Federal R&D Tax Credit
In today’s highly competitive business environment, companies must continually develop and improve products to maintain a competitive advantage—making robust research and development (R&D) programs the driving force behind growth for many businesses. The U.S. government realized the importance of R&D to the economy decades ago, prompting the enactment of the federal R&D tax credit in 1981.
A company’s overall R&D spend can be significant. The ratio of R&D to total sales, also referred to as R&D intensity, typically runs anywhere from 3 percent to more than 40 percent. Smaller companies in certain industries such as biotech or software may have significantly higher ratios, so company size is not necessarily a determining factor when evaluating R&D.
Many companies conduct R&D activities as part of their daily operations but may not realize it. Nor do they realize that both federal and state R&D tax credits are available to help offset the costs associated with R&D. The federal R&D tax credit reduces past, current and future years’ federal tax liabilities and is an actual dollar-for-dollar offset against taxes owed or paid—creating an immediate source of cash that companies can reinvest into the business. As a wage-based credit, salaries and wages paid to employees or contractors for conducting specific activities as well as supply costs qualify for R&D tax credits.
The SourceHOV | Tax approach to R&D tax credits
SourceHOV|Tax works with Fortune 1000, middle market and smaller companies across a variety of industries to evaluate their ability to claim federal and state R&D tax credits and to appropriately maximize use of the credit. Our approach is different than many service providers in that we educate our clients on the R&D tax credit rules and how to identify activities that will qualify versus those that won’t. By collaborating with our clients, we find that they are better prepared in subsequent years, making the process more efficient and often increasing the tax benefit as a result. The relationships we develop with clients are long-term, evidenced by the fact that more than half our R&D work is for existing clients.
Our R&D technical team members are dedicated R&D practitioners, with even the most junior members having no less than four years focused solely on R&D tax credit studies. Most have Big Four or industry experience in R&D as well, bringing a wealth of tax credit and industry knowledge to the table. We use a proven, client-focused approach when evaluating an R&D credit opportunity. This process typically requires only an hour of a client’s time but is a critical step in evaluating the credit. Before ever signing an engagement letter, we first:
- Discuss usability of the credit. If a company generates credits but cannot use the credits to reduce tax liability, it is often not in the best interest of the company to incur the expense of an R&D study. We typically work directly with a company’s CPA firm or their CFO to understand usability up front so the company can make an informed decision whether to proceed with an engagement.
- Conduct a feasibility assessment. After usability is evaluated, we meet with the client, either by phone or on site, to carefully assess activities and costs across the company to determine which meet the qualifying criteria. Once activities and costs are clarified, an estimate of the tax credit benefit is provided. It is important to note that the feasibility assessment is performed by our most senior R&D technical team members who collaborate with business development professionals.
- Evaluate documentation. We review a company’s specific documentation as it relates to qualifying costs and activities to ensure it is substantial enough to support the R&D credit in the event of an audit.
- Present the scope of work. Based on the number of employees, supply costs, documentation and number of years the credit will be claimed, we present an engagement letter that includes the scope of work, a fixed fee and a conservative, high-level estimate of benefit.
Once engaged, we assign a dedicated R&D project manager to the engagement immediately. On site, the project manager interviews all applicable individuals—from owners to shop floor managers—to verify activities, supply costs and documentation identified during the feasibility assessment. On average, we complete a study and present the final deliverable in 6-8 weeks.
We recommend conducting a credit study every year, not simply rolling over the credit calculation from the previous year—there are too many dynamics at play to take a “same-as-last-year” approach. Changes in the audit environment, changes in documentation requested by the IRS and changes in a company’s activities can produce a different result from year to year.
Some companies will eventually be selected for audit as a normal part of IRS diligence. SourceHOV Tax provides full audit support in the event one of our studies is audited. Our sustention rate in these cases is typically 85-100%.
What can prevent a company from benefiting or claiming the R&D tax credit?
Prior to tax year 2016, alternative minimum tax (AMT) is a limiting factor, particularly for owners or members of pass-through entities (S-Corporations, LLCs and Partnerships). Prior year credits can only be used to offset regular tax above minimum tax. So individuals who are paying AMT or close to paying AMT will not benefit from the R&D tax credit. With the passage of the PATH Act, this major limiting factor was eliminated for smaller taxpayers. Beginning in 2016, the R&D tax credit is able to offset AMT for taxpayers with less than $50 million in average gross sales over the prior three years.
Further, the rise in regular tax rates coupled with new additional taxes are increasing the difference between regular tax and minimum tax. This creates potential opportunity for individuals, who in the past had been limited by AMT, to now benefit from the credit. Secondly, sometimes companies generate credits that are not significant enough to warrant the fees associated with conducting a study. When we present our fee estimate, we include an estimated benefit net of fees, so the cost versus benefit is completely transparent, and the client can make an informed decision.
We recommend evaluating the credit opportunity each year to ensure that credit benefits are maximized. Now that the credit is permanent, companies can better plan knowing the credit will help offset the cost of additional research. Companies often find that the time commitment needed to evaluate the credit is far less than they expected and the benefit surprisingly more. To receive a call from one of our R&D team members, click here.