Governments typically incentivize private industry to produce research and development (R&D) as a strategic tool to advance their economies. Initially temporary, the federal R&D tax credit became the United States’ primary means for rewarding business for investment in research. The PATH Act of 2015 permanently extended the R&D tax credit and expanded its provisions. The author lays out the basics of R&D tax credit and investigates the initial impact of the PATH Act by surveying its effect on 40 companies.
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Rapid changes in technology over the past decades have forced most companies to constantly innovate. At every stage, companies encounter technical challenges related to developing new or improved products and trade processes and integrating them with existing assets. Being able to overcome these technical hurdles is critical to maintaining a successful, healthy business. As most business owners know, however, attempting to create and execute viable and worthwhile innovations can be extremely expensive and time consuming for management and employees. Innovative undertakings often fail with no return on investment.
Fortunately, the federal government, as well as many states, currently provides valuable economic incentives to alleviate some of the burden and reward companies for undertaking these inherently risky initiatives. These financial incentives are intended to foster innovation and technological advancement of U.S. companies, thereby creating jobs and increasing global competitiveness.
The federal R&D tax credit, also known as the Research and Experimentation (R&E) tax credit, was first introduced in 1981 as a two-year incentive and has remained part of the tax code ever since. Its purpose is to reward U.S. companies for increasing their investment in R&D in the current tax year. It is available to any business that attempts to develop new, improved, or technologically advanced products or trade processes. In addition to activities such as creating new products or trade processes, the credit may also be available to taxpayers that have improved upon the performance, functionality, reliability, or quality of existing products or trade processes.
Although many taxpayers have viewed this tax credit favorably, there were limitations on the applicability and utilization of the tax credit for certain taxpayers. On December 18, 2015, President Obama signed into law the Protecting Americans from Tax Hikes (PATH) Act. This legislation retroactively renewed and made permanent a collection of expired tax provisions for both businesses and individuals and addressed some of the credit’s limitations with regard to certain small businesses and startup companies.
How Does the R&D Tax Credit Work?
The rules of the R&D tax credit can be found under Internal Revenue Code (IRC) section 41 and the related regulations. The R&D tax credit may apply to any taxpayer that incurs expenses for performing Qualified Research Activities (QRA) on U.S. soil.
The R&D credit comprises the following types of Qualified Research Expenses (QRE):
- Wages paid to employees for qualified services (including amounts considered to be wages for federal income tax withholding purposes)
- Supplies (defined as any tangible property other than land or improvements to land, and property subject to depreciation) used and consumed in the R&D process
- Contract research expenses paid to a third party for performing QRAs on behalf of the taxpayer, regardless of the success of the research, allowed at 65% of the actual cost incurred
- Basic research payments made to qualified educational institutions and various scientific research organizations, allowed at 75% of the actual cost incurred.
To qualify as research according to IRC section 41, the taxpayer must show that the activities—
- are intended to resolve technological uncertainty that exists at the outset of the project or initiative, related to the capability or methodology for developing or improving the business component or the appropriate design of the business component;
- rely on a hard science, such as engineering, computer science, biological science, or physical science;
- relate to the development of a new or improved business component, defined as new or improved products, processes, internal use computer software, techniques, formulas, or inventions to be sold or used in the taxpayer’s trade or business; and
- substantially all constitute a process of experimentation involving testing and evaluation of alternatives to eliminate technological uncertainty.
If the development is related to internal use software (IUS), there are an additional three tests that must be satisfied:
- The software must be innovative. It should result in a reduction of cost or an improvement in speed that is substantial and economically significant.
- Developing the software involves significant economic risk, requiring the commitment of substantial resources and subject to substantial uncertainty of recovery in a reasonable time period.
- The software is not commercially available. The taxpayer cannot purchase, lease, or license and use the software for the intended purpose without having to make significant modifications that satisfy the first two requirements.
There are numerous activities that are not within the definition of qualified R&D activities. The following are 10 primary types of activities that are specifically excluded from the definition of qualified research:
- Research conducted after the beginning of commercial production or implementation of the business component (with some exceptions)
- Adaptation or duplication of existing business components
- Surveys, studies, or activities related to management functions or techniques
- Market research, testing, or development (including advertising or promotions)
- Routine data collection
- Routine or ordinary testing or inspection for quality control
- Computer software, except where developed for internal use
- Any research conducted outside of the United States
- Any research in social sciences
- Funded research.
