Manufacturing and technology companies can subsidize their research and development costs by using the R&D tax credit. But getting the most out of the credit requires a deliberate approach.
Since the early 1980s, the federal research and development (R&D) credit has been a powerful incentive in driving technology and innovation in the United States. The credit rewards businesses that invest in new and improved products and processes.
Manufacturing and technology companies in particular are great candidates for the credit; however, many manufacturers either miss a credit opportunity altogether or do not capture the full array of costs that may be eligible. As the global market becomes more difficult and competitive for manufacturers, the credit should not be overlooked as an excellent tool for subsidizing your R&D costs.
Overview of the R&D credit
In general, businesses that undertake a process of experimentation in order to create or improve a product or process can qualify. The major costs that can be captured are:
- Wages of individuals performing, supporting, or supervising R&D activities
- Supplies used in the R&D process
- Amounts paid to outside consultants or contractors for the performance of R&D-related activities
Many of the rules were written expressly for taxpayers engaged in manufacturing. What’s more, some of these rules have been liberalized in recent years, and many states also offer R&D credits to help minimize your state tax liabilities. Here are some highlights that manufacturers should have in mind when considering the R&D credit.
Capture qualified products and processes
The R&D credit may be claimed for both products and production processes. This two-pronged qualification opportunity puts manufacturing companies in a unique position to maximize their benefit.
For example, if your company has designed a new product and must create a new production process to manufacture the item and bring it to market, both development streams can qualify. Additionally, the tooling and fixturing costs incurred for production may qualify as well.
Capture all qualified personnel
Typically, qualified wages are the main driver behind an R&D credit, and the pool of potential wages that can be considered eligible for the credit is quite broad. The rules allow three categories of employee service time:
- The performance of qualified activities
- The direct support of qualified activities
- The direct supervision of qualified activities
Example
If a company is building a new medical device, the scientists and engineers developing the product’s core design and functionalities are clearly performing qualified R&D activities. From there, a prototype must be built with the assistance of the company’s production and fabrication personnel. Those individuals and activities may be considered the direct support of R&D. Lastly, assume one of the company’s senior engineers oversees the process from a technical standpoint and reports the findings to management. Those activities can equally qualify for the credit as the direct supervision of R&D.
Prototype, tooling, and supply expenses
For many years, the IRS took the position that in order for supplies to qualify for the credit, they had to be consumed during the R&D process. In other words, only supplies and materials that were scrapped during the process of experimentation were deemed eligible.
However, in 2014, Treasury regulations were released that altered this position to provide favorable treatment of costs incurred to produce a “pilot model” (i.e., a prototype). The regulations now provide that the “ultimate success, failure, sale, or use of the product is not relevant” so long as sufficient uncertainty exists with respect to the technical feasibility of the prototype.
With this rule change, qualified supply costs may now be claimed for a prototype irrespective of whether the item is scrapped or sold to a customer. These supply costs may be claimed in addition to the labor used to develop the prototype.
Tooling
The issue of tooling costs has been a problematic area for manufacturing companies when claiming the R&D credit. Tooling and fixturing can represent a substantial outlay when scaling up for production, and the process generally involves numerous iterations and technical challenges.
Oftentimes, contract manufacturers will incur tooling costs for items that their customers will ultimately own, even though the contract manufacturer will generally retain possession of the items.
Similar to the prototype issue, the IRS historically took the position that such costs did not qualify under the credit rules. But in 2018, the IRS conceded a case on the eve of trial where the taxpayer (an automotive supplier) claimed $9.3 million as qualified supply expenses.
The supplier’s costs related to metal stamping and injection molding for use in its production line. The taxpayer’s customers required it to sell unique tools produced for the customers, but the taxpayer retained possession of the tools. While this case is not precedent, it may indicate how the IRS will treat these costs going forward.
Documenting your R&D expenses
When claiming an R&D credit, documentation is critical. While estimating costs is permitted, having a robust project tracking methodology to quantify your creditable expenses will be the best source of support. Companies that do not have a mechanism in place to accurately track projects and costs may want to consider investing in such a system.
Additionally, the IRS will likely want to see why a particular project qualifies for the credit. Therefore, having a good sampling of technical documentation compiled for your projects when claiming the credit will save the time and hassle of having to go back and dig it up in the event of an IRS audit. Documentation can include conceptual design documents, design drawings and revisions, prototype results, and even emails. The goal is to build your credit support as contemporaneously as possible with your R&D efforts.
How CLA can help
CLA’s national R&D credit team helps manufacturing and technology companies of all sizes claim, support, and defend their federal and state credits. We customize our analyses to address those items the taxing authorities will request upon potential audit to help ensure your credit stands up to scrutiny.
CLA can also help you develop methods that will improve your project and cost accumulation procedures. We know that making the R&D credit an integral part of your company’s practices can result in valuable efficiencies while helping to optimize the credit benefit.