Now is a great time to consider the R&E tax credit
If your company has never taken the Research & Experimentation (R&E) income tax credit, now is a great time to consider it. If you do take the credit, make sure you are in compliance with recent changes to maximize the available credits.
The R&E income tax credit applies to taxpayers that develop and/or improve products, processes, formulae, techniques, software, or inventions. A four-part test must be met for projects to qualify. Besides having to fit one of the above categories, the project must also be technical in nature, possess uncertainty about the outcome, and involve a process of experimentation such as trial and error.
There are three types of expenses that qualify for the credit: eligible wages calculated from the qualified hours spent on projects, supply costs, and contract research incurred for certain third-party services.
The R&E tax credit has evolved since its inception in the 1980s. The biggest change occurred with the issuance of Treasury Decision 9104 in 2004.
Previously, a discovery test required the research to expand or refine knowledge within the industry. The 2004 decision removed the discovery test language, effectively lowering the “innovation bar” to where it only had to be new to the company.
Here is an overview of recent court cases that have affected the application of the credit:
Geosyntec Consultants Inc. v. United States
GSI is an engineering firm in Florida that developed solutions to environmental problems. The contracts considered were in the categories of fixed-price, cost–plus, and time and material. Both sides agreed from an economic risk standpoint that fixedprice contracts qualified and that time and material contracts were non-qualified.
The IRS disallowed research credits stemming from the cost-plus contracts, saying they did not qualify since they were funded by GSI’s clients and that GSI did not bear the risk of loss if it failed to perform under the contract. The court agreed with the IRS.
T.G. Missouri Corp. v. Commissioner
Supply costs for the research credit were traditionally restricted to those consumed during the development of the manufacturing process. The only tooling eligible as a supply cost would be expensed prototype tooling used to develop the process but not used during commercial production.
As a result of the T.G. Missouri case, tooling on which experimentation is performed during the development of the process and for which the taxpayer is at economic risk (payment is contingent on the manufacturer’s ability to produce a part that meets the customers’ specifications) can now be classified as a qualified supply cost for purposes of the R&E tax credit. This can have a significant effect on the size of the credit.
Suder v. Commissioner, T.C. Memo
This case reemphasizes support for the use of estimates to determine qualified research percentages; addresses the issue of reasonable compensation; allows inclusion of base salary and incentives, but not royalties; and upholds the concept that projects can be qualified even if relying on existing technologies, do not have to “reinvent the wheel”.
The net benefit of the federal R&E tax credit is approximately 6 percent of the qualified expenditures. Therefore, for every $100,000 in qualified wages, supply costs, and contract research, the company (or its owners in the case of flow-through entities) receives approximately $6,000 in tax credits.
To learn more, contact Rubin Brown’s Research & Experimentation Tax Credit Services Group.