What would cause a tax professional to need to consider the tax benefits of R&D for medium and small clients?
The main tax savings can come from the federal benefit, but many states have advantages as well. The usual focus is the R&D tax credit – officially “research and experimental credit” – which is not reserved for large companies.
Authorities at your fingertips
Here is a brief roadmap from the main authorities on our subject:
- Articles 38, 41, 174, 280C
- Reg. 1.41-0 Table of contents of regulations 1.41-1 to 1.41-9
- Reg. 1.174-1: bases of R&D
- Reg. 1.174-2: R&D defined
- Reg. 1.174-3: R&D treated as an expense
- Reg. 1.174-4: R&D treated as deferred charges
- Reg. 1.280C-4: Credit for increased research activities
- Form 6251 Alternative minimum tax – individuals (Part 1, line r)
- Form 6765 Credit for increased research activities (instructions include an outline of eligible expenses)
- Notice 2017-23: Election of an eligible small business to claim the payroll tax credit for the increase in research activities
Under Reg. 1.174-1, research and development may relate to a general program or a specific project. Expenses are deducted in advance, amortized or capitalized.
A 20 percent credit may be given for increased R&D, but the deduction is reduced from the credit. Credit is generally subject to special rules that may apply under section 280C.
It is generally possible to charge for R&D but, except for legislative relief, eligible expenses will soon have to be amortized over five years (15 years for research expenses abroad). The new amortization requirement has a mid-year starting point that generally applies to amounts paid or incurred in a tax year beginning after December 31, 2021.
It is possible that a relatively young start-up with social charges and little income could benefit from a tax advantage. Individuals may be faced with an adjustment to R&D spending for alternative minimum tax purposes.
What gives the right to special tax treatment for R&D?
In general, eligible costs are concentrated on research, including modeling, and the elimination of uncertainty in the sense of laboratory or experimentation. What is new and improved for the taxpayer may qualify. The taxpayer does not have to show that innovation is new to the world. Improvements to the old, and not just the development of the new, may be eligible.
Systematic, targeted documentation before and after tests or experiments is useful in establishing the objectives and the nature of the work. Contractual costs and supplies may be eligible, as well as internal expenses.
Patent and patent related costs may be eligible, including legal costs associated with the patent application. Salaries may be eligible (whether they are PhD or blue-collar workers) and are often the primary component of credit, so tracking time across multiple departments is often essential.
The nuances of time tracking are important. For example, tailoring research to meet the needs of a particular client will generally not qualify (Instructions on Form 2020 6765).
Support assistance for the R&D function can qualify. Consultants external to the company, p. eg engineering and design are eligible. Supplies consumed to develop new products, models, experimental designs, can be considered as part of the R&D process if the accounting records are sufficiently detailed to document these costs and their purpose.
The process should generally improve functions, results, quality or have evaluated design alternatives. Projects with specific objectives and detailed notes on experiences and their results are actually part of the company’s tax records because this information supports tax treatment.
Documentation is an essential element in maintaining the tax advantages of R&D (see Siemer Milling Co., TC Memo 2019-37, on the importance of documentation). Systematic improvement work, whether through modeling, trial and error or other means, should also be part of the structure to gain the tax benefit. Contract notes, project notes, lab reports, management notes, process-relevant qualifications may all need to be viewed in support of tax treatment.
Sometimes the process can seem very narrow, but the breadth of our topic is another important perspective. For example, packaging – and not just the product – can be the focus and benefit from tax incentives.
Research, in the general marketing or commercial sense, is not eligible. The purchase of an existing patent is also not eligible. R&D for which the payer does not retain any significant research rights is also not eligible.
Basics of R&D tax planning
What types of companies could attract the CPA’s attention in terms of R&D planning. Here are some general thoughts that may be helpful.
Types of businesses particularly likely to benefit from credit: medical, dental; construction, engineering, architecture; technology, manufacturing, food and beverage companies.
Engineering and computer science can be qualified, not just research in the biological, test-tube sense. For example, design improvements that help a building withstand earthquakes or extreme weather conditions may qualify.
The focus could be on more efficient use of water or renewable energies, improving air quality, reducing pollution or using renewable energies, such as energy solar, better window systems for energy. The type of building does not seem to matter for this purpose – home, business, office, school.
Food and beverage companies can qualify through experiences focused on reducing waste, extending shelf life and environmentally friendly packaging changes.
Software development that may be eligible may involve new platforms, virtual reality applications, and internal software enhancements.
The R&D of manufacturing companies can focus on process efficiency, improvement of machines used in the manufacturing process, improvement of peripheral aspects of production cycles, process design changes and l ‘improvement in the manufacture of product components.
The complexity of the process, such as is typical of the petroleum, natural gas and coal industries, should often suggest R&D planning demands on the part of the tax practitioner.
The CPA’s role in these areas may include not only tax planning and identifying qualifying activities, but also helping the client qualify by documenting with good systems and supporting information stories. The CPA’s experience with IRS exams can also make an important contribution, as well as knowledge of the complex tax rules governing R&D tax benefits.