Everyday manufacturing activities often qualify for the advantageous research and development (R&D) tax credit. Companies who test new materials, experiment with different prototypes, or implement revolutionary software should seriously consider whether they can claim an R&D tax credit for their work. With the rapid emergence of new technologies in the manufacturing industry such as AI/machine learning, advanced analytics, robotics, blockchain, Internet of Things (IoT), advanced materials, and 3D printing – there is a great chance that your business is engaging in R&D credit-qualifying activities. If so, your manufacturing business stands to benefit significantly from this dollar-for-dollar credit.
What’s in this article?
- What is the R&D tax credit?
- How can the R&D credit benefit my manufacturing business?
- How can I qualify for an R&D credit?
- What are some examples of qualifying manufacturing activities?
- Can new technology implementation qualify for the R&D credit?
- What activities do not qualify for R&D tax credits?
- What are some real-life examples of manufacturers utilizing R&D tax credits?
- What do I need to claim the R&D credit?
- How can Squar Milner help?
What is the R&D tax credit?
R&D tax credits, available at both the federal and state levels, provide companies with a dollar-for-dollar reduction in income and payroll taxes for qualifying expenses. On average, R&D tax credits equate 7% to 9% of eligible activity costs, such as wages, supplies, cloud service provider costs, or contract research costs.
Originally established through the Economic Recovery Act of 1981, the R&D tax credit has long aimed to stimulate R&D spending in the United States and to ensure that U.S. companies maintain a technical edge over international competitors. While initially beneficial for some companies, many others were often hesitant to rely on these credits as they were not guaranteed to exist each year. However, the PATH Act of 2015 changed that. The federal R&D tax credit is now a permanent benefit for those engaging in extensive research and development projects to develop and enhance products and processes. Furthermore, the R&D credit has become more available to small businesses over time.
Businesses who qualify for the credit can reduce their tax liabilities, increase cash flow/decrease outflow, increase and optimize investments in new technology, and help fund their operations.
Additional technical information about the R&D credit is available here.
How can the R&D credit benefit my manufacturing business?
Businesses who are developing or improving products or processes could greatly benefit from the R&D tax credit. As those in the manufacturing industry are constantly looking for ways to operate more efficiently and produce better products in a more convenient way, the R&D credit can be a useful way to reduce tax liability or stimulate cash flow. With more available funds, your business can use the money to initiate new operations and endeavors. You are most likely already engaging in qualifying R&D activities, so you might as well try to take advantage of this beneficial tax credit.
R&D expense and creditable items are found throughout the manufacturing industry. Now is the time to evaluate your R&D undertakings to determine whether or not you can capitalize on these available credits.
How can I qualify for an R&D credit?
To qualify for the R&D tax credit, regardless of industry, a business’s activities must meet four IRS criteria (known as the four-part test):
- Technological in nature: Activities must rely on engineering or scientific principles (e.g., mechanical engineering, electrical engineering, computer science).
- Permitted purpose: Activities must be aimed at developing a new or improved product or process.
- Technical uncertainty: Activities must involve technical uncertainty as it relates to capability, method or design for achieving the desired result.
- Process of experimentation: Activities must involve a systematic or iterative process of evaluating one or more design alternatives to achieve the desired result.
Companies should also note that the activities must only be new to the organization itself, not the industry as a whole, in order to qualify.
To claim the credit, you must be able to identify eligible projects, quantify R&D expenses, and provide sufficient documentation related to the qualifying projects.
What are some examples of qualifying manufacturing activities?
The research credit revolves around activities involving a degree of uncertainty and an assessment of alternatives (such as experiments or tests), whether that be in design, materials used, or how to apply technology.
Some manufacturing activities that may qualify for the R&D tax credit include:
- Development of new, improved or more reliable products, processes and techniques
- Development or improvement of production/manufacturing processes
- Development of prototypes or models (including computer-generated models)
- Design of tools, jigs, molds, layouts and dyes
- Development or testing of new concepts and technologies
- Development or customization of software
- Automation and/or streamlining of internal processes
- New line development
- Certain trials/laboratory experimentation
- Design of engineering applicable to multiple customers
- Modeling, simulation or testing to validate designs
- Just about anything leading to a patent or certification
Can new technology implementation qualify for the R&D credit?
