The Research & Development Tax Credit Presented By: David Greenberg Principal Tax Group International RECENT

STUDIES/TAX CREDIT BENEFITS OBTAINED COMPANY SOFTWARE DEFENSE ENTERTAINMENT FOOD HEALTH DRINKS ENGINEER MANUFACTURER INTERNET BROADCASTING REVENUES $10MM $15MM $100MM $50MM $5MM $20MM $125MM $250MM $2500MM TAX CREDIT GENERATED PER YEAR $900,000 $600,000 $1MM $300,000 $130,000 $120,000 $1.05MM $3MM $2.5MM

Research and Development Tax Credit

The information covered in this document is based on our knowledge, experience, and expertise. The content is aimed at taxpayers who may be involved in qualified research activities and want to reduce their tax liability. In the following document, we discuss the definition and history of the R&D tax credit. Next, we list examples of industries that typically qualify for the credit and give details of what activities qualify as research and development according to the IRS guidelines. Finally, we detail the typical life cycle of a qualified research and development product, discuss activities that are excluded from the credit, and provide examples of how the credit is calculated.

The R&D tax credit is a federal and state credit (credits for states vary from state to state) d e si g n e d t o s t i m u l a t e r e s e a r c h a n d d e v e l o p m e n t activity of US companies by reducing their after-tax cost. Companies that qualify for the credit can deduc t 20 pe rc en t of q u a li f ie d r e se a r ch expenditures above a base amount from their co r p o r a t e i n c o m e t a xe s . T h e R & D t a x c r e d it ( k n o w n p r e v i o u s l y a s R e s e a r c h a n d E x p e r i m e n t a ti o n o r R & E ) w a s i n s ti t u t e d i n 1 9 8 1 as part of the Economic Recovery Tax Act. The credit was created as an incentive for US co m p a n i e s to maintain t h eir technological competitiveness. However, due to extremely strict requirements and the high threshold of innovation only large corporations were able to utilize the credit (Guenther 2005). In 2001, President Bush and his administration reviewed the utilization of the credit and d i s c o ve r e d t h a t s m a l l a n d m i d d l e - si ze co m p a n i e s were not taking advantage of the credit. This prompted a change in the regulations that removed the high threshold of innovation and allowed the threshold of innovation to be relative to the individual company and not the industry (Rivera 2011). In 2 0 0 8 , C o n g r e s s p a s s e d T h e E m e r g e n c y E c o n o m i c Stabilization Act of 2008 which retroactively extended the credit and increased the Alternative S i m p l i f i e d C r e d i t r a t e t o 1 4 p e r ce n t .

What is the R&D Tax Credit?

History of the R&D Tax Credit

Until 2010, the credit could only offset the difference between regular tax and Alternative Minimum Tax (AMT). For taxpayers that were in A M T , t h e cr e d i t h a d t o b e ca r r i e d b a c k o n e ye a r o r carried forward for up to 20 years to offset future t a x l ia b ili t ie s . I n 2 0 1 0 , P r e s i d e nt O b a m a s i g n e d i n t o law the Small Business Jobs Act of 2010 which eliminated the 2010 AMT restrictions on sole proprietorships, partnerships and non-publicly traded corporations with $50 million or less in average annual gross receipts for the prior three years (Titan Armor 2010). This new law allows businesses to carry unused credits back five years. There are a host of industries that typically qualify f o r t h e c r e d i t . S o m e e x a m p l es a re : E l e ct r o n i c M a n u f a ct u r i n g Textile Manufacturing S o ft w a re D e v e l o p m e n t Graphic Designing F o o d a n d D r u g M a n u f a ct u r i n g Pharmaceuticals B i o l o g i ca l T r e a t m e n t W a t e r Tr e a t m e n t F o o d P r o c e s si n g C o s m e t i c D e ve l o p m e n t A e r os p a c e These are just a few examples of companies that c o u l d q u a l i f y , b u t m a n y m o r e m a y t a k e a d va n t a g e of this opportunity.

