The R&D Tax Credit Aspects of Doing Business in Pennsylvania

Pennsylvania, just like its population has an expansive and diverse economy.  Like most modern economies, it is driven in large part by technological innovation. In 2019, the state had real Gross State Product (GSP) of over $720 billion, which has generally been increasing since 2000. PA has a range of pioneering industries that drive production, including pharmaceuticals, agriculture, natural resources, appliances and food production. 

PA companies that are motivated to consistently improve their business products and/or processes in these and other industries are investing substantially in the state economy by expanding their operations.   The tax credit also helps them pursue new projects and save on their tax liabilities.
 
Companies such as these that develop products and services should be aware of federal and state R&D tax credits, which are available to help stimulate innovation in the great state of Pennsylvania.

In 2018, over 1,100 Pennsylvania companies utilized federal and Pennsylvania R&D tax credits.

Enacted in 1981, the now permanent Federal Research and Development (R&D) Tax Credit allows a credit that typically ranges from 4%-7% of eligible spending for new and improved products and processes. Qualified research must meet the following four criteria:

• Must be technological in nature
• Must be a component of the taxpayers business
• Must represent R&D in the experimental sense and generally includes all such costs related to the development or improvement of a product or process
• Must eliminate uncertainty through a process of experimentation that considers one or more alternatives

Eligible costs include U.S. employee wages, cost of supplies consumed in the R&D process, cost of pre-production testing, U.S. contract research expenses, and certain costs associated with developing a patent.

On December 18, 2015, President Obama signed the PATH Act, making the R&D Tax Credit permanent. Beginning in 2016, the R&D credit can be used to offset Alternative Minimum tax for companies with revenue below $50MM, and for the first time, pre-profitable and pre-revenue startup businesses can obtain up to $250,000 per year in payroll taxes and cash rebates.

The Pennsylvania State Research & Development Tax Credit largely mirrors the Federal Research & Development Tax credit discussed above.  Typical qualified expenses include the following:

• Wages paid to employees for qualified research services
• Cost of supplies used directly in research activities
• 65% of amounts paid to others for contracted research

Many non-manufacturing companies earn Pennsylvania R&D Tax Credits

The State of Pennsylvania is very transparent and annually publishes a detailed report including company name, industry and amount of state R&D Tax Credit.

From 2008 to 2017, two hundred and eight (208) taxpayers consistently received a PA R&D tax credit.  Of the 208 taxpayers, 66 of them qualified as small businesses.  Small businesses are those with net book asset values of less than $5 million.  And, of the 208 awarded taxpayers, 71 of them were not in the manufacturing industry.  In fact, between 2008 and 2017, the compounded annual growth rate of Pennsylvania R&D expenditures for small businesses was about 15%.

Even some of these companies who were not profitable benefitted from the credit, thanks to the feature of the Pennsylvania state tax credit that gives the ability to sell unused tax credits to others.  This method is especially beneficial for small businesses that incur research expenses but have no tax liability to offset. 

Pennsylvania recognizes the importance of innovation in businesses of all sizes and across all industries.

As discussed briefly above, Pennsylvania has a large and growing economy.  The $720 billion of GSP in 2019 amounts to more economic output than most countries in the world.  In fact, if the State were an independent country it would be roughly the 18th-20th largest economy in the world in terms of economic output.   

In 2018, there were 1 million small businesses in PA.  This comprised 99.6% of all PA businesses¹.   There were 2.5 million small business employees that comprised 46.7%, almost half, of the workforce throughout the State.  Pennsylvania is still the state where small businesses can “pursue happiness,” as the state’s motto indicates.

Over the past few decades innovators have transformed the oil and natural gas industry into one of the most technologically advanced industries in the nation.  Innovative technologies in the industry involve making the exploration and production of natural gas more safe, efficient and environmentally friendly.  New technologies allow producers to use fewer explosives, which reduces the impact of exploration on the environment. 

Seismic imaging uses state of the art computers to create 3-dimensional models of subsurface layers.  4-D seismic technology is even more innovative.  It allows exploration teams to observe how subsurface characteristics have changed in a certain region over time.  These x-ray-like technologies allow developers to identify drilling sites easier while causing less harm to the environment by placing drilling holes in the optimal position.  What’s more is that labor costs are greatly reduced, in turn reducing the cost of the final product for consumers. 

