The R&D credit was first put in place as part of the 1981 Economic Recovery Tax Act. At that time, the United States had undergone a period of decline in R&D spending and was being outpaced by countries like Germany and Japan, according to the Joint Committee on Taxation. Since that time, the credit has been extended 16 times, most recently in 2010, as the federal government has sought to encourage growth and development of business throughout the country. Today, medical device companies spend about 10% of their revenues on R&D, according to First Research, an industry trends and analysis tool.
Unfortunately, most companies do not take advantage of the R&D tax credit for a number of reasons. Some companies simply do not know that this credit exists. Many companies lack the time, resources, and expertise to adequately understand the rules and document their R&D activities. Other businesses are afraid of being audited, which can eat up time, money, and resources.
These are legitimate concerns, but most of these companies underestimate the cash value of the credits. In some cases, the credit amount can be substantial. Companies that have not traditionally taken the R&D tax credit may have the opportunity to amend prior years to claim credits that were previously missed. For flow-through entities, such as S corporations and limited liability companies (LLCs), the credit flows through to the ultimate owners.
As opposed to simply deducting R&D expenses, the R&D credit lowers the overall effective tax rate, which increases a company’s market value and earning potential while providing an immediate return on R&D investment dollars. For companies in a net operating loss position that hope to generate positive income and become taxable in the future, any federal R&D credits generated and not used can be carried forward for up to 20 years. Some of these companies may end up being acquired by other companies. Unused credits may provide future value for an acquiring company. This future value can allow the seller to leverage up the selling price for the business.
How can your company benefit from the R&D tax credit? Let’s take a look at qualifying activities and how to calculate the credit.
The first step in claiming the credit is to understand the technical requirements for determining which of your company’s activities qualify as R&D. You may be surprised to find that most of the technical requirements are familiar. Most medical device companies would argue that they perform these processes continually. Nevertheless, most businesses are unaware that the R&D tax credit can reward their day-to-day efforts aimed at producing new or improved products or processes.
There are certain technical requirements that must be met for expenditures to qualify for the credit. These technical requirements make up what is commonly known as the four-part test. The four-part test requires the following:
- At the outset of the project, there must be technical uncertainty as to the method, capability, or design of the business component. In other words, you may know where you want to go but not how to get there.
- To resolve the uncertainty, the company must work through a process of experimentation. This typically involves evaluating alternatives and developing, testing, and refining hypotheses to determine success or failure.
- The R&D activities must also be technical in nature, meaning they relate to hard sciences, such as engineering, physical, biological, or computer science.
- The R&D activity must be intended to develop or improve a business component’s function, performance, reliability, and quality. A business component is any product, process, formula, software, or technique intended to be held for sale, lease, or license, or used in the business.
Once you have determined that your company has met each of these tests, it is important to document the activities. Your accountant or business advisor can provide a great deal of guidance and assistance when gathering the information and preparing the documentation to support the R&D credit. Typically, the process involves interviewing and educating key personnel on the activities that qualify for the R&D credit, documenting as well as analyzing accounting, project, and job costing data to determine the relevant costs.
Calculating the Credit
Once you have determined that a particular activity meets the four-part test, the next step is to calculate the amount of credit.
There are two methods of computing the credit. Certain limitations may affect the amount of credit that can be used in any given year, but a general estimated benefit is 6.5% of the qualifying expenditures for the federal credit. For example, a company with $300,000 of qualifying expenses may qualify for a federal credit in the neighborhood of $20,000. This dollar-for-dollar reduction in the company’s tax liability is in addition to a tax deduction that can be taken for the expenses.
Qualifying expenses include wages paid to internal employees, the cost of supplies consumed in the R&D process, and 65% of the amount paid to outside consultants. Internal wages relate to technical personnel who are directly performing R&D and any employees providing direct support or direct supervision for the R&D activities.
In addition to the federal R&D tax credit, at least 35 states offer their own tax credits as an incentive for companies to perform R&D activities. In some states, the tax credit can equal as much as 20% of the cost of R&D activities. As an added bonus, states such as Georgia offer programs that allow companies, depending on their tax situations, to not only use the credit to offset income tax liability, but to convert it to cash, even if the company has no revenue or taxable income.
R&D tax credits can provide significant value for qualifying businesses. With or without the impending excise tax on medical devices, the federal R&D tax credit offers an opportunity that medical device companies should explore as a way to mitigate some of the costs of the medical device excise tax. Since most medical device companies are likely already performing R&D activities, the credit is an opportunity that should not be overlooked.
If your company has not taken advantage of this credit in the past, it is possible to amend prior year tax returns and claim the benefits at the federal and state level.
Kerry Defler is a tax partner in the technology & life sciences group at Habif, Arogeti & Wynne LLP. He serves clients in the area of state and local tax credits and incentives, focusing on the R&D tax credit. Defler earned a bachelor’s degree in accounting from Bellarmine College and holds and MBA from Georgia State University. E-mail him at [email protected].
Ori Epstein is a tax manager in Habif, Arogeti, & Wynne’s technology and life sciences practice. He regularly speaks at medical device industry conferences on topics such as the medical device excise tax, business trends within the medical device industry, and tax planning and preparation for medical device companies. graduated from the University of Georgia with a bachelor’s degree in accounting and a master’s of accounting with a concentration in tax. E-mail him at [email protected].