“I’m going to make him an offer he can’t refuse.” These words from the movie, The Godfather, are perhaps the most quoted movie line after “play it again Sam” in Casablanca.
Well, our government, the federal one that is, has made you an offer you shouldn’t refuse. That offer, frequently fifty percent matched by another government, the state one, is the Research and Development Tax Credit. The Research and Development Tax Credit provision of the US Tax Code offers manufacturers (and other companies) a credit against their tax liability for approximately ten percent of the eligible research and development costs incurred. The calculation is a bit arcane but when all is said and done it usually comes out to ten percent of IRS defined research and development expenses. What’s more, you can file for the credits going back three years plus the current year and, unused credits can be carried forward for twenty years. That’s right; you can get a credit of ten percent of these expenses simply by filing the right forms.
Why, you might ask, would anyone not take advantage of this apparent tax windfall? The answer is as simple as the calculation is complicated. Most companies either don’t know about the program or believe that they don’t do any research and development that qualifies. The fact is that almost all companies do research and development and either don’t realize it or don’t record it in the accounting records or both. If you are one of those manufacturers who aren’t taking advantage of the Research and Development Tax Credit, it may be time to examine the nature of your product development, process development and the customized products developed for your customers to see if you qualify. In the meantime, let’s give you a briefing on this unique provision of the Internal Revenue Code.
WHY THE R&D TAX CREDIT?
The American economic experience suggests that the road to higher living standards is paved with innovation and productivity and our government has recognized that phenomenon. As a result of recognizing the relationship between economic growth and the extent of research and development, the Congress several years ago decided to encourage research and development by giving companies a tax credit for engaging in qualified activities. In essence, the federal government and the state of New Jersey are providing manufacturers with a cash stipend to help them fund ever more research and development. It is a credit after all – a credit, not merely a deduction. That means that after your tax liability has been calculated, you reduce the liability by the amount of the credit. In other words, as Yogi Berra said, “they give you money which is almost as good as cash.”
By encouraging companies to engage in research and development, the government is betting on the winners and helping them to win again so they can keep the cycle going and have the funds to commercialize their successful developmental efforts. By the way, research and development need not be successful to qualify for the tax credit. The government recognizes that failure is part of the research and development process and trusts that if enough companies are doing research and development, the innovations will materialize with the consequent economic growth.
How does all this apply to small to midsize manufacturers? You need to stop being so modest! Research and development activity is not the private province of huge Fortune 500 companies who are inventing new chip technology or discovering the cure for one of the many diseases of our world. Research and development is equally the efforts of modest size companies who make products, lighter, stronger, cheaper and more utilitarian or make processes more precise, economical and versatile on a day-in-day-out basis through often unrecognized research and development and who are contributing to economic growth.
WHAT IS R&D?
Avoiding all the technical jargon in the Internal Revenue Code, here in simple terms are the types of research and development recognized as eligible. They are very similar to the kind of efforts business people would recognize:
Classic research and development resulting from deliberate decisions to develop a new or improved product or process.
Contingent research and development that is contingent on receiving an order when the company has made a bid knowing that their existing technology is insufficient to fill the order without some development effort.
Unplanned research and development arising from the sudden discovery, part way through filling an order, that an existing technology is inadequate and must be advanced by an emergency development if an order is to be filled.
Almost all research and development activities will fit into one of these categories. And then, there are requirements as to the actual work of the research and development effort – they are:
A technical advance must be targeted to achieve an improvement or a cost reduction by a new technical means which is related to the business of the company. Such technical advance knowledge may not exist in the public domain in texts, or technical journals. However, work to catch-up with competitors' superior technology is eligible if the competitor's technology is secret or proprietary and if the company's starting position is not in the elementary stage.
Uncertainty must exist or be unhappily discovered half way through a project concerning the best technical path to achieve the desired objective. This requirement excludes "routine engineering" from eligible activity. Routine engineering is work in which the outcome is known in advance if a series of known steps is faithfully followed.
A systematic, step-by-step approach to solve the technical uncertainties must be followed. This criterion is met by any competent technical group. It is directed against trial and error, hit and miss procedures. It aims to support an initial consideration of options and a careful choice of the best course of action.
There must be some documentation that relates in some meaningful way to the course of the experimental development work performed. This requirement can be fulfilled by such documents as notes, test results, CAD or paper drawings and the like. Also, there must be documentation of the costs incurred for research and development such as invoices for materials and subcontractors, scrap records, W-2 payroll data. Time records, while useful, are not required.
Not too onerous or difficult these. Most innovation oriented companies will meet enough of all these criteria to qualify for the tax credit.
ISN’T THIS JUST AN ACCOUNTING ISSUE?
Not really. In fact, discrete accounting for R&D expenses is not required in order to apply for the credit. If you’re wondering why your accountant hasn’t gotten you more Research and Development Tax Credits or any at all, it is because he or she can’t file for a tax credit they can’t quantify and if you don’t keep discrete records to account for these costs, quantification requires scientific or technical expertise that is usually outside their ken.
So, Research and Development Tax Credits is not an accounting issue. Certainly when you have figured out how much money you actually spent on research and development, your accountant can file the necessary documents but it takes scientific/technical knowledge to get the required data to put on the forms. The substantial issue however is getting the supporting scientific/technical data and narrative to support a claim for the Research and Development Tax Credit. The Internal Revenue Service wants the documentation in a report format that tells the “technical story” and demonstrates that the research and development work efforts are within the definition of their regulations. Most companies and most accounting firms don’t have all the scientific/technical competencies to document the research and development work, identify the costs and then write the reports in the language of the Internal Revenue Service under one roof. It is wise therefore to seek professional assistance from specialists in costing and documenting your Research and Development Tax Credit claim. Such professional assistance comes at a price much less than the amount of the tax credit claimed and gives you assurance that the claim is done with professional and legal correctness. NJMEP has vetted providers of Research and Development Tax Credit service. Your local field agent can put you in touch with a service provider through the NJMEP office.
Research and Development Tax Credits are definitely an offer you shouldn’t refuse. It is our government’s policy to support innovation through research and development and, believe it or not, the IRS wants to help you with tax credits.
Gerald Najarian is an NJMEP Account Manager responsible for the Firm’s Research & Development Tax Credit Service and Lean Financial and Manufacturing Practices sales and service. He can be reached by phone at 609-933-3990 or by e-mail at firstname.lastname@example.org.