Year after year, many small business owners are over-paying taxes to Uncle Sam because they and their tax accountants are not aware of the R&D tax credit. Learning about and using the misunderstood R&D credit can mean a source of much needed cash as well as reduced future tax liabilities; not to mention improved cash flow and enhanced enterprise value.
The very name “R&D Tax Credit” is a big reason why the credit is not pursued by smaller companies. The name conjures up an image of research lab experiments usually associated with large corporations, but that is definitely not the case. In fact, any company may qualify for the tax credit if they have spent time, resources and money designing, developing or improving their products or processes, techniques, formulas, inventions or software.
There are no distinctions as to a company’s size or its product offerings in order to qualify. Approximately 16,000 companies take advantage of the credit each year with roughly twenty-five percent of those companies having assets of less than $1 million. Sixty percent are in manufacturing leaving forty percent of participants in the non-manufacturing sector.
Enacted as a temporary measure in 1981, the R&D Tax Credit is aimed at stimulating competitiveness by offering a tax incentive for activities that spur developmental and continuous improvement. Early on, the credit was mainly utilized by large, highly technical companies. But over the twenty-eight years since its inception, the credit has been extended thirteen times with numerous legislative revisions that have made it broader and more applicable to small business. Revisions made in 2001 allowed for a wider range of companies, across virtually every business sector, to qualify activities as R&D. Courts have also helped make the credit more favorable to small business. A ruling in the summer of 2009 eased the requirements for documentation of R&D credit related activities. The credit is currently available through the 2009 calendar year as part of the Emergency Economic Stabilization Act of 2008. It is almost certain that the credit will be extended once again in 2010.
In simple terms, the R&D credit works by allowing companies to deduct from their income taxes an amount equal to twenty percent of qualified expenditures above a base amount. Formulas are used to determine the base amount for each individual company. Qualified expenditures can include wages, materials, and outside contracted costs for qualified activities (projects) such as:
- Product and component designs and improvements including the development of samples, prototypes and models
- Process and technique improvements that allow the company to be more competitive (included are continuous improvement and “lean” initiatives across the company)
- Testing to prove the validity of new concepts and
- Patent related costs
- In order to satisfy a broad definition of “research”, projects must involve people with related technical expertise, the projects must contain some element of risk, and they must resolve an element of uncertainty.
- Expenditures that do not qualify for the credit include:
- Ongoing quality control testing
- Costs for repair or replacement that do not include some quantifiable improvement
- Advertising or promotions
- Consumer surveys
- Efficiency surveys
- Management studies
- Research in connection with literary, historical, or similar projects and
- The purchase of patents, products, prototypes, production, or processes
Supporting documentation includes a description of the project and its relationship to one of the previously mentioned qualified activities. Also required is a breakdown of the expenditures related to each project along with some form of backup supporting those expenditures. In some cases, estimates of labor hours are acceptable. While documentation sounds like a big task, most companies already have the documentation in their records in one form or another. With some thought and planning, it is not that difficult to retrieve and format the information in a way that will meet the requirements. A descriptive spreadsheet can get the formatting job done.
In addition to 2009, taxpayers are currently allowed to amend their tax filings for the three prior years if they have qualifying expenditures. Accountants who are not familiar with the R&D credit might be hesitant to pursue the opportunity but that should not discourage owners from insisting on taking a hard look to see if they qualify. Generally, larger accounting firms are familiar with the credit and can quickly determine a company’s R&D credit base amount and which expenditures will qualify. There are also contingency-based consulting firms available that will examine a company’s prior year activities and prepare amended tax filings in return for retaining a portion of the dollars they retrieve for the taxpayer.
Because the number of companies using the R&D credit is on the increase, the IRS is now taking a closer look at all filings claiming the credit. However, that should not deter anyone from pursuing the credit if they believe they have qualifying expenditures.
Limited Liability Companies and Partnerships might experience a tax increase with the R&D credit because of the Alternative Minimum Tax. Therefore, before they pursue the credit, those owners should first talk to their tax accountants regarding their specific situation.
Tom Balistreri has over 35 years of business experience with 20 of those years in senior positions dealing with “change management”. He is President of Cape Coral based Balistreri & Associates LLC and President of CEO Focus of Southwest Florida which provides peer advisory groups for small business leaders. Tom can be reached at tbalistreri@ceofocus.com
