit
In general, the credit is subject to carryback for one year and carryforward for 20 years, so it should yield a benefit. Qualified research expenses include in-house research expenses and certain contract research expenses.
“In-house research expenses” are basically limited to wages paid an employee “for qualified services,” plus supplies, plus certain amounts paid to other people in connection with using their computers in qualified research.
“Wages” paid for qualified services are rather strictly defined. For example, the IRS audit manual tells the agent to look for (disallow) wages above first-line supervision unless the employee personally engaged in qualified activities.
Contract research services may be subject to differing percentages of qualification, but generally 65% of amounts paid or incurred to another person (other than an employee) for qualified research are eligible costs.
The credit under IRS Section 41 is generally complicated by the concept of having to increase research activities, so there is introduced the concept of having to quantify this year’s credit based on data from multiple years.
The increased-research concept isn’t just a matter of spending more on R&D but spending more in relation to your size — i.e., spending in relation to your gross receipts under the “regular” research credit. There is an “alternative simplified credit” approach that doesn’t factor in gross receipts.
Depending on a business’s history, there is a portion of the “regular credit” computation that may focus on data from 1984-1988, or the work may look to later periods in which the rules for determining your fixed-base percentage will periodically change. But there is yet a third, simpler approach to the R&D computation.
Computing the Alternative Simplified Credit
It is possible that this simplified approach to the credit will even yield a higher credit. But it’s main advantage is that it’s a practical, simpler alternative when it’s difficult, if not impossible, to garner the information needed for the computations under the regular credit.
Let’s start with the simplest scenario. A company is beginning R&D and has had no such expenditures in the prior three years. Under the alternative simplified credit (ASC), one basically takes 6% of the current year’s R&D expenditures.
The alternative simplified credit generally takes 14% of the qualified research expenses for the taxable year that exceed 50% of the average qualified research expenses for the three taxable years preceding the computation year. There is a rule under the regular method that applies the credit percentage to no more than 50% of the current year’s R&D; this rule doesn’t apply to the alternative simplified credit computation.
Those who may benefit from the ASC method include those with incomplete records needed for the regular computation, high base amounts of R&D for purposes of the regular computation, and high gross receipts in recent years. Gross receipts don’t enter into the simplified computation.
The following questions and tips are designed to help CFOs identify helpful actions:
- Who within the organization would know when we first began incurring R&D?
- Consider contacting the HR department for an estimate if not a resolution of the R&D labor costs.
- Consider whether the organization has identified supplies that enter into R&D.
- Resolve whether the organization may have contract R&D costs as well as in-house costs.
- Discuss with IT or others in the organization whether there may be software development costs that qualify under the new regulations.
- Discuss with headquarters and divisional accounting the system issues and classification changes needed to better capture the information to compute the tax benefits.
- Do we need to resolve whether our partnership investments may have missed?
- Are there acquisitions and M&A that affect our R&D tax calculations? Where are those records, etc.?
- Do we need to review forecasts of future R&D from the perspective of maximizing tax benefits?
Presuming that claiming the benefits would entail amended returns, contact the tax department or outside advisors as to the years still open for refund claims keeping in mind carryback and carryover issues.