In 1981, the R&D Tax Credit was enacted as part of the Economic Recovery Tax Act1 to provide an incentive to American companies to invest in research and development (R&D). The goal was to encourage innovation, revitalize American business, and drive U.S. economic growth. That is still its purpose today and, while large U.S. businesses have been taking advantage of this tax credit for decades, it is still largely unknown to the small and medium-sized business community—medtech’s primary company profile.
You may now be thinking, “That doesn’t apply to me. I don’t do any R&D.” This is a very common response I encounter when first speaking with clients. The reality is, while manufacturing is a complete bullseye for this credit, as a general rule, any company in any sector that designs, develops, or improves products or processes may be eligible, and can realize an immediate benefit with tax refunds, as well as an offset against future tax liability. Further, the R&D doesn’t only have to relate to creating new products; it can be R&D into new market opportunities, how marketing is done, new equipment to improve the manufacturing or design process, training of the workforce to make them more effective, and many other areas of business one might not readily associate with the term R&D.
Though it was initially introduced during the early days of the Reagan administration, the R&D tax credit initiative was supported and expanded through all subsequent administrations until it was made into law in 2015 as part of the PATH Act2 (Protecting Americans from Tax Hikes). The PATH Act not only made the R&D Tax Credit permanent, but added enhancements to provide for additional savings. In the past, some small and medium-sized manufacturers (those who knew about it) couldn’t claim the R&D Tax Credit because the owners would be subject to the Alternative Minimum Tax (AMT), which made the credit useless. The PATH Act eliminated the AMT for small businesses with less than $50 million in average gross receipts for the previous three years.
What qualifies for R&D tax credit is based on the activities in which a particular business is engaged. These activities are broadly defined in law and must pass the following four-part test:
- Permitted Purpose: To qualify for the R&D credit, the activity must relate to a new or improved business component’s function, performance, reliability, quality, or composition.
- Technological in Nature: The activity performed must fundamentally rely on principles of physical sciences, biological sciences, computer science, or engineering.
- Elimination of Uncertainty: The activity must be intended to discover information to eliminate uncertainty concerning the capability or method for developing or improving a product or process, or the appropriateness of the product design.
- Process of Experimentation: The qualifying activities must constitute the process of experimentation involving simulation; evaluation of alternatives; confirmation of hypotheses through trial and error; testing and/or modeling; or refining or discarding of hypotheses.
Any activities you engage in that meet the four-part test criteria can qualify.
These activities are called Qualified Research Activities (QRAs). These QRAs translate into Qualified Research Expenditures (QREs). QREs break down into three categories:
- Wages of people involved in these activities.
- Services paid to engage in these activities.
- Supplies purchased in the pursuit of these activities.
For example, if you’re working on bringing a new device to market, the design, the prototypes, the adjustments due to trial and error, and the entire process of experimentation is eligible to be considered for R&D tax credits, as are the wages of those specifically assigned to such a project. Even a certain potion of supervisory activities, if they are a part of the process, can be considered.
Perhaps a portion of the development is contracted to another business or a 1099. This would be an example of a service you paid for that could be considered for eligibility.
As another simple example, let’s say you are testing out a new plastic or glue in relation to a new development or even an existing product you are seeking to improve to become more competitive. This is an example of the supply category of QREs.
Manufacturing and remanufacturing companies engage in many different activities that are likely to be eligible for R&D tax credits. Some general types of qualifying activities include:
- New or improved products, designs, equipment, and manufacturing processes
- Creation of second-generation products
- Development of prototypes
- Design and evaluation of alternative processes aimed at enhancing cost-effectiveness and product performance
- New or improved methods to recover and reuse products
- Innovations that lead to better compliance with governmental regulations
- New processes that reduce waste, promote energy conservation, and lower carbon emissions
- Development of more efficient processes and technologies and identification of new product categories and markets
- Introduction of efficient technologies and processes, such as disassembling, cleaning, inspecting, and testing of used products
- Innovative or improved methods to rebuild and enhance products
- Improved processes that prevent costly workplace injuries, reduce inventory, and recycle as much core content as possible
- Improved material management (such as the establishment of conditions and configuration classifications)
Why Haven’t I Heard About Them?
As mentioned previously, R&D tax credits have been a well-kept secret from many companies who do not engage the services of large CPA firms that employ specialists in this area of the hugely complex and confusing federal tax code (which currently clocks in at over 74,000 pages).
It is a little-known fact that of the small to medium-sized businesses that qualify for these credits, over 90 percent never claim them. In April 2019, Forbes stated that this is one of the best tax credit opportunities for small to medium-size businesses.3
From many discussions with business owners, there are two primary reasons they are not taking advantage of R&D tax credits.
- They don’t know about them. Owners of manufacturing companies are generally not CPAs and normally rely on outside help for tax advice. When it comes to R&D tax credits, it frequently doesn’t happen. With a 74,000+ page tax code, it is frankly impossible for CPAs to keep up with it all. CPAs tend to focus on deductions and regulations rather than on activities, so businesses usually do not hear about this tax saving opportunity through this channel.