Who Can Benefit from the Credit?

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Research and Development Tax Credit

What Qualifies as Research?
bonuses, nonqualified stock options, etc.). If an employee performs both qualified and non-qualified activities, only the qualified wages will be considered. The appropriate met ho d of apportioning wages to the qualified activities is multiplying an employee's total wages for the year by a fraction, with the numerator consisting of the annual qualified activity hours and the denominator representing total annual hours worked in all activities. If the above apportionment calculation sh o w s t h a t t h e e m p l o y e e ' s q u a l i f yi n g p e r ce n t a g e i s at least 80%, then all of the employee's wages for the year will qualify for the credit computation. Qualifying services, which are required in determining wage payments available for the credit include the services engaged in qualifying research, direct supervision of qualified research activities, and direct support of qualified research activities. Supplies are defined as any tangible personal property (other than land, improvements, or property subject to the allowance for depreciation) directly used in the performance of qualified re s e a r ch . Any contract research paid or incurred by the taxpayer to another person, excluding employees of the taxpayer, to perform qualified research for the taxpayer qualifies for the credit. 65% of contract r e s e a r c h e x p e n s e s a r e c o n s id e r e d Q R E . The summation of qualified wages, supplies, and contract expenses is referred to as total qualified re s e a r ch e x p e n di t ur e s o r Q R E . There are two standard methods of calculating the 41 credit and an alternative method the company may elect. The first option is the regular credit, w h i ch co n si st s o f t w o b a si c co m p o n e n t s: 20% of the excess (or increase) in QRE for t h e cu r r e n t y e a r o ve r a b a se p e r i o d a m o u n t , p lu s 20% of the excess (or increase) of "basic research payments" (or "university basic research payments") made in the current ye a r o ve r a b a se a m o u n t p a i d t o u n i ve r si t i e s and other qualified organizations. The base amount is the average of the prior three ye a r s p a y m e n t s f o r b a si c r e se a r ch t o qualified organizations.

Under IRC 174, the IRS utilizes a Four-Part Test to d e f i n e q u a l i f i e d r e se a r c h . Part I: Permitted Purpose The activity must relate t o n e w o r i m p r o ve d b u s i n e s s c o m p o n e n t s i n o n e o r m o r e o f t h e f o l l o w i n g a r e a s: F u n ct i o n P e r f o r m a n ce Re lia b ilit y Quality Part II: Technological in Nature The activity performed must fundamentally rely on the p r i n ci p l e s o f : P h y si c a l s ci e n c e B i ol o g i ca l s ci e n c e Co m p u t e r s c ie n c e E n g i n e e ri n g Part III: Elimination of Uncertainty The activity must be intended to discover information to eliminate uncertainty concerning the capability or method for developing or improving a product or process, or the appropriateness of the product d e si g n. Part IV: Process of Experimentation Substantially a l l t h e a ct i vi t i e s m u st b e e l e m e n t s o f a p r o ce s s o f experimentation involving: E v a l u a t i o n o f a l t e r n a t i ve s Confirmation of hypotheses through trial and error, testing and/or modeling R e f i n i n g o r d i sca r d i n g o f h y p o t h e se s

What are Qualified Research Expenses (QRE)?

The Calculation Methods

Q u a l i fi e d R e s e a r c h E x p e n s e s a r e o u tl i n e d u n d e r IR C 41(b)(1) as amounts paid or incurred by the taxpayer during the taxable year in carrying on a trade or business relating to: (1) in-house research and (2) contract research. In-house research is the sum of all amounts paid or incurred for wages, su p p l i e s, a n d a m o u n t s p a i d o r i n c u r r e d t o a n o t h e r person for the right to use computers to conduct q u a l i f i e d r e se a r ch .