Implementation of enterprise resource planning (ERP) systems (including manufacturing resource planning (MRP), supply chain, customer relationship management (CRM) subsets) may qualify for an R&D credit. But how is this possible?
Investments in ERP solutions are often perceived as out-of-the-box software providing flexibility for easy deployment. However, contrary to popular belief, ERP implementations are often complex and anything but simple and routine. Final Internal-Use Software (IUS) regulations issued in October 2016 provide taxpayers with the opportunity to revisit their ERP and other software development projects and identify U.S.-based activities that may qualify for the research credit. Even if an entire software project does not qualify for the credit, the final regulations confirm that specific subsets may qualify.
Too often companies overlook this area when looking for qualified research expenditures.
From the integration of disparate systems to the creation of proprietary functionalities and interfaces, manufacturers use ERP and MRP systems to process massive amounts of data and develop new or improved functionalities to increase efficiency and advancement. As a result of their complex nature, the following components of ERP implementation and optimization projects may qualify for the R&D credit:
- Designing new or improved custom functionalities and models
- New add-ons and features, i.e., “apps”
- Integrating legacy and other systems and interfaces
- Processing, managing, modeling and analyzing large amounts of data
- Scaling multiple data sources and users
- Managing processes, response and reporting speed
What activities do not qualify for R&D tax credits?
Above we listed a number of activities that may qualify your manufacturing business for an R&D credit opportunity. Now, we have included a list of activities that do not qualify for the R&D credit:
- General and administrative activities
- Sales, marketing and business development activities
- Managerial functions not related to the technical aspects of a project (i.e. people management)
- Scheduling and budgeting
- Routine data collection (e.g., management studies, efficiency/consumer surveys, time studies)
- Repair and maintenance
- Routine customer, maintenance or production support
- Training (even if related to new technology or processes)
- Research conducted outside the United States
What are some real-life examples of manufacturers utilizing R&D tax credits?
Manufacturers are some of the best examples of how claiming the R&D tax credit can benefit your business. In fact, our R&D team has helped a number of manufacturing clients, including:
- Manufacturer designs and engineers new precision cutting products through the use of new raw materials and the development of new manufacturing processes.
- Luxury bus and shuttle van manufacturer develops unique designs and uses innovative materials to produce high-end buses.
- Electronics company designs and manufactures innovative wireless intercom systems used in a wide variety of sports, including football programs.
- Electronics company develops new and improved drive-thru system technology to increase workplace efficiency at fast food restaurants.
- Airline parts manufacturer uses innovative processes to manufacture rare aircraft components.
- Manufacturer uses technology and engineering science to develop smart scooters.
What do I need to claim the R&D credit?
In general, you will need two types of documentation: quantitative and qualitative. For your tax service provider to compute the credit, you will need to provide quantitative data like wages for individuals involved in the R&D projects (e.g. W-2s), as well as a percentage of time that they spend performing R&D activities. Time tracking is helpful, but is not a requirement. Estimates are acceptable for determining the amount of R&D time.
You should also provide total supply costs and third-party contractor costs related to your R&D projects. The information will be gathered for the current year as well as prior years.
Your R&D study provider will also ask for qualitative documentation. Various types of documentation are acceptable, including: meeting notes, project charters, PowerPoint presentations, design documents, emails discussing technical challenges, drawing iterations, or test reports. You should also be prepared for meetings with your study provider to answer questions about the R&D projects, technical uncertainties, and other aspects of your work.
How can Squar Milner help?
Our firm can work with you and your business to determine whether an R&D credit is available for your business. Not only do we have a strategic Manufacturing & Distribution practice to help you identify qualifying activities and optimize your tax planning, but we also have a team of professionals working exclusively on helping companies maximize their R&D credits. Our R&D practice leaders will perform a cost-free assessment to help you determine whether you have qualifying projects and costs for an R&D credit. If we discover there is an opportunity, we will work with your team to gather the proper documentation and conduct a comprehensive R&D Credit Study. Do not let this credit – and cost-saving opportunity – slip away from you. If you believe you may qualify for an R&D credit, please contact us today.
Disclaimer: This material has been prepared for informational purposes only, and is not intended to substitute for obtaining accounting, tax, or financial advice from a professional tax planner or financial planner. All information is provided “as is,” with no guarantee of completeness, accuracy, timeliness or of the results obtained from the use of this information.