Coil tubing is a technology that is used in creating drill pipes.  As opposed to the traditional rigid drill pipe, it involves a long, flexible coiled pipe string.  This method reduces not only the environmental footprint of drilling operations but also the cost. 

4-D seismic imaging and coil tubing are just two examples of innovation in the natural gas industry.  Corporations, government agencies, academics and private research and development firms are all developing new technologies to improve the efficiency of exploration and production operations and reduce the environmental footprint from them.

Company Many people see Pharmaceuticals and Biotechnology as two possible engines that will power Pennsylvania’s economy through the 21st century.  The State is home to a large number of key players, in both the small-to-mid-size economic sector as well as the large multi-nationals.  Pfizer has a small molecules, vaccines and biologics division in Collegeville, PA; GlaxoSmithKline has a similar division in Conshohocken, PA; Merck has one in Lansdale, PA; Alliance Pharma does contract research & consulting in Malvern and Novum has a clinical research center in Pittsburg.  These firms are just a tiny fraction of the Pharmaceutical and Biotech firms that have Research and Development operations in the state.  The rest of the pharmaceutical and biotech development is the result of the hard work of small to mid-size companies in PA.  For instance, one of our clients researches and develops new compounds and drugs to improve patient outcomes.  They experiment with new drugs that can achieve results in patients that often have tried everything else.  As a result of our client’s biomedical and chemical engineering projects, ketogenic patients that are unable to ingest sugars (which is a common coating for medications) and patients with mitochondrial diseases relying on feeding tubes (so they are unable to take their normal medications by mouth), can take their medications without adverse side effects.

Distribution centers and warehouses are the new brick-and-mortar for online retailers to store and distribute their goods to intermediary and end-user customers.  In the past, when capacity was restricted, distribution centers focused on increasing density.  Today, the goal is to relentlessly improve throughput.  Becoming the modern retail engine, warehouses have increasingly begun to invest in applicable innovative technologies.  These technologies include narrow-aisle forklifts, co-packaging spaces, collaborative robots (“co-bots”), and other technologies including smart cards and conveyors.  Other R&D credit eligible activities can range from software improvements (WMS, GPS, ERP, etc.) to integration of new processes to make shelving, picking/packing, and locating items more time and cost-effective.  All these improvements and technological advancements help Pennsylvania arrive at the right destination while bringing R&D tax credits as well.

The warehouse industry in Pennsylvania is a robust one.  Eastern Pennsylvania has an extensive highway and railway network as well as access to several busy Northeast markets.  Forever 21²,  Nordstrom and Urban Outfitters are all building large, new e-commerce fulfillment centers in Lancaster County.  The three centers will employ a total of 1,100 workers year-round and many more during the holiday season. 

The distribution center & warehouse industry has opportunities for Research and Development.  Robotic automation has entered warehouses, and it is on the brink of revolutionizing the industry.  Robot prices are falling fast, and technology is allowing them to become more and more capable of warehouse tasks such as picking, packing and transport. Throughout the nation, a growing number of companies are turning to robotic warehouse automation as a means to reduce costs and complexities associated with handling materials.

Robotics companies developing new and improved warehouse solutions as well as manufacturers, retailers, and distributors implementing robotic warehouse automation should be aware of R&D Tax Credits as these activities are often eligible for a large tax credit³.  One of our leading logistics clients has at least 3 warehouses situated in PA in addition to dozens in other states as well.  Warehouses are not empty buildings.  On the contrary, they require constant maintenance, are constantly receiving and shipping goods (requiring efficient throughput analysis), and must know exactly what is in those warehouses at any given time and where to find a particular item - quickly.  Our client integrates the latest technologies to better track items and constantly improve their throughput efficiency, which is critical in this industry.

Pennsylvania farms produce more than $7 billion in crops each year. The total value of food products produced in the state amounts to a $30 billion industry. 2018 saw investments in a number of areas, including the state’s dairy and apple industries.  Farmers and food producers are developing new and innovative techniques and processes to boost productivity and save money.

