Our familiarity with the letter and spirit of the current R&D Tax Credit program is partly the result of almost 20 years of contact with senior IRS officials. Beginning with discussions in the late eighties at the Office of the Chief Counsel of the IRS in Washington, the contact has continued with seminars organized through non-profit business support groups, at which one of our executives has either acted as moderator or has shared the podium with senior IRS personnel. These contacts have keep Cost Recovery Services, LLC informed concerning the intent of the program
The success of our clients at audit serves to confirm that our understanding of the program’s intentions is both thorough and accurate. |
We recognize that senior executives and financial officers in particular, will already be familiar with the R&D Tax Credit. However, we believe that our perspective on the Credit and the way it is administered will be a helpful addition to your present understanding. We therefore offer the following as an introduction to newcomers to the credit, and as a fresh look at the subject for tax practitioners. |
Why Do Governments Offer Tax Credits?
Governments in many countries have noted that those companies which spend the most on technical product and process development are the ones that employ more people during good economic times, and manage to stay in business with the fewest job losses during bad times.
As a result, governments in most western countries arrange ways to reward companies that engage in technical development. This is usually done via the tax code, so that companies pay less tax if they are performing R&D.
This has two benefits: - First, companies are somewhat more likely to engage in R&D if they know there will be at least partial financial support.
- Second, those companies that do engage in R&D find it easier to exploit the results of their efforts if they have more cash -- saved from the taxes they did not have to pay -- to spend on the necessary marketing, production preparations, and related components of a commercialization effort.
The government therefore can be seen to be betting on the winners -- those companies that engage in technical product and process development -- and helping them to win again by an even greater margin. Back to Top |
What Exactly Does the IRS Mean by “R&D”?
Over the past ten years, we have come to the realization that many engineers tend to regard "R&D" as an activity associated solely with computer chips or pharmaceuticals. They tend to regard their own efforts to make new, lighter, stronger, cheaper products, or to make more precise, more economical and more versatile processes as "just doing my job". They often shrink from labeling their efforts "R&D".
While this modesty is commendable, it runs counter to the government's efforts to reward technically aggressive companies. In looking at R&D Tax Credits, therefore, we should put aside conventional ideas of R&D, and consider only the government's definition. This definition is explained in detail on the pages which follow.
There are four main criteria:
1. A technical advance must be targeted.
The company must be trying to achieve a new technical improvement, or a cost reduction by new technical means, which is related to the business of the company. It should not be possible to find exactly how to do this from information presently in the public domain, as from textbooks or technical journals. However, work to "catch up" with competitors' superior technology is eligible, if the competitors have kept their methodology secret or proprietary, and if the company’s starting position is not at the elementary stage.
2. Uncertainty must exist -- or be unhappily discovered half way through! -- concerning the best technical path to achieve the desired objective.
This requirement excludes "routine engineering" from eligible activity. Routine engineering is work where the outcome is known in advance, if a series of known steps is faithfully followed.
3. Work to solve the technical uncertainties should proceed in a systematic, step-by-step approach.
This criterion is usually met automatically by any competent technical group. It is aimed against trial-and-error, hit-or-miss procedures. Rather, it aims to support an initial consideration of options and a careful choice of the best course of action.
4. There must be some documentation.
This documentation must relate in a meaningful way to the course of the experimental development work performed. This requirement for technical documentation can be filled in a variety of ways, including (but not limited to) notes, test results, CAD or paper drawings, and so on. We give a detailed list in the last two pages of this review.
There must also be meaningful documentation relating to the costs incurred, beginning with W2 information on salaries. Also helpful - but not essential - are time cards that may identify hours, days, weeks or months spent solving problems.
Additional useful documentation includes invoices for parts and for subcontractors’ assistance. Again we give a more complete list in the last two pages of this review.
Our experience is that the IRS will often accept reasonable estimates of R&D time spent by development team members for the first claim or two, but will expect to see more formal systems to track R&D costs as time goes on. We can help you identify and evaluate the documentation you already have, and can also prepare clarifying documents as required.
Types of R&D supported by R&D Tax Credit Programs
We regularly see three types of R&D situations supported by the R&D tax credit program. We can classify them as follows: - Classic R&D, resulting from a deliberate decision to develop a new or improved product or process,
- Contingent R&D, planned to be contingent on receiving an order, where the company has deliberately made a bid knowing that their existing technology is insufficient to fill the order without some development effort, and
- Unplanned R&D, arising from the sudden discovery, part way through filling an order, that existing technology is inadequate and must be advanced by an emergency development effort if the order is to be filled.
Of the more than two thousand projects that we have identified and successfully defended for our clients, we would say that types B and C together constitute 80% of the total. Back to Top |
What Expenses Are Eligible?
In the United States, there are several cost items that the government considers to be eligible. Among these we find: - Salaries or wages of technical staff who directly work on or supervise the development projects
- Salaries or wages of other staff who are supporting the technical staff engaged in the experimentation
Note: The IRS gives the example of a secretary typing up test results. This means that the time spent by everyone in the company should be reviewed to see if they have assisted someone engaged in a technical development effort - Materials, jigs, fixtures, test beds, tooling, etc., used up and/or discarded during the development project
- Scrap created during experiments and test runs
- Subcontractor charges for work done in support of the development projects, where the subcontractor is paid for each step taken
Note: If the subcontractor simply quotes a fixed price for final delivery of an item he develops, then the subcontractor takes the risk and the subcontractor gets the credit
The US government allows no claims for overheads other than for the indirect personnel referred to above. Also they do not support benefits. There is likewise no support for equipment purchased, though the time and materials consumed in developing a test-bed in house can be claimed, if the test-bed is to be used only for experiments and not for regular quality control. Back to Top |
How is the Credit Calculated?
