check four tests for qualified research.
by alex pak
source advisors
alex pak is a director in the los angeles, california office of source advisors.
the protecting americans from tax hikes (path) act of 2015 includes provisions that allow certain taxpayers to offset their amt liability with the r&d tax credit for taxable years beginning on or after jan. 1, 2016.
more: how the r&d tax credit has expanded over the years | the nine-point plan for handling §179d
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amt limitations
before the path act, amt restrictions prevented qualified companies from utilizing 100 percent of the r&d tax credit. the excess credits were often carried forward. today, small businesses can offset amt using the r&d tax credit for tax years beginning after dec. 31, 2015.
yet, some limitations, like the 25/25 rule, remain.
this regulation restricts taxpayers with over $25,000 in regular tax liability from offsetting more than 75 percent of their tax liability using the credit (sec. 38(c)(1)). carryforwards before 2016 are also still limited by amt.
eligible business types
non-publicly traded corporations, partnerships and sole proprietorships in any industry may qualify for the r&d tax credit. the most common industries engaged in qualified r&d activities include:
- technology and software
- manufacturing
- engineering
- life sciences
qualified research activities and expenses
qualified research, as defined by the irs, is based on the following four-part test:
- was it intended to develop or improve the functionality, quality, reliability or performance of a product, process, software, technique, formula or invention?
- was its development technological in nature?
- was there a technological uncertainty about either the capability, method or appropriate design at the outset?
- was a process or experimentation used to overcome the technical uncertainty?
the activities that qualify for the r&d tax credit are the same ones driving growth in your business:
- creating improved products, processes, formulas, software and techniques
- automating or improving internal manufacturing processes
- designing tools, jigs, fixtures and molds
- integrating new equipment
- development of data center, big data and data mining tools
- integration of apis and other technologies
- development of financial or pricing models
- hiring outside consultants to perform any of the listed activities
- manufacturing new or improved products
- developing prototypes, first articles, models
- evaluation of alternative materials
- development of firmware
- network hardware and software development and optimization
- developing simulators
- development of risk management systems
ensuring that you understand the qualification rules is an essential first step in claiming the r&d tax credit. this is normally done during a feasibility analysis, also referred to as phase 1. r&d activities are explored and identified at a high level along with related qualified research expenses (qres). this information is then used to estimate your federal and state r&d tax credits. education is key and provides the ability to identify qualified activities and qres so a more accurate benefit estimate can be determined.
the expenses that qualify for research activities within your company typically include employee compensation, materials and contracted services. various forms of documentation are sufficient to support your qualified expenses and may include payroll records, financial records showing supply or contract research expenses, and vendor invoices.
are small businesses eligible to offset the amt with the r&d tax credit?
a small business may be eligible to offset the amt with the r&d tax credit if it:
- is a non-publicly traded corporation, partnership or sole proprietorship with an average of $50 million or less in gross receipts over the prior three years
- has conducted qualified research defined under irc sec. 41
on average, companies are typically able to claim 7-10 percent of their qualified expenses as a federal r&d tax credit. for example, a single software developer, engineer or lab technician who receives a w2 of $100,000 a year may generate a tax savings of up to $10,000.
here’s an example of a case study for a company specializing in plastics and injection molding that successfully claimed the r&d tax credit:
this plastics company has been an innovator in the use of industrial plastics in new applications with roots in identifying products that could be produced using plastics. the company offers urethane casting, thermoforming, machining and plastic injection molding services. the company constantly evolves to expand its offerings into new industries and applications.
the r&d activity at this company started with a customer request. meetings were held between the customer and their contact, whether it was the sales department or the owner, to identify the design of the product as well as the specifications, performance and functionality requirements the product must meet. often, for more challenging projects, the heads of the different departments, including cnc, fabrication, injection molding and casting as well as the design engineers and operations managers would also get involved to perform more in-depth preliminary engineering calculations.
even if customers develop and provide a prototype of the product, they prefer mass-produced, technical sales and engineers to perform a detailed design for manufacturability review and would more often than not have to redesign the customer’s provided design drawings and prototypes to ensure that it is manufacturable on a large scale. this often included the development and fabrication of molds, casts or other custom tooling needed for production purposes.
preliminary engineering analysis was performed to determine if the product should be injection molded, fabricated or molded with urethane. this led to the experimentation with molds and casts to determine whether flow and cure rates were consistent to develop a repeatable process. qualifying activity continued with design engineers creating cad/cam design documents that were utilized as the basis to develop the cnc programming. in addition to developing the part and process designs, design engineers were responsible for developing custom tooling and fixtures to support the production process.
once the part and process designs were complete, the team began producing prototypes for validation. often, molds, casts and the parts themselves went through a validation process to determine whether quality, regulatory and performance standards were met. this process was highly iterative and required numerous trials to solve all the technical issues that were a ubiquitous part of any development process.
following the finalization of the process, the company needed to produce the first articles and perform validation to determine whether both the part and the production process were working properly, which was also a qualified activity. the first article sample rarely produced a part that met all their specifications. the team worked through an iterative process of optimizing the code, performing another trial run, analyzing the samples and further refining the process multiple times before they were able to create a product that met their customer’s specifications. once this stage was complete, multiple units were produced and the company continued to scale up production while monitoring the quality of the final product.
conclusion
with the complexity of their production process and the significant investment in technology and man hours, this company depends on r&d to remain a leader in the plastic injection molding industry. qualified research expenditures totaled nearly $900,000 in the initial study performed by source advisors in 2012. through the years, the company’s areas of research and development have expanded to exceed $1.4 million equating to an annual r&d tax credit of over $105,000.