Manufacturers have the opportunity to take advantage of valuable federal and state tax credits for their research and development activities. The federal government implemented the Research and Experimentation tax credits in 1981 to create jobs and spur technology. Known as research and development (R&D) tax credits, the program was meant to be a temporary measure to give the economy a boost.
The Protecting Americans from Tax Hikes (PATH) Act of 2015 made the R&D tax credit permanent. In addition, PATH expanded the benefits for certain businesses.
The R&D credit is intended for manufacturers who improve the manufacturing process by making it more advanced, efficient and environmentally friendly. The credit is also intended for activities related to process design and development.
Which Activities Qualify?
To be considered “qualified research,” the activity must meet the following criteria: (1) new or improved product or process, (2) technological in nature, (3) elimination of uncertainty, and (4) use a process of experimentation. The process of experimentation must be for purposes related to a new or improved function, performance or reliability/quality.
Examples of qualifying manufacturing activities include:
- Improving product quality
- Alternative material testing
- Increasing manufacturing capabilities
- Increasing production capacities
- Designing manufacturing equipment
- Prototyping and three-dimensional modeling
Examples of what qualified research does not include:
- Research conducted for a purpose related to style, taste, cosmetic, or seasonal design factors (think function over form)
- Quality control
- Research after commercial production
- Adaptation of existing business components
- Duplication of existing business component
- Surveys, studies, etc.
- Foreign research (research must be conducted inside the U.S or any possession of the U.S.)
- Funded research
After identifying qualified research activities, you must identify qualifying research expenses for use in the R&D credit calculation. Qualifying research expenses include in-house research expenses (wages and supplies) and contract research expenses.
- Wages paid or incurred must be to an employee for qualifying services. There are three types of qualifying services (1) engaging in qualified research, (2) directly supervising qualified research; or (3) directly supporting qualified research.
- Supplies paid or incurred must be used in the conduct of qualified research. Supplies are defined as any tangible property other than land, land improvements, or property subject to depreciation.
- Contract research expenses are for any amount paid or incurred by the taxpayer to any non-employee for qualified research. Contract research expenses are limited to 65 percent when computing the R&D credit. Contingent contracts do not qualify, so you must bear the expense of the contract research regardless of success
Historically, the ability to take advantage of this credit has been limited when the taxpayer is subject to Alternative Minimum Tax (AMT), but for tax years starting on or after Jan. 1, 2016, businesses with $50 million or less of gross receipts will be able to apply the R&D credit against AMT.
For tax years starting Jan. 1, 2016, small businesses (those with gross receipts under $5 million) can apply the R&D credit against the employer’s share of payroll taxes.
The R&D credit is computed and reported at the entity level on Form 6765, Credit for Increasing Research Activities and the credit can be carried forward for 20 years. In the case of pass-through entities, the R&D credit is reported to the individual shareholders or partners on Form K-1 so that they may benefit from the credit on their individual income tax returns.
State and Local Tax Research and Development Credits
Given the popularity of the R&D tax credit program, many states followed suit by establishing their own programs. Today, over 40 states offer their own R&D tax credits with additional advantages. When pursuing a federal R&D credit, it is important to keep in mind the potential R&D credits that might be available at the state level, though some states will have calculations different from the federal R&D credit. Before claiming a state R&D credit, you need to make sure the activities conducted by your entity qualify for the credit.
Ohio’s R&D credit is currently available against the Ohio Commercial Activity Tax (CAT). The credit cannot reduce the Ohio CAT liability below the minimum fee due. Any credit not utilized, can be carried forward for seven years. This credit is often missed in Ohio because when it was originally enacted it was not available to pass-through entities. Now that the credit is available against the CAT, all entity types can take advantage of the credit.
The R&D tax credit provides a valuable opportunity to manufacturers. If your company wants to take advantage of the credit, you must be prepared to identify, document and support their qualifying activities. It is essential that businesses establish appropriate tracking mechanisms and documentation strategies for their R&D activities.
It is important to work closely with your CPA to determine your eligibility for the R&D credit. There are many qualifying activities, and we can help you to identify the appropriate expenses in order to maximize your tax benefit.