A n y w a g e s p a i d o r i n c u rre d to a n e m p l o y e e i n th e performance of qualified research activities can be included in the credit computation. The term "wages" generally holds the same meaning as provided under IRC 3401 (base wages, direct

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Research and Development Tax Credit

T h e s e co n d o p t i o n i s t h e r e d u ce d cr e d i t . F o r t a x years beginning after 1988, taxpayers who select the regular credit method are required to reduce t h e i r d e d u c t ib le r e s e a r ch and development expenses under IRC 174 expense deduction (or capitalization). The election is made at any time prior to or on a timely filed (including extension) income tax return. The election is made on Form 6765. Once made, the election is irrevocable for that particular tax year and will allow the taxpayer to reduce the credit in lieu of being required to add back the credit to taxable income. T h e " b a s e p e r i o d a m o u n t i s d e fi n e d i n IR C 4 1 ( c ) a s the product of: T h e f i x e d - b a se p e r c e n t a g e a n d The taxpayer's average annual gross receipts for the four tax years preceding the taxable year for which the credit is being determined. T h e " b a s e p e r i o d a m o u n t " , h o w e v e r , ca n n e ve r b e b e l o w 5 0 % o f t h e cu r r e n t y e a r ' s q u a l i f i e d r e s e a r ch expenditures. Therefore, the "base period a m o u n t " ( u s e d t o co m p a r e t h e i n cr e m e n t a l i n c r e a se in qualifying expenditures for credit computational purposes) will always be the greater of: (1) the computed amount under IRC 41(c) or (2) 50% of t h e c u r r e n t q u a l i f yi n g e x p e n se s . Another option is the Alternative Simplified Credit (ASC). Since 2007, taxpayers have been able to elect the ASC, which equals 14% (for tax years beginning on or after Jan. 1, 2009 and 12% previously) of the QREs for the taxable year that exceed 50% of the average QREs for the three taxable years preceding the credit determination year. If the taxpayer has no QREs in any one of the three preceding tax years, the ASC rate equals 6% o f t h e Q R E s f o r t h e c r e d i t d e t e r m i n a t i o n ye a r . T h e election to claim the ASC must be made on the original tax return and cannot be made retroactively.

A l te rn a ti v e S i m p l i fi e d C r e d i t ( A S C ) :
ASC = (QRE Average of Previous 3 Years QRE x 50%) x 14%

R e g u l a r C re d i t:
20% (Current QRE Base Period Amount) + 20% (Current payments to University Base Period Amount) = R&D Credit

If t h e s p e c i a l e l e c ti o n i s m a d e u n d e r I R C 2 8 0 C ( c ) (3), the amount of the allowable credit is d e t e r m i n e d a s f o l l o w s: R e d u ce d C r e d i t :

Allowed Research Credit = (QRE Base Period Amount) x 13%

Base Period Amount:

Base Period Amount = Fixed-Base % x Average of Prev. 4 yrs GR

Fix-Base Percentage Computation F or t a x y e ar s b e gi n ni n g b ef o r e J a n u a ry 1 , 19 9 4 , t h e f i xe d - b a se d p e r ce n t a g e i s a f l a t 3 % . F o r t a x y e a r s a f te r D e c e m b e r 3 1 , 1 9 9 3 , t h e f o l l o w i n g t ab l e details th e fixed-based percentage

Current tax year beginning after December 31, 1993 First 5 years 6
th

Base years used in computing annual credit (years referenced are years beginning after 12-3193) Rate used is set at 3% 4
th

Fraction applied against aggregate R&D expenses/ aggregate gross receipts No fraction applied 1/6 1/3 1/2 2/3 5/6 No fraction applied

tax year tax year

&5

th

year 7 th

7th tax year 8th 9th tax year 10th tax year All subsequent years

5th & 6th 5th, 6 th & 5th, 6th, 7th & 8th 5th, 6th, 7th, 8th & 9th ANY 5 years between the 5th & 10th taxable

