All sorts of private companies are getting valuable tax credits from their research and development (R&D) investments. Are you leaving tax cash on the table?
You don’t need a room full of scientists peering into microscopes to be doing R&D. In fact, you might not employ any scientists at all. That doesn’t mean that you don’t qualify for some valuable R&D tax credits. In fact, you may already be leaving significant tax cash on the table every year. And you may not even know it.
Let’s talk credit
First, let’s be clear about what the credit actually is. The R&D tax credit is a dollar-for-dollar offset of federal—and in some states—income tax liability. For certain small businesses, the R&D tax credit may also offset payroll tax liabilities. It is claimed via Form 6765 on originally filed tax returns and may also be claimed retroactively on amended tax returns as well. Like other general business credits, the R&D credit can offset income taxes, and if it cannot be used currently it can be carried back one year or carried forward for 20 years – the rules are described in this article A Practical Guide to Tax Credit Ordering and Usage Rules.
One of the big misconceptions about the R&D tax credit system is that it’s only valuable to traditional research-heavy sectors like biotech, life sciences, and manufacturing. And while it’s certainly true that the system was initially developed back in the 1980s as a way to encourage those industries to keep R&D jobs and investment in the U.S., the application of the credits has broadened significantly since then.
Today, all types of different companies across business sectors are getting value from R&D tax credits. Financial services firms are getting credits for new and improved client-facing payments systems and applications they develop and for in-house use applications; construction and engineering firms are receiving credits for their new and improved designs and for applying new technologies; even retailers are seeing significant cash tax savings for developing new and improved tools like point-of-sale systems or for enhancing an off-the-shelf software solution to meet their unique needs.
What is common across all of these examples—and many others—is that these companies are trying to develop something new or improve on something that already exists. Whether or not they are ultimately successful, as long as they are paying internal or external employees to work on those initiatives, they will likely be eligible for the credit as long as the work is being done in the United States.
The dos and don’ts
Of course, not everything is considered “qualified research activity.” To be considered eligible, the activity DOES needs to tick four boxes:
- It must rely on the principles of engineering, computer science, physics, chemistry, biology, or any other hard science.
- It must be undertaken for the purpose of developing a new product, process, software, or technology OR to improve the functionality, performance, reliability, or quality of an existing product, process, software, or technology.
- It must have an element of technical challenge or uncertainty related to how the product, process, or software can be developed, the method of doing so or the most appropriate design of the item OR whether the product, process, or software can even be developed at all.
- It must include an evaluation of different alternatives through a testing process (the “process of experimentation test”).
However, there are also some boxes that do NOT need to be ticked—even though you may think they are important:
- You don’t need to have a dedicated R&D function or dedicated R&D professionals and scientists. In fact, company credits are often generated from activities performed outside of “core” R&D departments—production employees performing experimental production trials, technical sales personnel, or manufacturing process engineering teams, for example. Job titles and department names are helpful in identifying where qualified research activities may be performed, but it is the activity being performed that matters most.
- You don’t need to succeed. The credit is not related to the success of the research activity. In any innovative process, the research might fail, and the company might stop development. That does not mean the activity is not eligible. Ultimate success or failure is not a factor in credit eligibility. Indeed, in some cases, failure might even suggest that the activity clearly met all four checkboxes above. Activities only have to attempt to develop or improve a product, process, or software.
- You don’t need everyone to log their hours. Documentation to support R&D tax credit computations can take many different forms. But formal time tracking is not required. The only requirement is that the company must be able to provide sufficient usable forms of documentation to support its claimed R&D expenses. Those may include meeting notes, project charters, activity logs, email strings, calendar snapshots, and many other items (e.g., employee time surveys).
- You don’t need to be a “big spender” to benefit. It is the expenditures that generate the credit, and the size of the company in terms of revenue is not a factor in evaluating credit eligibility. In fact, based on most recent Internal Revenue Service (IRS) statistics, over a third of all credits claimed are from companies with revenues of less than $25 million. Qualified small businesses experiencing net operating losses may be able to use up to $250,000 per year for up to five years of their R&D credits against payroll taxes. Several states also have credit programs that allow for refundable credits, transferrable credits, and salable credits.
The trigger points that would indicate potential applicability can be varied depending on your industry. But they often include things like laboratory activities, new product development, development of manufacturing processes, new or recurring capital expenses, consolidation of facilities, sustainability efforts, or automating manual business processes using technology and/or software. I suspect many of you are already thinking of some of your own recent activities that might qualify.
Show me the money
The big question, therefore, is whether the credits are worth the effort. My experience working on hundreds of these credit filings over my career indicates that it absolutely is. I’ve helped companies secure tens of thousands to millions of dollars in R&D tax credits—depending on their size and scope, of course. But in every case, the reward has far outweighed the investment—often by ratios of 10:1.
The problem is that R&D tax credit studies can often be laborious and compounded by disruptive IRS exams. And few organizations have the time or the in-house capabilities to do all the data capture, documentation, and computing that might be required—let alone the experience dealing with the appropriate people at the IRS.
Thankfully, there is help available. And there are opportunities to streamline and automate the process in order to drive efficiency and reduce cost and effort. At KPMG, our Accounting Methods & Credit Services (AMCS) team is using new models and technologies (e.g., data mining of Jira and GitHub data to establish nexus between employees and qualifying activities) to help power the low-value tasks and bring new scalable solutions to help companies navigate the R&D process.
For example, our team is using the cognitive capabilities of IBM Watson and Alteryx to help clients more efficiently and effectively capture their allowable credits. And we are using technology to better streamline the R&D credit study process—helping companies identify more qualified research expenses and better supporting them under examination, all while keeping costs low.
Get the answers
I firmly believe that every private market company leader should be taking a few minutes to consider whether some of their activity might be eligible for R&D tax credits. If so, I’d encourage you to contact your tax department or your tax advisers to see what is on the table. You may find you are leaving valuable tax cash behind.