After being continually renewed since the 1980s, the research credit was finally made permanent under the Protecting Americans from Tax Hikes (PATH) Act. This change allows manufacturers to plan (with certainty) for their research and development (R&D) expenditures. And, it is expected to survive any tax reform legislation that will pass in 2017.
Here is an overview of the current rules on how to claim credits for R&D spending, including how the break has been expanded for certain small manufacturers.
What Costs Qualify?
If your company commits resources to developing new manufacturing techniques, improving processes, experimenting with alternative materials or devising other innovations, it may be eligible for the research credit. Generally, to qualify for the credit, a research activity must:
- Relate to development or improvement of a “business component,” such as a product, process, technique or software program;
- Strive to eliminate uncertainty over how (and whether) the business component can be developed or improved;
- Involve a “process of experimentation,” using techniques such as modeling, simulation or systematic trial and error; and
- Be technological in nature—that is, it must rely on “hard science,” such as engineering, computer science, physics, chemistry or biology.
To claim the credit, you must bear the financial risk associated with the research and enjoy substantial rights to the results. Otherwise, it will be considered “funded research,” which is ineligible for the credit.
What are the Benefits?
The tax benefits of the research credit are significant: a dollar-for-dollar, nonrefundable credit of up to 6.5% of qualified research expenditures (QREs). QREs include wages and supplies related to qualified research activities, computing costs and 65% of contracted outside research fees. “Nonrefundable” means the credit cannot exceed your tax liability for the year. So, you cannot use it to generate a loss and claim a refund. However, unused research credits may be carried back one year or forward up to 20 years to offset your tax liability in those years.
It is important to understand that simply conducting research is not enough to qualify for the credit. Rather, it is designed as an incentive for companies to increase their research activities. Calculating the credit is complex and there are several methods for doing so; however, essentially, it is equal to a percentage of the amount by which your current-year QREs exceed a base amount.
Companies that cannot establish their historical fixed base percentage, as well as those with an exceptionally high base percentage, may elect to use an alternative simplified method to calculate the research credit. Here, the fixed base is 50% of the average research expenses incurred in the previous three years, and the credit is 14% of the excess. For example, if a manufacturer averaged $200,000 per year of qualified expenses over the last three years, the credit would be $14,000 (14% of $100,000) even if its research activities did not increase.
The PATH Act made two important changes that expand the benefits of the research credit for smaller businesses. First, beginning in 2016, the act allows those with average gross receipts for the previous three years of $50 million or less to claim the credit against the AMT. This is good news for taxpayers, particularly owners of partnerships and S corporations, whose ability to use the credit is limited or eliminated by the AMT.
Second, also beginning in 2016, start-ups — generally, companies in operation for less than five years with less than $5 million in gross receipts — may use the research credit to offset up to $250,000 in employer-paid FICA taxes. This is a big advantage for companies that incur substantial research expenditures but can’t otherwise use the credit because they are not yet generating any taxable income.
While the research credit can be a valuable tax break for innovative manufacturers, claiming it requires complex calculations, detailed record-keeping and an in-depth understanding of the nuances of the tax rules.