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Research and Development Tax Credit

Product Development Life Cycle

Phase VIII Product/ Process Improvement

Phase I S al es a n d Marketing

Phase II Research Concept D e si g n

Phase III D e si g n Engineering

Phase IV Prototyping and Sampling

Phase V Testing and Validation

Phase VI Production and Manufacturing

Phase VII Maintenance and Support

Products that go from Sales & Marketing directly into Product and Manufacturing DO NOT QUALIFY

The flowchart above displays the development product goes through.

typical

product

development

cycle

that

qualified

research

and

Phase I: First an idea or need is developed in the sales and marketing phase. The need can be internally driven or externally driven by the customer. Phase II: Once the need is developed, the development team begins to research concepts, designs, and feasibility. During this phase the developers build several hypotheses. Phase III: Once a product concept is deemed feasible, the developers begin the experimentation phase by cr e a t i n g t h e r e se a r ch e d co n c e p t s. Phase IV: After the design is engineered, the development team typically builds prototypes or samples so that further testing can be conducted prior to production. Phase V: During the testing and validation phase, the product goes through series of testing as the d e ve l o p e r s l o o k t o e n su r e t h a t a l l u n c e r t a i n t i e s h a ve b e e n e l i m i n a t e d . Phase VI: Once the product has passed all validation testing, the research and development is complete and the product is ready to be manufactured. Phase VII: During the maintenance and support phase, companies typically provide customer with routine product support. This phase does not include any new or improved attributes developed for existing products. Phase VIII: When a company decides to enhance a product or process that is in production and sends it back through Phase II through Phase V, these expenditures may qualify toward the credit. Qualified expenditures in Phase I through Phase V may qualify toward the R&D credit; however once a product enters production, it is no longer qualified research and development. If an improvement to functionality, quality, reliability, or performance is introduced and the product goes through this life cycle t o a n s w e r t h e F o u r - P a r t T e st , t h e r e s e a r ch e xp e n d i t u r e s m a y q u a l i f y u n t i l t h a t p r o d u ct o r p r o c e s s g o e s back into production. If a product goes from the sale and marketing phase directly into production, it does N O T q u a l i f y a s r e se a r c h a n d d e ve l o p m e n t f o r p u r p o se s o f t h e t a x cr e d i t .

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Research and Development Tax Credit

Exclusions Example Credit Calculation: Regular Credit for Startup (Years 1 5)
Cu rre n t y e a r Q R E Fixed-base % (FBP) A v e r a g e G r o s s R e c e i p t s P r e vi o u s 4 y e a r s (AG R) Base amount = FBP x AGR S u b t r a c t B a s e a m o u n t f ro m Q RE = Minimum Base Amount Lesser of 50% QRE or Minimum Base Am ou nt M u l ti p l y b y 2 0 % = C r e d i t $150,000 3% $1, 000, 000 $30,000 $120,000 $75,000 $ 15 , 0 0 0

