Are You Minimizing
the Financial Risks of Your R&D
Written by Patrick Donahue, Director of Research Tax Credit Services,
Hull & Knarr LLP,
for publication by Somerset CPAs, P.C.
In the past the research tax credit was largely reserved for the large manufacturers because the IRS required an academic approach to conducting a process of experimentation. Around 2001 the IRS eased up on that stance, realizing that most companies cannot take an academic approach to research and development because it is not cost effective.
This development opened up the opportunity to small and medium sized companies. This was exemplified when 84% of the claims in 2005 were made by companies smaller than $50 million in total assets. And if you think that the credit opportunity may not be as valuable to the smaller companies you would be wrong—these smaller companies are awarded credits that, on average, equal 3.2% of their assets versus less than 0.1% for the very large companies. And contrary to common belief, the credit is not only for manufacturers. In 2005, 28.8% of the credit claims were made by companies that had an SIC other than manufacturing. As this demonstrates, you may have an opportunity, but there are requirements for qualified research. While the IRS’s four-part test that defines qualified research can be subjective, there are some metrics that can help determine whether this opportunity should be pursued by your Somerset tax professional.
Product maturity is a good initial indicator for identifying credit potential. The governmental intent for the credit is to promote innovation to new or existing products to expand knowledge and application of engineering principles. For this reason, conducting routine engineering functions such as product maintenance, load calculations, head calculations and other static engineering calculations does not qualify. But if an existing product or engineering principle is reengineered to improve the fit, form or function, there might be a permitted purpose for qualified engineering.
If you are performing some type of product innovation, then there is probably an engineering staff supporting these efforts. The size of a company’s engineering staff is a good indicator for credit opportunity for two reasons—1) engineers are not hired to mop floors; they are hired to improve products or processes to compete in a marketplace and 2) the credit potential is contingent on the amount of money being spent on qualified research and the largest expense for most company’s wages. Therefore one can assume more engineers, more wages spent on product development.
The other indicator is the "coolness factor." Common sense will tell you if there was a significant amount of development efforts, the end result will be impressive. Keep in mind when using this test that on the surface a product may look very standard, but there may be an interesting component to that product. An example is shampoo; there are seemingly innumerable brands of shampoo that all look the same, but some of these shampoos have highly developed polymers, emulsifiers and surfactants that are synthesized for various characteristics. You may have to dig a little to find the coolness factor of the product.
This is probably an appealing proposition for many of you, but there is some investment of time and an increased audit risk associated with making a claim for the credit. The time investment is centered on the research credit professional talking with you and your employees to determine the opportunity. Anyone you use to conduct a study should not charge your company a significant fee if a credit is not identified. The audit risk is only associated with research tax credit, and a claim will not spark a general audit of your company. Additionally, audits should be handled by your R&E credit service provider.
The potential for increased profits and increased funds for research activities far outweigh the risks. By comparing these indicators against your normal business operations, you not only determine your credit potential but you also may reevaluate where you want to be with your business. If there seems to be opportunity, contact your Somerset tax professional to discuss this credit.
Wherewithal
is provided by Somerset for our clients and other interested persons
upon request. Since technical information is presented in generalized
fashion, no final conclusion on these topics should be made without
further review. For additional information on the issues, please
contact
a member of the firm. Somerset provides total financial solutions,
including accounting, assurance, information solutions, litigation &
valuation, tax, wealth management and management consulting services to
entrepreneurs and their businesses. This document is not intended or
written to be used, and cannot be used, for the purpose of avoiding tax
penalties that may be imposed on the taxpayer.
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P.C.
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