The Bottom Line: An R&D Tax Credit Update
This credit seems to be the most significant way a mold builder can reduce its income tax liabilities.
The R&D tax credit seems to be the most significant way a mold builder can reduce its income tax liabilities. Approximately 35 states have a credit program that is based on the federal tax incentive. Many mold shops today are claiming the research tax credit and amending past income tax returns to claim it.
Often misunderstood, the R&D tax credit rewards mold builders for activities that are inherent in the development of complex, novel, unique, one-of-a-kind tooling. These include, but are not limited to, developing new mold designs, developing tool-specific fixturing, experimenting with processing variables to improve processes, improving manufacturing processes through automation, experimenting with new alloys and performing first-article inspections on new tools.
The activity must meet four requirements to qualify:
1. Permitted purpose. The mold builder’s activities must be aimed at developing or improving the functionality, reliability, performance or quality of a business component. Most shops are developing new tools to customer specifications, so they are assisting customers in developing alternative mold designs to evaluate or improve manufacturability, developing specialized fixturing or other tools specific to the manufacturing process, experimenting with new alloys or machining techniques, and testing new technology. The countless design variables lead many new mold designs to qualify as a business component, which means that a shop has the potential for qualified research activities for each new tool.
2. Technological in nature. The research activities must fundamentally rely upon the engineering disciplines. However, that’s not to say that the mold builder must be expanding, exceeding or even refining knowledge in the moldmaking industry. Rather, the moldmaker may rely upon existing engineering and moldmaking principles to solve the uncertainty that exists related to the development of a new mold’s design.
3. Elimination of uncertainty. Uncertainty must exist at the outset of the research activity. Uncertainty exists if the capability of developing or improving the business component is unknown, the method of developing or improving the business component is unknown, or the appropriate design of the business component is unknown at the outset of the research activity. Multiple design alternatives may establish the uncertainty required under the statute.
4. Process of experimentation. The technological design uncertainty must be eliminated through a process of experimentation, which is defined by treasury regulations as an evaluative process capable of evaluating more than one alternative. This may include modeling, simulation, or systematic trial and error. Mold builders regularly use 3D modeling to evaluate design alternatives, mold flow analysis or warpage studies to simulate the mold’s performance, as well as systematic trial and error.
Only wages paid for qualified services, supplies used in the conduct of research and contract research are allowed when calculating the R&D tax credit. Wages paid for qualified services include wages paid for engaging in qualified research, directly supporting qualified research and directly supervising qualified research. Qualified services include those performed by the engineering, production and quality departments prior to the elimination of design uncertainty, as well as management oversight of the research efforts.
Mold builders may also include the cost of supplies and materials used in the research, regardless of whether the materials are part of the finished product. These expenditures can be significant, as oftentimes the prototype or production mold being produced is the first mold. This means that the appropriate design may still be uncertain when the moldmaker begins to cut steel. That is, the design uncertainty is still being eliminated at the time of manufacturing.
Finally, companies may include 65 percent of the amount paid for contract research. This includes payments to third parties for research performed on the mold builder’s behalf. These may include services related to new molds, such as heat treating or polishing, that are incurred prior to elimination of the mold’s design uncertainty.
Treasury regulations finalized in 2014 have helped clarify the nature and type of expenditures that may be classified as research expenditures. First, the regulations clarify that it is irrelevant whether the results of a mold builder’s research are sold to a customer or used in the business. That is, in developing the first (and perhaps only) mold for its customer, a moldmaker may eliminate design uncertainty through the production of a fully functional pilot model/prototype/first-article mold. So, the “prototype” used in experimentation may be the finished, fully functional production mold.
Second, the regulations clarify that only expenditures paid or incurred prior to the elimination of design uncertainty may qualify as research expenditures. This puts the determination of whether an expenditure qualifies as research more on the timing of the expenditure than on the nature of the expenditure. So, if the mold builder is paying wages and incurring the cost of material in the production of a mold prior to the elimination of design uncertainty, those underlying expenditures may qualify for the research tax credit.
Many moldmakers have taken the position that the labor and material expenditures incurred in the production of the first mold, where the design is uncertain at the time of production, qualify for the research tax credit.
For years, mold builders, especially S corporations, LLCs and partnerships, struggled in using all the R&D tax credits they generated, due to the Alternative Minimum Tax (AMT) limitation. The R&D tax credit may not offset the AMT unless the credit is a “specified credit.”
In addition to making the R&D tax credit permanent, the Protecting Americans for Tax Hikes Act of 2015 (the PATH Act), which was passed in December of 2015, identifies the research tax credit as a “specified credit” for eligible small businesses in tax years beginning after December 31, 2015 (tax year 2016 and thereafter for calendar-year taxpayers). Eligible small businesses include those trades or businesses whose average gross receipts (sales) over the prior three tax years is less than $50 million.
With the AMT limitation falling by the wayside for most U.S. mold builders, I have seen an increase in the number of companies claiming the R&D tax credit to offset a significant amount of income tax, assuming the entity generating the credit has taxable income.
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