Chances are you’re familiar with the federal research and development (R&D) tax credit but thought it was a benefit reserved only for the big players – corporations with revenues in the hundreds of millions and up. Not so! Thanks to recent enhancements in the 35-year-old program, it deserves a re-visit, particularly since a company that qualifies can get up to 9.1 percent of its annual eligible research costs applied dollar for dollar against its federal income tax liability – and likely something similar against what it owes the state (each state is different). Also, this credit is over and above any tax deduction for R&D expenses. Add the retroactive and carry-forward provisions, and the credit starts to look very attractive.
In late 2015, The Protecting Americans from Tax Hikes Act (“PATH” Act) made the federal R&D tax credit permanent, which removed uncertainty as to whether the credit would be available to claim. The PATH Act also added two new provisions to make it more accessible to smaller businesses. First of all, eligible start-ups with less than $5 million in gross receipts can now apply up to $250,000 of their R&D tax credit against their payroll taxes. So, even a start up with minimal or no tax liability can get funds to continue engaging in qualified activities. Secondly, pass-through entities – like S Corporations – with $50 million or less in gross receipts can apply their R&D tax credit against any Alternative Minimum Tax (AMT) liability.
What are those “qualified activities”?
You won’t get too far into the R&D tax credit without encountering “The Four-Part Test.” Basically, your activity must:
- Be intended to develop or improve a product or process; e.g., its functionality, performance, quality or reliability. Or, it has to reduce its cost.
- Endeavor to eliminate or reduce a technical uncertainty about a product or process.
- Evaluate alternatives, including prototyping, testing, modeling and simulation.
- Be technological in nature; i.e., it must rely on hard sciences like engineering, physics, chemistry, biology or computer science. Marketing and marketing research activities do not qualify.
John Madsen of Black Line Group, a Plymouth, MN, firm specializing in helping companies navigate the tax credit, points out the spirit of the credit is to encourage innovation and mitigate a company’s exposure as it ventures into new, uncharted territory.
“Companies that qualify for the credit aren’t required to demonstrate success,” he says. “They need to document how they propose to reach their goal, not whether or not they can or did reach it. This is critical to the program: The intent is to encourage risk-taking and discovery that will make American companies more competitive, and the tax credit can eliminate a good portion of the financial risk in going down that path. The tax savings are intended to be reinvested back into the business – to help it grow faster, be more profitable and compete globally.”
What are the qualifying expenses?
Amounts paid for salaries, supplies, contract research and computer leasing all could qualify for the credit. Salaries paid to employees performing the aforementioned qualifying activities are generally the largest part of an R&D tax credit claim.
Retroactive claims and credit carry forward
Companies also can file amended returns and claim the credit for the three previous tax years (possibly more, if the company had losses during that time). Also, if you have no tax liability but are engaging in qualified activities, you can file a claim that carries forward to offset tax on future profit – for up to 20 years. This puts money back in the companies’ coffers to continue development and research and creates value for a start-up that might be operating at a loss. Studies show 70 percent of credit dollars are used to fund further R&D and pay the salaries of those engaged in it.
The local angle
Historically, there was no question it was the big players who benefitted from the R&D tax credit. A 2017 Evaluation Report from the Office of the Legislative Auditor of the State of Minnesota acknowledged the state’s version of the credit was positive for business, but its authors also weren’t afraid to offer up a few recommendations that would likely make it more accessible to a wider group of companies.
First, it noted most of the Minnesota research tax credits go to C corporations. From 2010 through 2014, C corporations claimed 81 percent of the credits. In 2014, the most-recent year for which complete data are available, C corporations claimed $34 million in research tax credit, while shareholders in S corporations and individual partners in partnerships claimed $16 million.
The largest 20 percent of C corporations (as measured by national sales) received two-thirds of the tax credit received by all C corporations claiming the credit in the years between 2010 and 2014. Among C corporations, the manufacturing industry has claimed the largest share – 65 percent – of the tax credit.
The report suggests this big-company bias may be due in large part to what the report calls the “limited guidance the state has provided to help taxpayers understand the documentation necessary to claim and substantiate the credit.” For one, it said the Department of Revenue should provide additional and more specific information to taxpayers about the documentation needed to substantiate claims – perhaps in the form of online tutorials and examples of acceptable documentation for substantiating the credit.
It’s also very important to note these findings are for 2014 – before passage of the aforementioned PATH Act that makes the credit more accessible to smaller companies.
Should you take a closer look?
That question will elicit an enthusiastic “yes” from Kurt Muehler, CFO at AGCO-Amity JV, LLC, in Wahpeton, N.D. The company’s 125 employees manufacture agricultural implements and for several years, AGCO-Amity has taken the credit for expenditures related to new-product development.
“The benefit is substantial, and we use the credit dollars to fund research and development for future projects,” he says. “Any company of any size that has R&D expenditures should look into it.”
Muehler suggests the first step is to have a discussion with a certified public accountant (CPA) or with someone at a firm that specializes in the R&D credit. He also notes that in the case of AGCO-Amity, the dreaded documentation requirements aren’t bad at all.
“We track the hours and costs associated with our projects, anyway,” he continued. “And that can translate very easily into acceptable documentation of labor costs and expenditures that qualify for the credit.”
While Muehler encourages a company of any size to explore whether to pursue the credit, some others suggest it might make more sense to start exploring the R&D tax credit applicability when the company has reached at least $5 million in revenue, has 25 or more employees and is profitable. But they acknowledge this is not a hard and fast rule as each company’s situation is unique and there could certainly be opportunities for smaller entities.
Want to know more? Here’s the first thing you should do.
Whoever first uttered “the devil is in the details,” may have been reacting to the R&D tax credit. Unfortunately, despite the changes that make it more accessible to smaller businesses, experts estimate claiming the credit remains one of the most challenging provisions of the tax code. As Muehler suggested, the thing to do is get help.
Jeff Holmberg, a business consulting services manager at Froehling Anderson in Minneapolis, can assess your project or process, determine its viability for a tax credit
and advise you on how to proceed.
“Anyone who’s working with AURI to develop a product may be an excellent candidate for the tax credit,” Holmberg says. “Some of the ‘rules’ about revenue and staff size can be useful, but it’s all relative: A smaller tax credit may be a boon to a smaller company, so it’s probably not a bad idea to give it a look. The benefits can be significant.”
What will it cost to learn more?
Some firms might have minimum revenue or other requirements, but many companies will do an initial consultation at no cost. They’ll offer a high-level assessment to determine whether it’s worth continuing. If it is, their fees will be clear upfront on either a fixed rate or a percentage of the credit realized.
AURI executive director Shannon Schlecht hopes Minnesota’s agricultural entrepreneurs will give the tax credit a closer look to see if can benefit their bottom line.
“AURI clients are all about innovation, and the R&D tax credit is another tool to support the eventual commercialization of innovative ideas,” he says. “If companies and entrepreneurs can use this tool to offset costs to help foster additional research, it could spur new creativity and innovation that leads them to the next great agricultural product or process.”
BLG is a nationwide professional services firm comprised of industry experts with a passion to help improve the value of businesses. To learn more about the R&D tax credit potential to your business, contact John Madsen at 763-746-1265.
Froehling Anderson is a full-service CPA and business consulting firm with a specialty in R&D tax credits. To get help navigating the complex R&D tax credit calculations and documentation call 952-979-3100.