By Scott Earls
March 25, 2010
Misconceptions about research and development tax credits are keeping many business owners from saving their companies thousands of dollars each year.
Many owners of companies do not look into R & D credits because they believe that the credit is really only for large companies or that claiming the credit will cause the company to undergo an IRS audit. Other reasons are because they don’t see what they do every day as “research,” or they think there is no sense in identifying credits in a year in which they experience losses.
A business can qualify for Research and Development credits if it:
-¢ Employs a dedicated research staff
-¢ Manufactures a product that is continuing to advance technologically
-¢ Creates products or processes that can be patented
-¢ Creates prototypes
-¢ Designs products to meet specifications imposed by a customer
-¢ Is financially at risk for research performed
-¢ Provides a “value added” component for customers
“Research” as defined by the IRS is actually much broader than the stereotypical picture of scientists in lab coats working in a laboratory all day.
There are numerous activities that may constitute qualified research, including:
-¢ Activities intended to discover information that would eliminate uncertainty regarding “if or how a product can be developed.”
-¢ Development activities constituting a “process of experimentation” employing the technical principles of physical, biological, engineering or computer sciences.
-¢ Trial and error testing to evaluate alternatives and eliminate uncertainty.
-¢ Activities relate to a new or improved functionality of a product, or the products performance, reliability or quality.
-¢ Development relating to style, taste, cosmetic or seasonal design factors will not satisfy this requirement.
Interestingly, reverse engineering does not qualify and neither will research where the solution exists in the public domain.
The credit is based on a company’s excess expenditures as compared to a base amount. The smaller a company is, the smaller the base amount. However, even small companies can generate thousands of dollars of R&D credits. Historically, a company’s base amount required the accessing of data from 1984-1988. However, recent tax law changes have made it far easier to compute a base amount, requiring only data from the three years prior to the year the credit is claimed.
Claiming the Credit in a Loss Year
R & D credits can be claimed for any open tax year. For pass-through entities, the credits are calculated and claimed at the entity level and then passed through to the partners/shareholders. For C corporations, the credits are claimed at the entity level, and excess credits can be carried back one year or forward 20 years. Note that under current IRS rules, related groups of entities must compute the credit as if they were one taxpayer, and allocate any credits amongst the entities.
Qualifying costs include wages, supplies and 65 percent of contract services performed in the U.S. It is important to note that R & D tax credits currently expired as of Dec. 31, 2009. This is a frequent occurrence, and Congress has historically renewed the R & D tax credit provisions on a retroactive basis.
Scott Earls is a Managing Director – Tax at UHY Advisors and a Partner in UHY LLP in Southfield, MI. Scott has been serving privately held middle market businesses for 24 years, including 19 years at a Big Four firm and the last five with UHY. He can be reached at [email protected].