The leaders of the manufacturing clients that populate our firm’s client base are by their very nature – innovators. Innovators that are constantly experimenting, refining processes, and trying to determine how to do things better, faster, and cheaper. In particular they are interested in how to create innovations that can bring long-term value to their organizations and their customers.
This value creation from innovation creates jobs and is the main reason that the R&D credit exists in our tax code. So why aren’t more middle market manufacturers claiming this credit? – It seems to me that is likely for one of the four reasons explained below:
- Lack of Knowledge
Many manufacturers are third or fourth generation businesses, which could mean a third or fourth generation CPA relationship that may have not kept pace with innovation and current tax law and regulatory changes. Another possibility is that perhaps many years ago you re- engineered your own company tax returns to be performed by an internal department that gets no reward for taking any risks or innovating with new ideas. Sorry to be that blunt, but if the shoe fits- at least take a look at it.
- Fear, YES I said Fear
A fear that claiming any credit or incentive is jumping the shark with the IRS and certainly most of my manufacturing clients have enough scrutiny and regulations, that they certainly aren’t prone to invite more regulatory oversight unnecessarily. The fear thing, well it’s natural and is developed in all of us to govern behavior and preserve our lives, so we are by nature created with this emotion for a reason. That being said, this isn’t a fight or flight situation. So it should not freeze us like Elsa from Frozen (blatant Disney grandkid reference) in a business situation that can be assessed, measured, reasoned, and controlled to benefit our company and the families that work in it. Remember, middle market manufacturers create most of the jobs in your respective communities. So our government is helping you help them, which should not be a reason for fear.
- Cost/Benefit Uncertainty
This seems to be the main reason that clients don’t embrace the credit. To combat this, our firm has aligned with several engineering firms and specialty tax consulting firms that specifically do an upfront cost/benefit analysis to help clients assess the credit, do a rough estimate, and propose a plan to file and claim the credits. Generally, a rough estimate of the tax benefit can be attained before you start spending any consulting dollars with us or one of our specialists. If you are a Texas manufacturer- beginning in 2014 you also get to add to the analysis a bonus of a 5% credit against your Texas Franchise tax or margin tax on your gross margin. This can be used to offset up to 50% of your franchise tax in any year. Even my smaller manufacturers are seeing significant Texas credits in 2014 and 2015. Also, once you build the model you can repeat it in future years.
- Ignorance of the Law
Many leaders of manufacturing firms come from an engineering background, and they just want to know how things work before they dive in. They want to understand what it takes to qualify and how the credit is calculated. So to help with this natural curiosity- here is an example of the basic calculation of the Alternative Simplified Credit:
It’s the sum of your qualified expenses in the current year less (the average of the three years previous qualified expenses multiplied by 50%), which gives you the amount subject to the credit multiplied by 14% to get the actual credit amount.
Assuming you spent $280,000 of qualified activities costs( which is really easy to accumulate if you have any engineers and other smart guys on your management team, ( see the qualifiers below ) in 2014, and the average of your three prior years was say $100,000, then the delta would be $180,000 of qualified expense multiplied by 14% which equals $25,200. If you add the Texas credit to the federal credit that’s an additional $9,000 resulting in$34,200 in tax savings in one year. Better than a poke in the eye with a sharp stick.
So what kind of qualified expenses qualify- I found this great summation of the rules written for manufacturers in this article written by FreedMaxick CPA’s, a New York State firm that does quite a bit of R&D credit work. Here’s their summary and examples of the four qualifiers for the credit.
Four-Part R&D Credit Qualifier Test per FreedMaxick CPA’s:
- Permitted Purpose
The activity must result in a new or improved process, function, product, performance, reliability, quality, or significant reduction in cost. Probably the most common type of activity overlooked by companies regarding these specific criteria involves significant improvements made to production-line operations. A very common example of this sort of improvement would be the updating of production-line capabilities by a manufacturer that ultimately improved efficiency, increased production capacity, and eventually yielded an overall reduction in costs. An example of this type of activity would be a company that manufactures heavy equipment, and relied upon a labor-intensive approach to production. If that company were to implement improvements in its manufacturing process, by way of automation or some other means that required investment in new equipment for the plant floor, then it’s very possible that the costs associated with the implementation of the new production process could be eligible for the R&D tax credit.
- Elimination of Uncertainty
Were the activities conducted and intended to eliminate uncertainty concerning the development or improvement of a product? This criterion specifically involves the identification of information that is uncertain at the onset of the project or activity. Such uncertainty can relate to the capability of the product, the method used to produce it, or the appropriate design of the product. The examples that we typically encounter when consulting with clients in this arena deal with issues such as: Will the new or improved manufacturing process integrate with our current system, on any level? Will our new product development meet the customer specifications? Will the potential benefits outweigh the potential risks? Or will the new or improved product or activity even work?
- Technical in Nature
Does the research fundamentally rely on the principals of, engineering, physical or biological science, or computer science? This criterion is usually a fairly easy one to deal with. What it really does is eliminate the soft sciences from the formal definition of technology. In other words, products or activities that are predicated upon literary, historical or social sciences do not qualify for the R&D Tax Credit. In all of our experiences, this technology criterion has never been an issue when performing an R&D study for a manufacturing company.
- Process of Experimentation
Does the activity involve developing one or more hypotheses for specific design decisions, testing and analyzing those hypotheses, and refining and discarding the hypotheses? A key factor regarding the Process of Experimentation hurdle was recently crystallized, when Treasury Regulations changed the wording to evaluation of one or more alternatives. Previous language defined the process as evaluation of more than one alternative.
So now that you know the rules, you can quantify and control the risk, and you can rest assured you are in the fairway not in the rough. So, now it’s time to see if you have created enough innovation recently to qualify for the credit.
Alright then, my innovative bunch of manufacturers, we have one more year of certainty with the R&D credit and we have the ability to amend and claim up to three years of credits until you slide past your extended filing deadline. So as part of your yearend planning, capital expenditure budgeting, and tax forecasting for 2015 and projecting for 2016, please consider the R&D credit and look at the improvements you made to your business in 2014 and 2015. You more likely than not manufactured an R&D credit along with that bazillion widgets you produced for ACME Industries last year!
To find out more about R&D credits and other tools in the manufacturing tool box, or if you would just like to talk some things over about your manufacturing business, contact Gary Jackson, CPA at Cornwell Jackson, PLLC.
Blog post written by: Gary Jackson, CPA, Tax and Consulting Partner