The cost of acquiring fixed assets used in a taxpayer’s trade or business is also excluded.
Changes to the R&D Tax Credit under the PATH Act of 2015
The PATH Act permanently extended the R&D tax credit. Additionally, it made two very important changes effective for tax years beginning after December 31, 2015, which are intended to expand the reach of the credit. First, the legislation allows small businesses to take the R&D tax credit against their alternative minimum tax (AMT) liability for tax years beginning after December 31, 2015. The AMT restriction has long prevented qualified companies from utilizing the R&D tax credit; the legislation removed that hurdle for eligible small businesses (ESB), defined below. Second, the PATH Act allows startup businesses with no federal tax liability and gross receipts of less than $5 million to take the R&D tax credit against their payroll taxes for tax years beginning after December 31, 2015, essentially making it a refundable credit capped at $250,000 for up to five years.
Beginning January 1, 2016, ESBs can use the R&D tax credit to offset AMT. An ESB is defined as a corporation that is not publicly traded, a partnership, or a sole proprietorship with average annual gross receipts not exceeding $50 million for the three taxable years preceding the current taxable year. Special rules under IRC section 448(c)(3) apply. If the business (including predecessor entity) was not in existence for an entire three-year period, the gross receipts test applies to the period it was in existence, and gross receipts for short taxable years are annualized. For a short tax year, gross receipts are annualized by multiplying the gross receipts for the short period by 12 and dividing the result by the number of months in the short period. For a partnership or S corporation, the gross receipts test must be met both by the entity and by the partner or shareholder for the tax year.
Also beginning January 1, 2016, qualified small businesses (QSB) can use the R&D tax credit to offset the FICA employer portion of their payroll tax. A QSB is defined as a business with less than $5 million in annual gross receipts and having gross receipts for no more than five years (for 2016; not available for companies that had gross receipts prior to 2012). The election to offset payroll taxes must be made on a timely filed income tax or informational return, including extensions. In the case of a QSB that is a partnership or S corporation, the election must be made at the entity level. A small business that is not a corporation or partnership (such as a sole proprietor) must take into account the aggregate gross receipts it receives in carrying on all its trades or businesses. For corporations and partnerships, the gross receipts and the credit limitation apply on a controlled group basis.
Survey Methodology and Results
In order to gain some insight into the impact of the PATH Act, a brief survey was sent to CEOs, CFOs, vice presidents of tax, and tax directors at 40 companies, including taxpayers currently claiming a research credit on their tax returns and others who currently compute the research credit but have been limited by AMT or startup restrictions in the past. These companies came from a wide variety of industries, including food and beverage, financial services, software, chemicals, pharmaceuticals, medical devices, engineering, technology, and manufacturing. Companies surveyed ranged in size from small startup companies to companies that had more than $3 billion in top line revenue. See details below
Research and Development Tax Incentives for the Mechanical Engineering Industry
It’s an unfortunate truth that far too many mechanical engineering firms fail to realize that their activities may constitute qualified research and development (R&D) activities under the tax code, potentially entitling them to significant R&D tax credits. If you think you have to be a pharmaceutical company, designing a space shuttle, or operating in a laboratory to be conducting qualified activities as defined by the Internal Revenue Code, think again.
Examples of activities and innovations eligible for R&D tax incentives include the following:
- Designing and installing heating and air conditioning systems
- Developing ventilation systems
- Designing plumbing systems
- Designing piping systems
- Installing fire protection systems
- Conducting new product development and design
- Designing and developing equipment
- Fabricating or designing pumps, heat exchangers, pressure vessels, etc.
- Designing chillers, boilers, fire heaters, etc.
- Installing refrigeration systems
- Developing engineering drawings and specifications
- Performing CAD modeling
- Achieving sustainable design
- Introducing new or improved construction techniques
- Researching new wastewater treatment trends
- Conducting fluid dynamic analysis and design
- Designing pollution control systems
- Developing air quality detection and system
- Exploring new toxic waste disposal processes
