In 1981, as part of the Economic Recovery Tax Act, Congress enacted a new tax credit. The purpose was to encourage companies to incur expenses related to the conduct of research activities in an effort to stimulate an increase in capital for the development of ideas leading to increased productivity.
The original legislation was intended to expire in 1985; however, since then, the credit has expired and been extended 16 times with various changes in the method of calculation and the definition of qualified research expenses. The last extension occurred with the Tax Increase Prevention Act of 2014 which extended the credit for QREs paid or incurred before 2015.
Why should I be concerned about R&D credits since the federal credit expired at the end of 2014?
Earlier this year, the U.S. House of Representatives proposed to restore, permanently extend and expand various provisions of the R&D tax credit. But, the chances for a more long-term incentive are currently unsettled. Right now there is strong bipartisan support for the credit since it is seen as critical to competing in a global market. However, there is a conflict in thinking. The Senate Finance Committee has separately proposed a two-year extension and expansion of the credit. Because of the conflict, it is expected that in the coming months Congress will enact a two-year extension of the credit, not a permanent extension, effective retroactively to when the credit last expired on December 31, 2014.
What are the potential benefits of the R&D tax credit?
The regular federal R&D tax credit equals 20 percent of QREs that exceed a base amount. The Alternative Simplified Credit amount is 14 percent of QREs that exceed a base amount.
The base amount limitation often decreases the maximum net federal credit benefit into the 6 to 7 percent range, before consideration of state R&D-type credits which many states now offer. The credit results in a dollar-for-dollar reduction in federal tax liability. This can reduce an effective tax rate, improve earnings-per-share, and improve cash flow.
As noted above, the R&D credit is generally calculated using one of two different methods: the Regular Credit or the ASC. The Regular Credit relies on historical data that may require the taxpayer to go back over 30 years to compute a base amount. Use of the ASC eliminates “base period” difficulties.
The R&D tax credit is a business credit subject to the general business credit limitation rules. Any unused general business credits may be carried back one year and forward 20 years.
Many companies take advantage of the R&D tax credit every year. The R&D tax credit is available for:
• the development of a new product, process, formula, or software design;
• the building and testing prototypes or models (including computer-generated models);
• design related to construction or engineering activities;
• improving or enhancing existing production or manufacturing processes;
• developing, customizing, or upgrading software; or
• automating or streamlining internal processes.
Non-qualifying activities includes activities done outside of the U.S., market research, and nontechnical research, such as consumer taste or styling.
“Qualified research activities” are those activities undertaken specifically for the purposes of:
• discovering information which is technological in nature
• eliminating uncertainty in the development of a business component
• relying on the process of experimentation, or
• creating a new or improved function related to performance, reliability, or quality.
“Technological in nature” refers to the process of experimentation utilized in the research. Information is deemed technological if the process of experimentation fundamentally relies on principles of the physical or biological sciences, engineering, or computer science.
“New” means new to the taxpayer and is not freely available to the public.
“Qualified research expenses” include:
• In-house research expenses, which include wages paid to employees (including support and supervision personnel) for qualified research activities; and supplies purchased for use in qualified research activities (excluding land, improvements to land, and depreciable property); or
• Contract research expenses which are amounts paid to a third party for purposes of conducting qualified research activities on behalf of the taxpayer.
Indirect, general & administrative, and overhead expenses do not qualify as “qualified research expenses.”
Taxpayers that qualify for the R&D credit and have not claimed the credit can amend returns for any open tax years.
Contact your CPA to investigate and reevaluate your situation to ensure you are making the most of the potential credits available.
Nissa Jimenez, CPA, is the Tax Senior Manager at Eide Bailly LLP.