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Millions In Unclaimed Credits For Small And Mid-market Companies

Jan 22, 2008
The Research and Development (R&D) tax credit was created by Congress as part of the Economic Recovery Tax Act of 1981(a.) to encourage American industry to invest in research and development activities. The purpose of the credit was to stimulate R&D activities among businesses through tax incentives.

However, due to the stringent requirements that existed under the provisions of the Credit, a vast majority of the small to mid-size companies were unable to reap the substantial benefits of the R&D credit. Realizing that a majority of innovation in the U.S. was in fact transpiring from these small to mid-size firms, Congress in 2001 liberalized the statutory requirements to enable small and mid size companies across the U.S. to take advantage of the R&D benefits.

------ Relaxed Regulations for R & D Tax Credit ------

Specifically, the new regulations provided that companies were no longer required to maintain precise timesheets documenting every hour an employee spent conducting qualified R&D activities. Furthermore, the research no longer had to result in a product that was new to the industry; instead, the resulting product or process simply had to be new to the company that developed it.

Despite the recently enacted and less stringent regulations, an overwhelming majority of companies expending substantial amounts of wages on qualified research activities through their daily activities fail to take advantage of the hundreds of thousands in R&D credit dollars they are entitled to receive each year.

An estimated $137.2 billion in federal R&D funding has been requested by the Bush Administration for FY 2007, which is approximately a 2.6% increase over the $133.7 billion that was approved in FY 2006.(b.) Nevertheless, despite Congress' considerable efforts to alleviate the growing concerns regarding the ability of U.S. companies to compete in the technological global sphere, the intended beneficiaries of the R&D credit - small to mid-size firms - continue to disregard these benefits. Meanwhile, the amount of money expended by these companies nationwide on R&D has been growing exponentially.

------ Why do CPA's Neglect the R&D Tax Credit ------

There are typically two primary reasons for the neglect by CPA's of claiming the credit:

1) There is most often the misconceived definition of research and development. Whereas typically, the words "Research & Development" tend to invoke thoughts of scientists in white lab coats and dedicated R&D departments, the definition as adopted by the IRS is significantly broader and applies to everything from your small machine shops to your engineering firms, manufacturing firms, software development firms, bio-technology firms, to even wineries or bakeries that have any product or process developments or improvements.

According to I.R.C. Section 41, qualified activities include the design or development of new or improved business components(c.), where the term "business component" is further defined as products, processes, techniques, formulas, software, or inventions.(d.)

2) CPA's typically do not maintain the necessary hard science & legal (engineering & intellectual property) backgrounds required to both qualify and quantify the credit amounts.

------ Qualified Research Expenses ------

Under the current version, section 41 allows a tax credit of twenty percent of: (1) qualified research expenses that exceed the base amount(e.), and (2) basic research payments.(f.)

Qualified research expenses are expenses for qualified research performed in-house or under contract.(g.) Such expenses include the following:

(a) Wages paid to employees engaged in the actual conduct of the research effort or in the direct supervision or support of such effor(h.)t; (b) Costs of supplies used in the research(i.); (c) Payments made to third parties for computer time used in the research(j.); and (d) 65% of the contract fee paid to a third party for research conducted on the taxpayer's behalf.(k.)

------ Qualified and Unqualified Expenditures ------

The regulations provide that the qualified research generally includes all costs incident to the development of an experiment or pilot model, a plan process, a product, formula, an invention or a similar property. However, the regulations provide that the term research and experimental expenditure does not include the following:

1. Ordinary testing or inspection of materials/products for quality control; 2. Efficiency surveys; 3. Management studies; 4. Consumer surveys; 5. Market research, (including advertising or promotions); or 6. Promotions.(l.)

------ Four Parts of the Qualified Research ------

In order to satisfy the section 41 qualified research requirements, not only must an expense be for research and experimentation within the meaning of section 174(m.), but must also be for the purpose of discovering information that is "technological in nature." In addition, the application of the information must be intended for use in the development of a "new or improved business component" of the taxpayer.(n.) The research must use the "scientific method of experimentation," and the purpose of the contemplated developed technology must be for a new or improved function.(o.)

1. Technological in Nature

Research is undertaken for the purposes of discovering information that is technological in nature if the process of experimentation depends significantly on a hard science, such as physics, biology, engineering, or computer science, as opposed to relying on a social science, such as economics.(p.)

