Unfortunately, moldmakers, like most manufacturers, have vastly underutilized the use of the R&D Tax Credit to reduce their tax liabilities.
The Research and Development (R&D) tax credit was created by Congress as part of the Economic Recovery Tax Act of 1981 to encourage American industry to invest in research and development activities. The purpose of the credit was to stimulate R&D activities among businesses through tax incentives. However, due to the stringent requirements that existed under the provisions of the Credit, a vast majority of the small to mid-size companies were unable to reap the substantial benefits of the R&D credit.
Realizing that a majority of innovation in the U.S. was in fact transpiring from these small to mid-size firms, Congress in 2001 liberalized the statutory requirements. Specifically, the new regulations provided that companies were no longer required to maintain precise timesheets documenting every hour an employee spent conducting qualified R&D activities. Furthermore, the research no longer had to result in a product that was new to the industry; instead, the resulting product or process simply had to be new to the company that developed it.
No Change in Qualified and Unqualified Research Expenses Definition
The R&D Tax Credit extension did not change the definitions of what constitutes a qualified or unqualified research expense. Under the current version, section 41 allows a tax credit of 20 percent of: (1) qualified research expenses that exceed the base amount, and (2) basic research payments.
Qualified research expenses are those for qualified research performed in-house or under contract. Such expenses include the following:
(a) Wages paid to employees engaged in the actual conduct of the research effort or in the direct supervision or support of such effort.
(b) Costs of supplies used in the research.
(c) Payments made to third parties for computer time used in the research.
(d) Sixty-five percent of the contract fee paid to a third party for research conducted on the taxpayer’s behalf.
The regulations provide that the qualified research generally includes all costs incident to the development of an experiment or pilot model, a plan process, a product, formula, an invention or a similar property. However, the regulations provide that the term research and experimental expenditure does not include the following: 1. Ordinary testing or inspection of materials/products for quality control; 2. Efficiency surveys; 3. Management studies; 4. Consumer surveys; 5. Market research (including advertising or promotions); 6. Promotions.
In the moldmaking world, activities such as machining, design and engineering, quality assurance and improving the manufacturing process all qualify. So the question is not “Do I qualify?” but to what extent.
No Change in the Four-Part Test of the Qualified Research
In order to satisfy the section 41 qualified research requirements, not only must an expense be for research and experimentation within the meaning of section 174, but must also be for the purpose of discovering information that is “technological in nature.” In addition, the application of the information must be intended for use in the development of a “new or improved business component” of the taxpayer. The research must use the “scientific method of experimentation,” and the purpose of the contemplated developed technology must be for a new or improved function.
The Major Changes to the R&D Tax Credit
There are currently three different methods available to taxpayers to calculate the credit; the Regular Credit, the Alternative Incremental Credit (AIC) and the Alternative Simplified Credit (ASC). The extension has significant changes to both the AIC and ASC.
- Extension of Credit through tax year 2009
- Termination of Alternative Incremental Credit at the end of tax year 2008
- Increase of Alternative Simplified Credit to 14 percent from 12 percent for tax year 2009
Implications of Major Changes
The AIC is being phased out and tax year 2008 will be the last year to use this method of calculation. This is good news. The AIC has been a very confusing calculation method and could only be used for the current year. You could not go back and amend your returns and use the AIC.
Even better, the Alternative Simplified Credit is being increased from 12 to 14 percent starting in tax year 2009. The ASC is much easier to calculate and allows companies to use this method if they cannot calculate their base percentage or if their base percentage is too high. So many companies will be transitioning to using the ASC in 2009.
Substantial Increase in Credits (16.7%)
By using the simplified credit calculation method, companies now will be able to claim a credit equal to 12 percent of qualifying research expenditures in excess of 50 percent of the average qualifying research expenditures for the three tax years preceding the tax year for which the credit is being determined.
If a company has no qualifying research expenditures in any one of the three previous tax years, a credit of 6 percent of the current year’s qualified research expenditures may be claimed. It is important to note that, in this case, the credit is based on 100 percent of the current year’s qualifying research expenditures and not on an increase in qualifying research expenditures (QREs). This is not changed in the extension.
An existing small mold manufacturer had $400,000, $600,000, $500,000 and $800,000 (estimated) of qualified research expenditures in its 2005-2008 tax years, respectively. A research credit of $66,000 may be claimed on its 2008 tax return calculated as follows:
12% x [$800,000 – (50% x (($400,000 + $600,000 + $500,000)/3))= $66,000
Using 14% for 2009, the R&D tax Credit would be $77,000 a 16.6% increase over $66,000.
Although the ASC is easier to calculate, the substantiating document requirements have been heightened recently and are as rigorous as the Regular Credit. More importantly, the resulting ASC is about 50 to 60 percent of the Regular Credit. However, the increase to 14 percent will narrow that gap.
The R&D Tax Credit Extension will be of great benefit to many mold manufacturers by making it easier for them to take the credit by transitioning away from the Alternative Incremental Credit and increasing the credit for 2009, and hopefully beyond.