WHAT HAPPENS TO UNUSED R&D CREDITS?

Author | Source Advisor

3 May, 2020. 9 min read

Unused R&D tax credits may still be available to eligible businesses if they file amended tax returns for the years in which they failed to claim the credit. Businesses can then carry forward the unused credits for up to 20 years after first carrying them back for one year.

As the name implies, the R&D tax credit “carry forward” allows businesses to take unused R&D tax credits generated from a given year’s QREs and apply them to future tax liabilities. This circumstance typically applies to businesses that either invested in R&D and did not turn a profit, or were eligible for a larger tax credit than what they currently owed or paid in income taxes.

In order to claim a refund, carryforward credits have to be carried forward to an open, amendable tax return. The carryforward credits must also be reduced by any amounts that could have been utilized in closed taxable years during the carry forward period.

Additionally, the Tax Cuts and Jobs Act (TCJA) eliminated the alternative minimum tax (AMT) for C-corporations and provided businesses with the opportunity to further reduce their tax bills using past, present and future R&D tax credits. It also amended Internal Revenue Code (IRC) Sec. 172(a) for tax years beginning after December 31, 2017, restricting the application of net operating losses (NOLs) to 80% of taxable income.

This amendment may motivate some taxpayers to look to the R&D tax credit as another potential tax offset based on their QREs. However, the TJCA’s 80% limitation was temporarily suspended by the 2020 CARES Act and will be reinstated for tax years beginning after 2020.

Under the TCJA, the “25/25 limitation” restricts C-corporations with over $25,000 in regular tax liability from offsetting more than 75% of their tax liability using the R&D tax credit. Also, the IRC Sec. 38 (c) limitation restricts the amount of tax liability that can be offset to the greater of either the tentative minimum tax or 25% of any tax liability greater than $25,000.

The activities that qualify for the R&D tax credit are the same ones driving growth in your business.

  • Creating improved products, processes, formulas, software, and techniques
  • Automating or improving internal manufacturing processes
  • Designing tools, jigs, fixtures, and molds
  • Integrating new equipment
  • Development of data center, big data, and data mining tools
  • Integration of APIs and other technologies
  • Development of financial or pricing models
  • Hiring outside consultants to perform any of the listed activities
  • Manufacturing new or improved products
  • Developing prototypes, first articles, models
  • Evaluation of alternative materials
  • Development of firmware
  • Network hardware and software development and optimization
  • Developing simulators
  • Development of risk management systems

Ensuring that you understand the rules for qualification is an essential first step in claiming the R&D tax credit. This is normally done during a feasibility analysis, also referred to as Phase 1. R&D activities are explored and identified at a high level along with related qualified research expenses (QREs). This information is then used to estimate your federal and state R&D tax credits. Education is key and provides the ability to identify qualified activities and QREs so a more accurate benefit estimate can be determined.

The expenses that qualify for research activities within your company typically include employee compensation, materials, and contracted services. Various forms of documentation are sufficient to support your qualified expenses and may include payroll records, financial records showing supply or contract research expenses, and vendor invoices.

On average, companies are typically able to claim 7-10% of their qualified expenses as a federal R&D tax credit. For example, a single software developer, engineer, or lab technician who receives a W2 of $100,000 a year may generate a tax savings of up to $10,000.

Here’s an example of a case study for a company specializing in Plastics & Injection Molding:

This plastics company has been an innovator in the use of industrial plastics in new applications with roots in identifying products that could be produced using plastics. The company offers urethane casting, thermoforming, machining and plastic injection molding services. The company constantly evolves to expand its offerings into new industries and applications.

The R&D activity at this company started with a customer request. Meetings were held between the customer and their contact, whether it was the sales department or the owner to identify the design of the product, as well as the specifications, performance, and functionality requirements the product must meet. Often times, for more challenging projects, the heads of the different departments, including CNC, Fabrication, Injection Molding, Casting as well as the design engineers, and operations managers would also get involved to perform more in-depth preliminary engineering calculations.

Even if customers develop and provide a prototype of the product they prefer mass produced, technical sales and engineers to perform a detailed design for manufacturability review and would more often than not have to redesign the customer’s provided design drawings and prototypes to ensure that it is manufacturable on a large scale. This often included the development and fabrication of molds, casts, or other custom tooling needed for production purposes.

A preliminary engineering analysis was performed to determine if the product should be injection molded, fabricated or molded with urethane. This lead to the experimentation with molds and casts to determine, if flow and cure rates were consistent in order to develop a repeatable process. Qualifying activity continued with design engineers creating CAD/CAM design documents that were utilized as the basis to develop the CNC programming. In addition to developing the part and process designs, design engineers were responsible for developing custom tooling and fixtures to support the production process.

Once the part and process designs were complete, the team began producing prototypes for validation. More often than not, molds, casts, and the parts themselves went through a validation process to determine if quality,regulatory, and performance standards are met. This process was highly iterative and required numerous trials to solve all the technical issues that were a ubiquitous part of any development process.

Following the finalization of the process, the company needed to produce first articles and perform validation to determine if both the part and the production process were working properly which was also a qualified activity. The first article sample rarely produced a part that met all of their specifications. The team worked through an iterative process of optimizing the code, performing another trial run, analyzing the samples, and further refining the process multiple times before they were able to create a product that met their customer’s specifications. Once this stage was complete, multiple units were produced and the company continued to scale up production while monitoring the quality of the final product.

RESULTS SPEAK FOR THEMSELVES

With the complexity of their production process, and the significant investment in technology and man hours, this company depends on R&D to remain a leader in the plastic injection molding industry. Qualified research expenditures totaled nearly $900,000 in the initial study performed by Source Advisors in 2012. Through the years, the company’s areas of research and development have expanded to exceed $1.4 million equating to an annual R&D Tax Credit of over $105,000.

Companies of all sizes and across many industries meet the federal government’s test for qualified innovation activities and can claim Research and Development (R&D) Tax Credits. However, many companies are not aware they qualify. There are thousands of companies that are leaving money on the table and not taking advantage of significant federal and state R&D tax credits.

Many people used to think R&D tax credits only applied to those that wear lab coats or create new best-in-class products. This is not the case – R&D credit is much more expansive and far-reaching than most people realize.

In addition, research and development tax credit guidelines for software development have relaxed. All of this opens the door for companies that have not taken advantage of or maximized their R&D tax credits in the past.

These research & development tax credit industries now include manufacturing, software, engineering, financial services, and many others.

If you’re improving or enhancing products and processes to remain relevant and profitable, you may be qualified for R&D tax credits.

Companies of all sizes and across many industries meet the federal government’s test for qualified innovation activities and can claim Research and Development (R&D) Tax Credits.