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Research & Development Credit: To Be, or Not to Be?

Think you need employees in white lab coats to qualify for the research and development tax credit? No! The R&D tax credit is for taxpayers that design, develop, or improve products, processes, techniques, formulas, or software. The R&D credit is an often underutilized means of lowering your company’s tax burden. For the year 2009, the credit represented an estimated $5.6 billion federal subsidy. Yet, very few companies qualifying for federal research credits are actually claiming these tax incentives. Many companies routinely do work that qualifies for significant research tax credits as they attempt to create a product that is more reliable, durable, or has higher precision or accuracy.

What is Research and Development?

In order for research and development to qualify for the credit, it must meet all three of these requirements:

• It must be undertaken for the purpose of discovering information that is technological in nature.
• It must constitute a process of experimentation.
• The experimentation must relate to a permitted purpose.

What are some activities that qualify?

• Developing new or improved products, technology, processes, or formulas
• Developing prototypes or models
• Developing new technology
• Developing or improving software technologies
• Developing or improving internal processes
• Developing or applying for patents
• Certification testing
• Environmental testing
• Building or improving manufacturing facilities

What expenses qualify?

The credit is based on the qualified research expenditures during the year. Qualified research expenditures include:

• employee wages attributable to qualified research,
• supplies attributable to qualified research, and
• 65% of contract research expenses paid to outside contractors in the US for conducting qualified research on the taxpayer's behalf.

How is the credit calculated?

The IRS allows taxpayers to adopt one of two methods to calculate the R&D credit.

• Under the regular method, the credit is up to 20% of the excess of qualified research expenditures over the base period amount. The base period amount is a calculation that can involve information dating back to 1984 and an increase in qualified research expenditures greater than 1% of the average annual gross receipts from the prior four years.
• The alternative simplified credit method averages the last three years of qualified research expenses, thus avoiding the base-period-amount calculation above. The credit is equal to 14% of the current-year qualified research expenses that exceed 50% of the prior three-year average.

The credit should be computed under each method to determine which will give the taxpayer the most tax savings.

Potential Greater Credit Utilization in 2010

In September of 2010, President Obama signed the Small Business Jobs and Credit Act into law. This bill included two important features that could affect the R&D credit if it is extended:

• It allows a five-year carryback of general business credits from eligible small businesses generated in 2010, such as the R&D credit. An eligible small business credit is from an entity that is not publicly traded and has average annual gross receipts from the prior three years that do not exceed $50 million.
• Eligible small business credits generated in 2010 and forward are no longer limited by the alternative minimum tax (AMT). In previous years, taxpayers could not fully utilize general business credits if their AMT exceeded their regular tax.

2010 Credit?

While the R&D credit expired as of 12/31/2009, it has been extended in the past year after year through various pieces of legislation. Recent "extender" tax bills have included either a temporary one-year extension of the R&D tax credit for 2010 or a permanent extension of this tax credit. Based on the legislative history of this credit and President Obama's backing of research and innovation of US businesses, we anticipate that this credit will be extended again by early 2011.

Your Blackman Kallick representative can help you evaluate your activities so you can take advantage of the R&D tax credit.

For further information please contact Michael Calahan at 312-980-2996, Cara Hoffman at 312-980-3274, or your Blackman Kallick representative. Our thanks to Justin Kleckner for his contribution to this article.

This publication is part of Blackman Kallick’s marketing of professional services, and is not written tax advice directed at the specific facts and circumstances of any person and/or entity. Contents of this publication are of a general nature, and you should not act on this information without obtaining professional advice from your business advisor that is appropriately tailored to your individual needs and circumstances. This written advice is not intended or written to be used, and cannot be used by any taxpayer, for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code.