Certain activities, which appear to meet the above requirements, may still be statutorily excluded from qualified research. Following are the statutory exclusions. If the answers to any of these exclusions are yes, then the activities do not qualify (IRS 20 0 8) . Research after commercial production "Was any research conducted after the beginning of commercial production of the b u si n e s s c o m p o n e nt ? " A d a p t a t i o n o f e xi st i n g co m p o n e n t s - " W a s any research related to the adaptation of any existing business component to a particular customer requirement or need?" D u p l i ca t i o n o f e xi st i n g b u si n e ss co m p o n e n t "Was any research related to the production o f a n e xi st i n g b u si n e ss co m p o n e n t ( i n w h o l e or in part) from the physical examination of t h e b u si n e ss co m p o n e n t i t s e l f o r f r o m p l a n s, blueprints, detail specifications, or publicly available information with respect to such b u si n e s s c o m p o n e nt ? " S u r v e y s , s t u d i e s e t c . - " W a s r e se a r ch r e l a t e d to any efficiency survey, activity relating to management technique, market research, testing, or development (inclu ding advertising and promotions)?" Computer Software Computer software developed by or for the company primarily for internal use will only qualify if (a) the co m p u t e r s o f t w a r e i s c r e a t e d f o r u s e i n a n activity which constitutes qualified research, (b) the computer software is created for use in a production process, or (c) the computer software meets three specific internal use software tests. In order to meet the three specific internal use software tests, th e software must be innovative, created at s i g n if i c a n t e c o nomic r i sk and not co m m e r ci a l l y a va i l a b l e . Foreign research - "Was any research co n d u c t e d o u t si d e t h e U n i t e d S t a t e s? " Social Sciences, etc. - "Was any research in th e s o c i a l s c i e n c e s , a r t s , o r h u m a n i ti e s ? " F u n d e d r e se a r c h - " W a s a n y r e se a r c h t o t h e extent funded by any grant, contract, or o th e r w i s e b y a n o th e r p e rs o n ? "

Ex a m p l e (Year 6)

Credit Calculation:

Regular

Credit

Cu rre n t y e a r Q R E A g g re g a t e Q R E y e a r 4 & y e a r 5 Aggregate GR year 4 & year 5 % of AQRE divided by AGR x 1/6 A v e ra g e a n n u a l G R p re v i o u s 4 y rs Base amount = FBP x AGR S u b t r a c t B a s e a m o u n t f ro m Q RE = Minimum Base Amount Lesser of 50% QRE or Minimum Base Am ou nt M u l ti p l y b y 2 0 % = C r e d i t

$150,000 $100,000 $800,000 2.08% $1,000,000 $20,800 $ 1 2 9 ,2 0 0 $ 7 5 ,0 0 0 $15,000

Example C r edit Simplified Credit

Cu rre n t y e a r Q R E

Calculation:

Alternative

$150,000 $ 1 1 0 ,0 0 0 $55,000 $9 5, 00 0 $ 1 3, 3 0 0

Average QRE previous 3 yrs Multiply Average QRE previous 3 yrs by 50 % S ubt r ac t f r o m c ur r e nt y e ar Q R E Multiply by 14% = Credit

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Research and Development Tax Credit

Example Credit Calculation: Under Section 280C Current year QRE Fixed-base % (FBP) Average Gross Receipts Previous 4 years Base amount = FBP x AGR Subtract Base amount from QRE = Minimum Base Amount Lesser of 50% QRE or Minimum Base Amount Multiply by 13% = Reduced Credit Conclusion Reduce Credit
S o m e q u e st i o n s t h a t m a y h e l p i n d i c a t e w h e t h e r t h e company qualifies for the R&D credit are: What products do you manufacture? D o yo u sp e n d t i m e o r m o n e y t o d e ve l o p n e w o r i m p r o ve d p r o d u ct s o r p r o ce s s e s? Do you have any patented products? Who carries the economic risk for the p r o j e c t s o n w h i c h yo u w o r k ? D o y o u h a v e e n g i n e e r s o n s t a ff ? D o yo u e m p l o y i n d e p e n d e n t c o n t r a c t o r s ? How are your contracts written? Fixed-price o r t i m e a n d m a t e r i a l s? H o w d o y o u r e m p l o ye e s t r a c k t i m e i n v e s t e d on each project? These are just a few questions that may assist companies with understanding whether their business may qualify for the R&D tax credit. If you believe you may qualify for the R&D tax credit, you should talk with a qualified tax professional.

$150,000 3% $1,000,000 $30,000 $120,000 $75,000 $9,750

The R&D tax credit can produce significant tax savings. It rewards companies for being innovative. A l t h o u g h t h i s cr e d i t i s a v a i l a b l e t o m a n y co m p a n i e s , it is estimated that less than ten percent of the companies eligible for the credit actually utilize the c re di t .

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