Â鶹app

By Justin Mentele and Travis Free

The Research & Development Tax Credit (R&D credit) continues to be one of the most generous tax benefits available to manufacturers.

K·Coe Isom has helped manufacturers with annual sales ranging from $1 million to $1 billion generate R&D credits. Every manufacturer has the potential to improve its cash flow through this credit, and many have the option to capture state R&D tax credits, too. Do not pass on this opportunity. 

Background

Historically, Congress had to renew the R&D credit each year. In 2015, the PATH Act made the R&D credit permanent—or as permanent as anything is in Washington, D.C.  

In 2003, one of the most important changes to the R&D credit happened when the Discovery Rule was eliminated. Prior to 2003, research activities had to be geared to new-to-the-world discoveries. The credit was used by companies that had scientists running around in lab coats.

Since the change, research only needs to be new-to-the-company discoveries. Even if hundreds of companies are making a product or using a process, if it is new to you, it qualifies for the R&D credit. This has been a game changer.

In 2017, when the Tax Cuts and Jobs Act (TCJA) became law, the R&D credit became an even greater opportunity. The TCJA reduced the C-corporation tax rate to 21 percent, which had the indirect effect of increasing the impact of the R&D credit by as much as 15 percent.

Qualifying R&D Activities

Manufacturers make many improvements that qualify for the  credit. Improvements are not limited to inventions or patents. The credit is often used by companies that are improving an existing product or a manufacturing process.  

Qualifying expenses include labor as well as materials and supplies. In fact, for most of our client companies, the largest R&D expense is labor. Consider this partial list of activities that qualify:

Manufacturing process improvements, including changing materials and reducing labor;

Process changes to meet increasing regulatory requirements;

Improving product quality;

Evaluating the most efficient flow of production;

Developing second generation or improved products;

Designing the shop floor to improve flow, including cellular manufacturing;

Tooling and equipment fixture design and development;

Designing, building and testing product prototypes;

Three-dimensional modeling;

Developing new applications for old products.

It is easiest to track R&D expenses as you incur them, but companies also can gather the information after the year ends.

What to Expect in 2022

There are changes to the R&D credit starting in 2022. Today, in addition to generating a credit, R&D expenses are deducted in the year incurred as ordinary and necessary expenses. In 2022, R&D expenses are required to be capitalized and amortized over five years; R&D credits would not change.

K·Coe Isom anticipates that lawmakers will change the provision and continue to allow R&D expenses to be deducted in the year incurred, in part because the law as it is planned would create undue burden on companies to identify research expenses. Manufacturers would be required to identify all research costs, even on improvements that the manufacturer otherwise might not capture for the credit.

It is an unresolved question worthy of manufacturers’ attention. 

Justin Mentele, CPA is a Principal at K·Coe Isom specializing in services to manufacturers. He works across financial spheres – audit, tax and consulting – to help his clients understand their financial performance and make adjustments that dramatically impact profitability, efficiency and employee retention.

CPA Travis Free is a manager at K·Coe Isom. He has dedicated his entire career to helping manufacturers, including specializing in multi-state taxation, tax incentives, inventory management, and traditional tax, audit and accounting services.

Using the R&D Credit for Years Past, Those Ahead

Prior Years

A company can review the past three tax years to claim R&D credits. The process requires filing amended tax returns that include the R&D credit information. The IRS will refund the amount allowed.

Looking Ahead

This year is shaping up to be tough. Some companies will generate a taxable loss. The CARES Act allows taxable losses in 2018 through 2020 to be carried back five years to generate refunds. But in 2021, net operating losses can only be carried forward to offset future years’ taxable income.

In addition, there are annual limits on using taxable loss carryovers.  

C-corporations net operating losses are limited to 80 percent of taxable income. The CARES Act suspended this provision for 2020, but it returns for 2021. The remaining 20 percent of 2021 taxable income will be taxed. In 2021 and beyond, during profitable years, the R&D credit can offset tax on the 20 percent of taxable income.  

Flow-through entities (S-corporations, partnerships and LLCs) also have limits on the use of net operating losses. The maximum annual loss deduction is $500,000 for married filing joint and $250,000 for single. The CARES Act suspended this provision, but it returns for 2021. If an owner’s 2021 and future years’ other income (wages, interest, dividends, gains, farming, rental, etc.) exceeds the loss limit, R&D credit can be used to offset tax on the other income.