R&D Tax Credit Fundamentals
For over thirty years the Federal R&D
tax credit has helped American firms recoup the costs of their
innovation. The vast majority of these firms are not engaged
in white lab-coat activity, as one might associate with the
term 'R&D.' By contrast, the credit is available to any
company that meets the criteria described herein. Since 1981,
the credit has existed in all but two years; in the likely
event it is again extended, firms seeking growth through
innovation should familiarize themselves with the basic
principles of R&D tax law.
Qualifying for the
Credit
Employee wages drive the credit.
Eligible employees must work within the hard sciences,
engineering, or software development. Ideally, those employees
either have formal training in a relevant technical discipline
and/or a lengthy professional background in their trade.
Eligible wages must then
be allocated to particular projects, termed "Business
Components" in the law. The most common business components
are specific products and processes. In addition, business
components can include techniques, formulas, inventions and
software. It is not enough to report qualified wages on a
general level, without segregating them into components.
Bayer, the leading pharmaceutical, remains in ongoing
litigation centered on this very issue.
Further, it is not
enough to show that a technical employee has contributed on a
general level to a given project or business component.
Eligible activity must relate to specific "permitted purposes"
that the law regards as especially contributory toward
innovation. These include making a given business component
more reliable, functional, higher quality, better performing
or more cost effective.
The kinds of activities
which frequently achieve these ends include prototype
development and testing, product design and redesign, process
development (pre-production), technical feasibility analysis
and patent application work. Frequently, these activities help
resolve instances of technical uncertainty, and involve the
examination of alternatives. Both technical uncertainty and
the examination of alternatives are specifically cited in the
law as key determinants of eligible activity. The challenge
for a taxpayer is to uncover and demonstrate the extent to
which these principles of scientific discovery underlie their
own firm activity.
Documenting the Credit
from the Bottom Up
Ultimately, each employee has a
percentage applied to his wage reflecting the portion of his
time spent on R&D. Substantiating this percentage is a
list of eligible business components showing which employees
contributed R&D to which component.
Firms using
project-based accounting are in a better position to tie their
employee's R&D activities to specific business components.
By contrast, firms using cost-based must supplement their
documentation more thoroughly to arrive at appropriate
estimates. Supplementary items include contemporaneous
documentation - meaning documents generated at the time of
R&D which corroborate the credit claim - and oral
testimony from employees. The most relevant examples of
contemporaneous documentation should be procured into a
binder, and a list of other potential resources, such as
emails, logs, notes, travelers, models, outside contractor
reports, etc., should be developed.
Firms are not
disqualified simply because they may be required to estimate
certain figures due to their accounting methodology. In Cohan
vs. Commissioner, a taxpayer without exact records of past
business expenses was allowed to estimate them . The same
principal was later applied specifically to R&D
documentation in Fudim v. Commissioner . The key issue is
today is not whether estimation has occurred, but how
thoroughly those estimates are substantiated.
Regardless of the
taxpayer's accounting approach, every R&D study should
also be supported by interviews with relevant personnel. These
interviews provide insight into the appropriate division of
each employee's time as well as to the challenges faced on
each project. The validity of oral testimony in particular as
an element of estimation was affirmed in United States v.
McFerrin.
Documenting the Credit
from the Top Down
The credit is, ultimately, a tool for
national growth and job creation. As such, good documentation
will also make a compelling case along these broader lines.
Manufacturing firms, for example, should detail the
exceptional competitiveness of the industry and its specific
impact on their companies; any manufacturer that has survived
the recent wave of off-shoring is well-positioned for R&D
credits by sheer virtue of the competitive pressures endured.
Likewise, tech startups should emphasize the shift to an
incubation model on behalf of US universities and the role
this framework has played in job creation for the new economy.
Research has shown that for each dollar of foregone tax
revenue, GDP has increased by at least an additional $1
High-level connections to growth and job creation therefore
tie in to the bottom line of the legislation itself. Likewise,
if a firm's activities substantially connect with any
governmental initiative aimed at economic development, those
connections should also be highlighted. For example, firms
engaged in health care innovation, particularly those products
which reduce costs and streamlines efficiency, relate directly
to national efforts at fighting health care inflation.
Excellent documentation identifies these relationships in much
the same way the R&D law explicitly creates a patent safe
harbor.
Conclusion
Many firms which do not take the Federal
R&D tax credit do so out of a mistaken belief that they
are not eligible. Any firm employing professionals who are
resolving technical uncertainties, testing alternatives, and
contributing to their firms' own knowledge bank should take a
close look at this incentive. The knowledge gleaned need not
be new to the world; rather, it must be part of a firm's own
intellectual progress and scientific know-how.