2. Scientific Method of Experimentation

The term scientific method of experimentation describes those activities used to design a business component when the component's design is unclear or unknown at the commencement of the process and must be derived by the scientific method of testing and discarding various hypotheses. The process is described as a sequential design process that develops the overall component through the formulation of hypotheses for specific design decisions, followed by testing, analysis, and then either refinement or rejection.(q.)

3. Functional Purpose

R&D is treated as conducted for a functional purpose only if it relates to a new or improved function, performance, reliability, or quality. Activities undertaken to ensure achievement of the intended function, performance, reliability, or quality of the business component after the beginning of commercial production of the component do not constitute qualified experimentation. R&D relating to style, taste, cosmetic, or seasonal design factors is not treated as conducted for a functional purpose and hence is not eligible for the credit.(r.)

4. Business Component

The three-pronged test -- technological in nature, scientific method, functional purpose -- is applied on a ' shrinking back' basis pursuant to which the three elements of the test are first applied at the level of the entire product, next at the most significant subset of the product, and thereafter at the next most significant subset. Thus, the term 'business component' is redefined at each level to mean the most significant subset of elements of the product at which the three parts of the test are satisfied. The ' shrink back' to the next lower level of the product is continued until either all three parts of the tests are met or the most basic component of the product or process is tested and fails.(s.)

------ State R&D Tax Credit Programs ------

In addition to the benefits of the federal R&D credit program, a majority of states have implemented R & D tax credit programs to reward R&D expenditures and encourage future investments in R&D within their state by enacting an R&D tax credit.

Currently, there are over 33 states that provide the R & D tax credit benefits to companies conducting qualified activities. In some states, the R&D state credit benefits equal or surpass the federal R&D credit amounts. For example, the California legislature has enacted regulations to make its R&D credit more attractive than the federal R&D credit, especially to those in the high-tech, biotech, and aerospace industries. Here are the top ten states in R&D performance for 2003.

State R&D $ Millions 1) California: 59,664 2) Michigan 16,894 3) Massachusetts 15,638 4) Texas 14,795 5) New York 13,031 6) New Jersey 12795 7) Washington 11,469 8) Illinois 11,045 9) Maryland 10,162 10) Pennsylvania 9,944

------ CASE STUDIES ------

Example #1: Machine Shop

Sampling of activities:

* Prototyping * CAD/CAM * Precision CNC Machining * Solvent and Adhesive bonding * Quality Assurance * Thermoforming Processes

Annual Payroll: 2003 - $1MM 2004 - $1.5MM 2005 - $2.5MM 2006 - $2MM

Net Credit Benefit for 2003 thru 2006 tax years: $110,000

Example #2: Welding Shop

Sampling of activities:

* Laser Technology * Shielded metal arc welding * Resistance welding * Quality Assurance

Annual Payroll 2003 - $6MM 2004 - $7MM 2005 - $8MM 2006 - $ 9MM

Net Credit Benefit for 2003 thru 2006 tax years: $500,000

------ References ------

(a.) Economic Recovery Tax Act of 1981, Pub. L. No. 97-34, 221(a), 95 Stat. 172 (1981) (codified at 26 U.S.C. 44F ( 2000)). (b.) Congressional Research Service Report for Congress, Updated October 10, 2006, Received through the CRS Web, http://www.fas.org/sgp/crs/misc/RL33345.pdf. (c.) I.R.C. 41(d)(1)(B)(ii). (d.) I.R.C. 41(d)(2)(B). (e.) I.R.C. 41(a)(1). (f.) I.R.C. 41(a)(2). (g.) I.R.C. 41(b)(1). (h.) I.R.C. 41(b)(2)(A)(i). (i.) I.R.C. 41(b)(2)(A)(ii). (j.) I.R.C. 41(b)(2)(A)(iii). (k.) I.R.C. 41(b)(3). (l.) I.R.C. 41(d)(4)(D). (m.) I.R.C. 41(d)(1)(A). (n.) I.R.C. 41(d)(1)(B). (o.) I.R.C. 41(d)(3)(A)(i). (p.) I.R.C. 41(d)(1)(B)(i). (q.) I.R.C. 41(d)(1)(C). (r.) I.R.C. 41(d)(1)(C), (d)(3). (s.) I.R.C. 41(d)(2).
About the Author
Paradigm Partners offers a FREE R&D Tax Credits Feasibility Study or contact Mark Lauber at (866) 378-4310 or MLauber@ParadigmLP.com
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