The actual tax credit is calculated from a complex formula, but for most companies amounts to 10% of the eligible costs. Having stated the simple ending to the story, we should state the formula. There are two approaches, and the method you will use depends on whether your company was performing R&D and creating sales revenues in at least three of the years from 1984 to 1988.
If your company did have R&D costs and revenues for three years in the 1984 - 1988 period, you calculate the ratio of R&D to sales in those years; this is your “Fixed Base Percentage” (FBP). This percentage of your claim-year sales is the “hurdle” you must clear before you receive any R&D Tax Credit. Above that hurdle, the Credit is 20% of your eligible costs, but once your eligible costs reach twice the amount of the hurdle (by which time the Credit amounts to 10% of your total eligible R&D costs) they cap the credit at 10% of eligible cost. Thus: - No Credit is granted below a hurdle defined as current sales x FBP.
- Credit is 20% of costs above that level, until costs reach 2 x sales x FBP, whereupon the Credit is 10% of total R&D costs.
- Credit continues at 10% of total R&D costs once that 2 x FBP x sales level is passed.
If your company did not have R&D costs and revenues for three years in the 1984 - 1988 period, your hurdle rate is derived from the rules governing “start-up companies” as described in the regulations.
Our experience as consultants in this field has taught us two important lessons in this area: - Any firm with cutting-edge technology in its field is likely to have eligible R&D costs of more than 3% of its sales revenues. Companies in engineering or electronics can easily have eligible costs 2.5 times this level or even higher.
- Except for companies launched with a flurry of R&D, most companies operating in the ‘eighties were spending a smaller percentage of their sales on R&D in those years compared to the rate of R&D expenditure in the more competitive ’nineties.
This means that most companies with some cutting-edge technology in their field are likely to be eligible for R&D tax credits. Back to Top |
What Kind Of Technical Support Records Are Required?
A. The report that the consultants should prepare for you:
The IRS National Issues Specialist for the R&D Tax Credit has recommended at seminars that an R&D project for which a tax credit is to be claimed should be described in a report. Unlike the technical reports that you will normally write for internal or customer use, this report does not have to contain all technical information known to you concerning the project. Nor does it have to be in such detail that someone could reproduce your work from the report.
This report, however, must completely fulfill one objective: to demonstrate to the IRS that the project work was R&D within the meaning of the regulations.
The report must therefore highlight: - the difficulties posed by the technical targets;
- the uncertainties facing the development staff;
- the unexpected difficulties encountered during the course of the development work, and
- the experiments performed in an effort to resolve the uncertainties.
The report must be written for three audiences:
1. Your company: The report must be technically competent.
2. Government technical auditors: The report should invoke government definitions of R&D wherever possible, without being inaccurate or overly heavy-handed.
3. The person on the street: The report must be written in plain language. This is because the first government individual to read the report may be an accountant. Your cause is advanced if this person enjoys reading the text, even if they don’t understand the technical specifics of the project.
In view of these demands, Cost Recovery Services goes through a 5-step process in preparing each report, from obtaining the technical "story" during a conversation with a member of your technical staff, through successive drafts of a text, to mock "audits" of the text carried out by our senior staff members, to a final read and critique by a non-technical staff person. The report is then submitted to you for your review and approval.
The final report then joins the body of documentation supporting your return against the eventual day of audit.
B. The records that you must collect yourself:
The formal project reports need to have some back-up. This can be in one or more of the following forms: - dated notes of experimental or test results taken during the project;
- dated drawings at various stages of the project's progress;
- dated photos of test parts at one or more stages of the project;
- dated minutes or notes taken at meetings concerning the project;
- letters or memos or e-mails between your staff, between your plants, or between your company and its customers' engineers, referring to problems;
- actual physical test parts fabricated during the project;
- any other dated material that refers to events, designs, results, difficulties, etc., during the project.
These records, similarly, should be held at your company against the eventual day of audit. Back to Top |
What Kind Of Financial Records Are Required?
In our experience, governments will initially accept allocations of people’s time to identify R&D labor involved in a project. As time passes, however, the government expects you to become more structured with your cost tracking methods and would expect to see some form of labor reporting system that captures R&D hours by project.
Some examples of useful back-up documentation are as follows: - W2 earnings documentation for each employee who was involved in the project;
- work sheets showing how the estimated or recorded percentages of each person’s time spent in R&D have been used to calculate R&D labor costs;
- copies of any invoices that show the cost of subcontracted individuals or companies you may have hired to help with the project;
- copies of any invoices that indicate materials ordered and consumed during the project;
- scrap records showing parts, jigs, fixtures or tooling discarded during the development project.
In the end you should develop an easy-to-use system whereby costs that are incurred in trying to solve a technical problem are recorded in an identifiable sub-account. We will work with your financial staff, if requested, to help set up such a cost tracking system. Back to Top |
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