Offset Research and Development Costs with Tax Credit

Updated regulations may offer a new means for increasing your bottom line.

By Mark Andrus, Grant Thornton LLP

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Recent changes in the tax rules will help to provide companies with additional funding for innovative product development. Whether or not your company has taken the research and development (R&D) tax credit in the past, now is the time to re-evaluate your facts based on these changes to be sure you are maximizing the potential credits available to you.

Finding the capital to spend on research and development often can mean the difference between success and failure for manufacturers. The federal R&D credit is a 20 percent incentive, and many states provide additional R&D credit incentives.

Companies that have conducted the following activities should consider the R&D tax credit: developed new or improved products; developed prototypes or have any trade secrets or proprietary information; developed any new patents; enhanced their production process; utilized technical personnel; have an internal engineering department; built a new manufacturing facility; or automated their process or added sophisticated software.

The credit has expired 11 times and has been temporarily extended 12 times. Throughout this turbulent history the definition of qualified research has been a moving target. The final regulations bring clarity to the definition of qualified research. Additionally, the mechanics of the calculation have changed over time and so have the opportunities and potential pitfalls.

Those opportunities are:
  • Increased R&D activity. The 33rd Annual Food Processing R&D Survey predicted that 2005 will be a year of novel, new products backed by slightly higher budgets. The R&D credit is an “activity”-based credit. It rewards taxpayers that spend time on qualified R&D tasks. Even if your company’s R&D budget has not significantly grown, but the amount of R&D performed has increased, the potential credit opportunity is larger than in the past.
  • New definition of R&D. After more than 20 years, the Internal Revenue Service issued final regulations in 2004 defining qualified research activities. This definition is much more taxpayer-friendly than the prior “working” definition of qualified research used by the IRS. The most significant change is the elimination of the new technologies discovery requirement. These changes can be applied retroactively. This new definition has already proven to be a benefit to taxpayers. As the IRS agents embrace this new definition, we expect to see even more activities qualify for the credit.
  • R&D Credit extension. The R&D credit expired in July 2004. However, the Working Families Tax Relief Act of 2004 extended the R&D credit through December 31, 2005. With 2005 promising to be a significant year for tax legislation, tax practitioners expect to see an additional extension or maybe even have the credit become a permanent credit.
  • Industry trends. The food industry, like most industries, requires innovation to meet the ever-changing demands of consumers. One of the four tests defining qualified research requires that the research be intended to: develop new or improve existing product function, performance, reliability, or quality; or  provide a significant cost reduction. These are the very demands consumers are placing on food companies. Companies developing new products that are healthier, quicker to prepare, packaged to stay fresher longer, etc., are typically engaged in qualified research activities.
The potential pitfalls are:
  • Continued IRS scrutiny. Although the definition of qualified research has been modified in a way that benefits taxpayers, the IRS is still watching very closely to ensure that taxpayers only take the credits they are allowed. For several years, the IRS has been training engineers to audit the R&D credit. These engineers are becoming better at understanding the law and finding those cases where taxpayers are taking more credit than allowed.
  • Sufficient documentation. Along with the increased scrutiny, taxpayers are encouraged to have their R&D activities documented and be able to tie their qualified research costs back to the activities. This can be a difficult hurdle for companies that are focused on getting new products to the market; however, the cost of producing some documentation today should result in large benefits when the credit is audited in the future.
The next steps? Food processors and equipment manufacturers who have not previously taken the Research Tax Credit should implement a detailed study to identify and claim research credits in the current and prior years. Taxpayers already claiming the credit should perform an in-depth analysis of additionally qualifying activities in light of these new regulations or re-examine the content of their current documentation to consider these new regulations.

“The devil is in the details” is an old adage that applies to the R&D tax credit. Even though the R&D tax credit was enacted more than 20 years ago, 2005 promises to be a year of both opportunity and potential pitfalls for taxpayers that either have taken the credit in the past or have not yet taken advantage of the credit.

About the Author
Mark Andrus is the national director of research tax credit studies for Grant Thornton LLP. He may be reached at 503-276-5910 or mark.andrus@gt.com.
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