- They don’t know how to easily claim them. Small to medium-sized businesses are typically resource constrained. Business owners are busy and the subject of taxes comes up maybe four times a year so it is not a daily priority. Even if they have heard of R&D tax credits, they don’t know how to go about taking advantage of them. In addition, more often than not, when they ask their tax advisor, they are told this is not a thing and they probably don’t qualify anyway. Further, many companies who do specialize in claiming R&D tax credits, and there are more and more of them popping up, do expensive and time-consuming audits without any guarantee the manufacturer will qualify.
There are some companies who will conduct a free analysis of the potential R&D credits and charge on a contingency basis so there is no real risk to the company. They either do or don’t qualify, and can proceed accordingly.
If you haven’t claimed R&D credits in the past, the really good news is you can go back three years and claim R&D credits for which you are entitled. For manufacturers, these can often be in the tens of thousands to hundreds of thousands of dollars, which can really help cash flow. In addition, the IRS pays 6 percent interest on money refunded.
The catch is the government doesn’t just hand out money to anyone who asks, and this is probably particularly true for small and medium-sized business owners. In order to get actual cash back, there are basic qualifying factors.
- The company must be engaged in R&D activities.
- The company must have actually paid taxes.
- The company must have W2 employees.
Different companies use different processes to submit for the R&D credits. Some require detailed time sheets and write-ups in order to claim these credits. Others create expensive and time- consuming 200-page reports to back up the claim.
One of the simplest and most elegant methods, however, and an excellent option for small to medium-sized manufacturers, uses the following process.
Step 1: The R&D tax consultant conducts an in-depth interview with the subject matter expert—usually the business owner or manager, and can include several different people—to understand the business and identify the qualified R&D activities in which they engage. This is accomplished using a list of questions related to known qualified activities that help reveal the true R&D actions of the company.
Using this information, the business and R&D experts can accurately define an estimate of time spent on R&D activities, which qualify for tax credits. This method of estimating is supported by the Suder v. Commissioner of Internal Revenue 2014 case wherein the IRS Tax Court ruled business owners can estimate the time spent on this.
The Suder decision is important in that the Tax Court ruled applying the work of others or performing applied research may be eligible to claim the incentive.
Previously, the IRS did not recognize “routine research” or “routine engineering,” as qualifying R&D activities, which significantly reduced the number of businesses that could claim them. The Suder decision ruled that companies don’t need to reinvent the wheel to be able to claim the R&D credit. It was a great step forward for small business in claiming the R&D credit.
Step 2: After the interview is complete and it is determined there are qualifying R&D credits available, a review is performed of the business’ last three years of tax returns as well as any additional information needed to support filing amended returns to claim refunds of the earned R&D tax credits.
Step 3: The interview process, the tax returns, and the profit and loss statement tell the tale. That data is crunched and tallied based on the industry and a team of experts in various fields come up with the credit for the company.
Step 4: From there, it is simply a matter of producing and filing the amended returns and waiting (usually three to four months) for the IRS to process the claim and issue a tax refund.
This is a far less intrusive process for the business and offers a way to more easily apply for this credit without a major distraction to business operations.
Another benefit of this method is the business owner receives a free incentive analysis to determine if they qualify. If they do not, there is no cost to them for the work. All work is completed on contingency—if there is no recovery, there is no cost.
On a Personal Note
When I first heard of R&D credits being applied broadly, I have to admit my skepticism, just as many with whom I’ve spoken were and perhaps even those reading this article. I had been aware of R&D credits from inception. During my time at a software company in the 1980s, we regularly took advantage of this program.
Unfortunately, I hadn’t kept up-to-date, and the fact the definition had been so broadened and the process made so much easier was new.
After conducting the necessary due diligence, I decided (as a proof of concept) to see if my own business would qualify. I had researched and invested time and money into new business ideas and ventures for my small consulting firm. I applied for R&D credits, and frankly did not expect much to come of it.
To my surprise, I qualified and received a refund for all three years. I quickly became a believer and have since helped many businesses in a number of states and industries apply for and receive R&D tax credits.
I addition to the federal R&D tax credits available, many states also offer such credits to attract, retain, and reward businesses in their states.
Most manufacturers are engaging in R&D to some degree, and many have a substantial amount of activities they may not be aware can be classified as R&D. The majority of small- and medium-sized firms, however, are not taking advantage of the R&D tax credits created specifically to help them innovate and improve their business. As a result, these companies are giving up money that is rightly theirs—money that could drive growth and improve efficiencies, help with existing expenses, allow additional hiring, and help address the many financial issues keeping business owners up at night.
If your firm is engaging in qualified R&D activities, get these legitimate and deserved credits from the government on taxes, and/or offset your tax liability.
Isn’t it worth checking out?
Chris Lake is the president of a professional services consulting company in Los Angeles, Calif. She has more than 40 years of experience in business management, with a focus on research and development, operations, and financial issues. In addition to having held senior management positions at a number of companies in the technology, insurance, and financial services industries, Lake has owned and been part-owner in three successful businesses and understands the issues facing small and medium-sized business owners. She is passionate about helping businesses understand and take advantage of available R&D tax credits, and, as a result, helping businesses and the American economy stay strong. You can contact Chris Lake at email@example.com.