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White lab coats not necessary
Some manufacturing executives in the region may be missing out on a federal tax credit simply because they think their businesses aren’t the type that qualifies for research-and-development tax breaks.
“I think what the misperception is, at least in manufacturing, is that you need a bunch of people in white lab coats walking around creating something revolutionary, something absolutely new. That’s just not the case.
The Research and Development Tax Credit, which has been around since 1981, was extended again last month for two more years as part of the $858 billion 2010 Tax Relief Act that President Barack Obama negotiated with Senate Republicans.
The tax defines an action that a firm takes as an “activity,” and there are four criteria an activity must meet to qualify for the credit.
First, the activity must relate to a new or improved product or a new or improved process to make an existing product. This is called having a “permitted purpose.”
Secondly, the activity must be fundamentally technological in nature, meaning it has to rely on a physical, biological, or computer science technique, or involve an engineering procedure.
“The example that I use is, if a color makes a difference on a buyer’s habits, that’s not really a science that qualifies for this credit,” said Wierenga, who also pointed out an activity has to occur in the U.S. for it to qualify. “If someone is doing this in China, China may have a credit for it but we’re talking U.S. activities, as it’s a U.S. tax incentive.”
The third criterion is an activity has to eliminate some doubt as it relates to the capability, method, or appropriate design of a product or a process. “There has to be some level of uncertainty before someone starts a process or starts investigating a product.
“And the fourth step is really just some type of process of experimentation where someone is trying, evaluating and refining different hypotheses,” said Wierenga.
Wierenga said the R&D credit reimburses three related expenses. One is the W2-taxable wages for personnel directly involved in an activity, going one level up and one level down. “So you have your engineer, his or her support person and his or her supervisor. So you have wages, but you don’t have benefits. It’s purely taxable wages only,” he said.
The second related expense is for supplies. Things such as materials used during an activity qualify, but depreciable assets don’t. “If someone has to buy a new press to test something, if it’s depreciable, it doesn’t qualify,” said Wierenga.
But Wierenga added that if a press is purchased this year, another aspect of the tax relief act allows for machinery and equipment to be fully deducted on a company’s tax return.
“The expense of that press would not be part of the R&D tax credit. But someone could clearly get the tax benefit of writing off 100 percent of the cost of that press,” he said. And the cost can be deducted if the press was purchased from another country. A similar write-off is available for plant expansions.
The third related expense is for contracting with an R&D firm to do some of the research. But companies should note that only 65 percent of the expense involved with hiring a research firm can count toward the credit, while 100 percent of the taxable wages spent and the supplies used in an activity can count.
Wierenga said there are two ways the credit can be calculated. One method is more beneficial as the credit can be a tad higher, but it’s also more susceptible to audit changes. The other is a simpler method and is the one that Congress has been pushing.
“When we calculate the credit for clients, we do it both ways and pick the most beneficial one,” he said.
One reason some manufacturers may have been reluctant to consider applying for the credit is the record-keeping necessary to file an application. Wierenga said much of that process becomes a cost-assignment effort, which can be tedious or even taxing for a firm’s accountant.
“When we do a study, we’re creating a pretty thick binder on an annual basis that is basically handed to an IRS auditor if someone gets audited. Some companies just don’t want to go through the process, and there is a cost to producing that product for that binder,” he said.
Another possible deterrent for not going after the R&D credit is the uncertainty about how long it will be offered. Even though the tax has been around for the past 30 years, Congress typically has extended it for a year or two at the most, as was the case last month when it was given two more years of life.
“That may deter some companies from pursuing it because they don’t know for sure if it will be retroactive. Like this year, we went all the way to the end of December before we had a credit that was retroactive to Jan. 1,” said Wierenga. “There is definitely an uncertainty factor because of the hesitation to make it a permanent credit.”
There is one catch to the credit of which some business owners should be aware. A firm can’t use the R&D credit against the Alternative Minimum Tax, which is an important factor for partnerships and Subchapter S corporations where the business taxes are paid by the individuals who own a company.
Still, that situation shouldn’t discourage those business owners from looking into the R&D credit.
“More and more individuals are subject to the AMT. But if someone is subject to the AMT and is in a flow-through company, they may just decide that they’re not going to get a benefit anyway and not bother with putting all this information together to claim the credit,” said Wierenga.
“But even if someone doesn’t use it in the current year because of AMT, they can carry it back one year or forward 20 years. So that’s our comeback to a client if they tell us they’re going to pass on it.”