In the agriculture industry, agrobots are automating the process of picking small produce products like strawberries. Such tasks have long required the backbreaking efforts of tens of thousands of low-paid workers.  However, recent labor shortages in the industry have forced farmers to start rethinking the way they pick the berries.  “It’s no longer a problem of how much does a strawberry harvester cost,” said Juan Bravo, inventor of Agrobot, the picking machine. “Now it’s about how much does it cost to leave a field unpicked, and that’s a lot more expensive.”⁴  Even though the machine costs about $100,000 it would still be profitable for farmers because it saves them the expense of leaving their patches unpicked when they cannot find workers.

Agrobots are not the only innovations in farming technology.  Crop protection, irrigation, nitrogen use efficiency, no-till farming, water harvesting and precision agriculture all involve substantial research and development.

Consumer demand is also driving innovation on the production side of the food industry.  Meaningful changes in core ingredients for food products require laboratory activity because consumers are demanding healthier products that still taste the same as their less healthy counterparts. Large food manufacturers have huge contingents of chemists, scientists, and nutritionists constantly seeking solutions to concerns created by emerging health awareness. 

The major challenge for food producers is creating a product that tastes good but is healthy at the same time.  Food companies do particularly well in establishing the R&D tax credit.  Pennsylvania has a significant amount of food manufacturing, production and distribution companies due to the state’s vast amount of available resources.

Food manufacturers can qualify for an R&D Tax Credit in multiple ways – both for product development, but also for process improvement.  Today’s food shoppers are far more discerning than the previous generation was.  Today’s consumer demands organic, whole-grain foods, with reduced trans-fats, sugar and salt, that are preservative-free.  Today, food companies are substituting processed ingredients with healthy alternatives all while adhering to regulatory health and safety guidelines.  Food companies also face technical hurdles in the area of packaging and distribution developments and improvements as well.  Sample activities that food companies engage in that qualify for the R&D tax credit include test kitchen activities, experimenting with new ingredients, shelf-life testing and maximization, initiatives to increase nutritional value, and incorporating new or lean manufacturing procedures.  The delicious food PA is home to is often the silent result of systematic testing and experimentation.

Developing a food product that meets these standards involves a deep process of experimentation, which can be costly and time-consuming as well.

In addition to industry, PA’s advanced academia is also conducting substantial research and development. In 2018, the University of Pittsburgh received $808 million in research funding. Researchers and engineers there are using this funding to develop a diverse array of technologies which include the following:

• Dental bone-grafting technology designed to improve bone healing
• Augmented reality medical simulation systems for training healthcare workers
• Mattress overlay technology designed to alter the skin temperature of the person sleeping on the mattress (A technique used for treating and preventing certain medical conditions).
• Computer software designed to help students write better
• Motion analytical technology that allows user to analyze their baseball swing
• Smartphone application software that improves awareness for smokers who wish to regulate their smoking patterns. 

Many of these technologies created at the University and listed above have vast startup potential.  UPitt’s research center has an enterprise development team that caters to local entrepreneurs interested in starting new companies around innovation that emerges from the center.  In 2018, the economic impact of the University’s research was about $1.7 billion. 

The same services offered to potential start-ups are also available for venture capitalists looking for new opportunities.⁵ The Pitt Ventures initiative provides a systematic roadmap for successfully translating early-stage intellectual value into products, services and, ultimately, new enterprises that create jobs, wealth and tax revenue.

Carnegie Mellon University (CMU) is an extremely well recognized, world-class research institution. 

CMU’s research institution has staff in a range of fields from computing to environmental technology to robotics to biotechnology⁶. The University is particularly well known for its Robotics Institute which has developed a significant number of robotics technologies such as drones⁷,  automated cars⁸,  space-bots and industry robots⁹.  

Like many modern research institutions, the University is striving to bring innovative ideas developed in the labs to market.  It is one of 25 universities in the world that annually join the World Economic Forum’s “Global University Leaders Forum.”   At the forum, the world’s top 1,000 companies gather to shape global, regional and industrial agendas.

While Wharton is traditionally world-renowned for its business and economic training more than its technological developments, it does have industrial aspects to it as well.  Three Wharton business school graduates named Neil Blumenthal, Jeff Raider, and Andy Hunt were one of the first to make online eyewear a major product category by launching Warby Parker during their first year MBA program.  More online eyewear retailers followed and now, particularly with the COVID-19 crisis, the trend has exploded.

Numerous 3D printing glasses manufacturers have since entered into the eyewear business.¹⁰