What would lead a tax professional to consider research and development tax breaks for medium or small customers?
The main tax saving may come from the federal benefit, but many states have benefits as well. The usual focus is on the R&D tax credit – officially “research and testing credit” – which is not only reserved for large companies.
Authorities at hand
Below is a brief roadmap of the key authorities on our topic:
- Sections 38, 41, 174, 280C
- Registration number. 1.41-0 Table of contents of regulations 1.41-1 to 1.41-9
- Registration number. 1.174-1: R&D basics
- Registration number. 1.174-2: R&D defined
- Registration number. 1.174-3: R&D treated as an expense
- Registration number. 1.174-4: R&D treated as prepaid expenses
- Registration number. 1.280C-4: Credit for increasing research activities
- Form 6251 alternative minimum tax – natural persons (part 1, line r)
- Form 6765 credit to increase research activity (instructions including an overview of eligible expenses)
- Announcement 2017-23: Choosing a Qualified Small Business to Apply for Income Tax Credit for Increasing Research Activities
Under regs. 1.174-1, Research and development can relate to a general program or a specific project. Expenses are deducted, depreciated or capitalized in advance.
A credit of 20 percent can be granted for increased R&D, but the deduction is reduced by the credit. The credit is generally subject to the special regulations that may apply according to Section 280C.
In principle, it is possible to estimate R&D, but subject to legal relief, qualified expenditure will soon have to be written off over five years (15 years for expenditure on foreign research). The new depreciation obligation begins in the middle of the year, which generally applies to amounts that have been paid or accrued in a tax year beginning after December 31, 2021.
It is possible that a relatively young start-up company with wage tax and low income will receive tax breaks. Individuals may experience an adjustment in R&D spending for the purposes of the alternative minimum tax.
What qualifies for special tax treatment in the area of research and development?
In general, qualifying costs are focused on research, including modeling, and the elimination of uncertainties in a laboratory or experimental sense. What is new and improved for the taxpayer can qualify. The taxpayer doesn’t have to prove that the innovation is new to the world. Improvements to the old, not just developing the new, can qualify.
A systematic, goal-oriented before-and-after documentation of the experiments or trials helps to define the goal and type of work. Contractually agreed costs and deliveries as well as internal expenses can be recognized.
Patent and patent-related costs may be eligible, including legal fees related to the patent application. Wages can be qualified (whether PhD or worker) and are often the main component of credit, so time tracking between multiple departments is often critical.
Nuances of time tracking are important. For example, customizing research to meet the needs of a particular client is generally not qualified (Instructions on 2020 Form 6765).
Support help for the R&D function may qualify. External consultants, e.g. engineering and design, are authorized. Consumables used in the development of new products, models and experimental designs can be considered part of the R&D process if the accounting records are detailed enough to document these costs and their purpose.
In general, the process must have improved functions, results, quality or evaluated design alternatives. Projects with a specific purpose and detailed records of experiments and their results are actually part of the company’s tax records as such information aids tax treatment.
Documentation is a critical part of maintaining R&D tax benefits (see Siemer Milling Co., TC Memo 2019-37, for the importance of documentation). Systematic improvement work, whether through modeling or trial and error or otherwise, should also be part of the structure to qualify for the tax break. Contract notes, project notes, laboratory reports, management notes, process-relevant qualifications may need to be accessed to support tax treatment.
The process may seem very narrow at times, but the breadth of our subject is another important perspective. For example, the packaging – not just the product – can take center stage and qualify for tax incentives.
Research in marketing or general business terms is not appropriate. The purchase of an existing patent is also not qualified. R&D where the payer does not retain substantial rights to the research is also out of the question.
Fundamentals of R&D tax planning
What types of companies might be getting the CPA’s attention in relation to R&D planning? Below are general thoughts that you may find helpful.
Types of Businesses Particularly Eligible to Benefit from the Loan: Medicine, Dentistry; Construction, engineering, architecture; Technology, manufacturing, food and beverage companies.
Engineering and computer science can qualify, not just research in the biological sense of the test tube. For example, design enhancements that help a building withstand earthquakes or extreme weather conditions may be considered.
The focus could be on more efficient use of water or renewable energy, improved air quality, reduced pollution or the use of renewable energies such as solar energy, better window systems for energy. The type of building does not seem to play a role – residential house, shop, office, school.
Food and beverage companies can qualify with experiments that focus on reducing waste, extending shelf life, and making environmentally friendly packaging changes.
Qualifying software development can include new platforms, virtual reality applications, and internal software improvements.
Manufacturing company R&D can highlight process efficiency, improvement of the machinery used in the manufacturing process, improvement of peripheral aspects of production runs, changes in process design, and improvements in the manufacture of product components.
The complexity of the process, typical of the oil, gas, and coal industries, should often lead to R&D planning inquiries from the tax advisor.
The role of the CPA in these matters may include not only tax planning and identifying qualifying activities, but also assisting the client in qualifying through documentation with good systems and narrations of supporting information. The background of the CPA with IRS exams can make an important contribution as well as the knowledge of the complex tax rules for R&D tax breaks.