A version of this article was originally published November 2022 in the Denver Business Journal.
Manufacturers are increasingly focused on solutions that are faster and more cost-effective in a business landscape that’s increasingly automated by the day. That innovation often translates to qualifying for cost-saving R&D tax credits.
Despite the opportunity, many in the industry are unaware that developing new or improved products or processes could result in R&D tax incentives that provide significant savings.
Additionally, start-up companies may be eligible to apply R&D tax credits against their payroll taxes for up to five years.
To help break down this complex topic, here’s a list of common questions manufacturing and consumer products companies have about the R&D tax credit:
What Is the R&D Tax Credit?
The federal R&D tax credit is a dollar-for-dollar tax savings that directly reduces a taxpayer’s regular or payroll tax liability.
There’s no limitation on the amount of expenses and credit that can be claimed each year. If the R&D credit can’t be used immediately or completely, any unused credit can be carried back one year or carried forward for up to 20 years.
How Much Can a Company Save with R&D Tax Credits?
There’s no limit, but several factors can impact savings—and because there’s such a wide variety of qualified expenses within the manufacturing and consumer products industry, it’s difficult to give an exact estimate of potential savings.
Depending on a company’s size and the types of activities performed, typical savings can range anywhere from $50,000 to $5 million through the R&D tax credit.
The amount saved stems from the amount of expenses determined eligible for the credit, not the revenue a company generates. Generally, the amount of credit can be approximately 5%–15% of a company’s R&D expenses during a given year. Typically, the more a company spends to innovate, the more they can potentially save.
What Types of Manufacturing Activities Qualify for the R&D Tax Credit?
The R&D tax credit isn’t limited to the work of scientists or dedicated R&D laboratories. Most manufacturing and consumer products companies perform qualifying R&D activities as part of their normal operations.
Most qualifying expenses fall into three categories:
- Contractor expenses
Qualifying employee wages can include Form W-2, Box 1, or pass-through income subject to self-employment tax. This would include individuals performing qualified research as well as those that directly support or supervise the research. The rules specify if an employee is 80% qualified, 100% of their wages can be included to calculate the credit.
When considering employee wages, it’s important to assess the impact of highly compensated employees on the credit, with an emphasis on those in executive roles.
Eligible staff includes staff who are engaging in the qualifying activity as well as those supervising the activity.
Some examples include the following:
- Product engineers designing and developing new prototypes
- Manufacturing engineers, technicians, or machinists developing new tooling and equipment
- Process engineers developing new manufacturing processes
- Software engineers developing operating systems in new products
- Supervisors that directly oversee R&D activities
- Production and assembly staff crafting test batches and building prototypes
- Lab or quality assurance personnel testing new products
Qualified supplies include tangible property used in the qualified research, such as:
- Materials used to develop and test prototypes and first articles
- Small- or large-scale test batches
- Custom and unique equipment or tooling
- Mold costs
- Materials used or scrapped during process development
Payments to contractors may also be eligible, but they’re subject to some restrictions.
Qualified expenses typically include the following costs:
- Outside testing
- Other third-party services
Qualified expenses typically include the following types of activities:
- Designing and testing prototypes and pilot models
- Introducing new technologies to improve the manufacturing process
- Developing customized equipment
- Testing alternative materials to improve product performance and manufacturing
- Creating specialized technologies, such as artificial intelligence or machine learning
- Developing software applications to use internally or to interact with customers or vendors
- Imbedding software applications
- Developing new methods for sustainability
Additional Opportunities Related to R&D That Are Often Missed
Companies are required to capitalize R&D costs, including software development costs, incurred in tax years after December 31, 2021. Starting in 2022, a company is required to capitalize and amortize over five years for domestic R&D or 15 years for foreign R&D costs.
There’s legislation with bipartisan support in Congress that could repeal the current law. However, the prospects of this legislation are uncertain.
What Documentation Is Necessary for the R&D Tax Credit?
Improperly calculating and claiming R&D credits can have consequences in the form of penalties and fines.
With increased IRS scrutiny around R&D credits, it’s crucial to understand what’s necessary to substantiate a credit claim. Like many other aspects of tax compliance, documentation is important for both the quantitative and qualitative aspects of the R&D tax credit.
From a quantitative perspective, taxpayers should maintain documentation for employee wages, specifically Form W-2 data, as well as general ledger detail for any supplies or contract research related to R&D. Ideally, these amounts should be tracked by project, account, and vendor and be easily identifiable within the general ledger.
From a qualitative perspective, taxpayers should retain all formal and informal documentation created during the R&D, such as:
- Project descriptions or plans
- Design revisions
- Test logs and reports
- Notes, presentations, and emails
We’re Here to Help
Each company’s goals, values, and resources are unique, so it’s important to develop a customized project plan to identify, calculate, and support your company’s R&D credits and activities.
With recent increased IRS scrutiny around R&D credits, it’s crucial to understand what’s necessary to substantiate a credit claim.
To learn more about R&D tax credits, see Five Misconceptions about R&D Tax Credits—and if Your Company Qualifies, or request a credit benefit estimate to see how much your company could save.