The R&D Tax Credit is an Opportunity Manufacturers Shouldn’t Miss

A resurgence in basic business principles is occurring amid the COVID-19 crisis and current state of the economy. Namely, businesses and advisors are revisiting a cash flow principle as old as time: cash is king. While there are many ways to open channels for cash flow, the R&D Tax Credit is an often undervalued, or even overlooked, channel for manufacturers, especially those considered among small to mid-sized businesses.

To keep businesses from outsourcing their R&D efforts overseas, and to stay on par with global competition, the U.S. Government established the R&D Tax Credit in 1981, which, in its original form, was only a temporary government-sponsored effort to bolster the U.S. economy, keep technical jobs on U.S. soil, and encourage national innovation. Through legislative evolution over the years, the R&D Tax Credit is now permanent and has become the largest tax credit available to U.S. businesses for innovation. 

Manufacturers account for the majority of R&D Tax Credits claimed annually. In addition to federal benefits, most states, including Massachusetts, offer their own R&D tax incentives. What makes these R&D credits an opportunity manufacturers shouldn’t miss? They can help you minimize your tax liability, make cash flow available to maintain or grow operations and product lines, and to maintain payroll or hire new employees. How can you qualify? Let’s take a look.

Qualified Research Activities

By way of legislation in 2003, the Discovery Rule was removed, which has opened up new incentive for manufacturers, as research activities no longer had to be “new to the world.” Now, innovation qualifies if it is “new to the taxpayer.”

Just as your business needs and customer demands are evolving year after year, your operations, products, and processes are likely evolving in tandem to improve and effectively meet those business and customer needs. Even some of the adaptations occurring in your everyday operations can qualify for the R&D Tax Credit.

Generally speaking, improvements or developments in your products, designs, or processes, as well as those to product prototypes and software, qualify. A Qualified Research Activity (QRA) is innovation originating in a hard science, such as biology, engineering, or computer or physical science, and that includes testing and evaluation procedures. 

Green initiatives, such as ecological packaging and improvements and developments in recycling and waste management, qualify. Manufacturers should also look at new or redesigned engineering processes, tools, and trial production runs when assessing QRAs. 

Everyday quality control procedures don’t qualify as a QRA; however, developing a new or improved quality control process would qualify as a QRA. Making that distinction, around what qualifies and what doesn’t, is often where several manufacturing clients are missing tax credit opportunities. That’s where your business advisor can help. I have advised several manufacturing clients on the R&D Tax Credit, which led to new opportunities for significant savings.

Qualified Research Expenses

By quantifying and calculating the Qualified Research Expenses (QREs) for your QRAs, manufacturers are able to maximize their credits received. Manufacturers must track and report wages and benefits paid to employees working on a QRA and for general ledger expenses, such as supplies and certain third-party expenses, associated with the QRA to receive the full benefits. Overall, payroll records, general ledger expense detail, project lists and notes, as well as employee testimony go into your R&D Tax Credit eligibility, so proper bookkeeping, financial records, and process documentation are key.

Additional Incentives for Small Manufacturers

The PATH Act recognized R&D as part of the daily operations of businesses of all sizes, by expanding eligibility beyond large, established businesses to include emerging businesses and small businesses. The PATH Act introduced benefits that can eliminate tax liability, dollar for dollar, for qualifying businesses.

To qualify as an Eligible Small Business (ESB), a manufacturer must be a corporation that is not publicly traded, a partnership, or a sole proprietorship with average annual gross receipts that, for the past three taxable years, have not exceeded $50M. Manufacturers meeting these qualifications may use the R&D Tax Credit to offset Alternative Minimum Tax (AMT) in the current tax years, as well as past years by using a three-year lookback period.

To qualify as a Qualified Small Business (QSB), a manufacturer must have less than $5M in annual gross receipts and must not have gross receipts for a period of more than five years. Manufacturers meeting QSB standards may use the R&D Tax Credit to offset the employer portion of their FICA payroll taxes, up to $250K per year.

Contact Livingston & Haynes

My team at L&H specializes in helping manufacturing companies like yours take full advantage of available tax credits that minimize tax liability and maximize cash flow. Our clients rely on our knowledge, transparency, and accuracy in providing accounting, auditing, tax, advisory, and bookkeeping services. Contact me today to get started. 

by John P. McGonagle, CPA

John P. McGonagle, CPA, began his career in 1980 with Ferngold Company. John became a partner in Ferngold in 1986 and remained with the company when it merged with Livingston & Haynes in 2002. He works with privately-held businesses, specializing in tax services that concentrate in manufacturing, real estate, family wealth transfers, and trusts.