Nabbing Tax Credits Like the Big Boys

Small and mid-size companies should get into the R&D tax credit game, as soon as Congress passes the inevitable extension.
Marie LeoneJune 12, 2008

The research and development tax credit has made more comebacks than sitcom stars of the 1970s. And it’s about to happen again.

The research credit expired on December 31, 2007, but the Senate Finance Committee pushed through proposed legislation on Tuesday to extend the tax break for the 13th time since it was enacted in 1981. (Congress allowed the credit to lapse completely only once — between 1995 and 1996.)

The proposal is a substitute amendment to H.R. 6049, the Renewable Energy and Jobs Creation Act of 2008, a piece of legislation that also proposes alternative energy solutions and other tax relief for consumers and businesses. The provision is the government’s way of spurring innovation among U.S. companies, giving tax breaks for increasing investment in R&D.

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If the proposal survives a vote in its current form, the credit will be retroactive for expenses paid or incurred after December 31, 2007, but it will expire — once again — at the end of 2008. “Nobody wants to commit to the fiscal impact [of the tax credit] every year,” comments Michael Silvio, a director at CBIZ Accounting and Tax Advisory Services, who counsels companies on how to take advantage of the credit. “This pay-as-you-go approach always needs an offset.”

The estimated cost of the proposal is nearly $10 billion over 10 years. The Senate Finance Committee wants to fund the credit by delaying a planned tax benefit that would give multinational corporations additional tax deductions in the United States, noted a statement released by Montana Democrat Senator Max Baucus, the committee chair. The committee also is looking to require hedge fund managers to report and pay taxes on their compensation as they receive it, instead of stashing the funds in offshore accounts to avoid a tax hit.

Despite a dip in participation during the 2001 to 2003 time frame, which is explained by the economic recession during those years, there has been a steady climb in the number of companies that use the credit, as well as a rise in the dollar amount claimed. In 2005, the most recent year for which data is available from the IRS, more than 17,700 public and private companies claimed research tax credits for a total of $6.6 billion in tax breaks, according to a report released in April by the R&D Credit Coalition, an advocacy group. That represents a 6 percent increase in the number of companies claiming credits, and a 50 percent rise in the total dollar amount, for the eight years covered by the study — 1997 through 2005.

Of the companies claiming R&D credits in 2005, 79 percent were defined as small, having under $25 million in total assets. However, the lion’s share (62 percent) of the credits in terms of dollar amount was gobbled up by large companies, defined as having $2.5 billion or more in total assets. That makes sense, because the credit is calculated on, among other things, increases in R&D spending. So, companies that continually innovate, and spend large sums year after year to do so, garner a tax break on the additional spending.

Despite the enthusiastic turnout by small and mid-size companies, however, many businesses still are unaware of the research tax credit, contends Silvio. Smaller, private companies, including those owned by venture capital funds, “leave money on the table” when it comes to cashing in on the research tax credit. “The Fortune 500 companies know about the credit and take advantage of it, but smaller companies don’t realize that this is a way to infuse cash into their business.”

Silvio mentions several clients to prove his point. Witness an aerospace parts company that regularly generates $400 million by manufacturing components for jet engines. The first time the parts maker, which is owned by a venture capital firm, applied for the credit it received $1.75 million of savings over a three-year period. Similarly, a $180 million furniture manufacturer during the heyday of the housing market boom grabbed a $5 million credit over four years, while a $100 million agricultural company snagged $350,000 worth of credits over a three-year period. “I think the manufacturing process is what most companies are missing [regarding claiming the tax credit],” asserts Silvio.

Indeed, many executives unfamiliar with the credit don’t realize that it applies to more than just high-profile pharmaceutical, medical, and software developments, says Silvio. In fact, the manufacturing sector claimed the majority of the credits in 2005, followed by the services and information industries, according to the R&D Coalition report.

Consider the variety of allowable R&D activities. The Internal Revenue Service approved credits for the jet engine parts maker to offset money spent to revamp its manufacturing process to meet its specifications for high-tolerance components. The furniture maker applied the credit to expenditures related to the development of unique styles of cabinet doors made from nontraditional woods. Meanwhile, the small agribusiness owners used their credits to offset expenses incurred while developing organic pesticides for fruits and vegetables.

Smaller companies also snatch up credits for more traditional R&D programs. For example, a $60 million medical software developer received a $3 million credit over a three-year period for money spent on enhancing patient-tracking software to comply with the Health Insurance Portability and Accountability Act. Further, a tiny $20 million pharmaceutical company qualified for a $300,000 credit for one year’s work related to development of a generic drug for horses and other domestic animals.

Interestingly, the pharma R&D program did not compare to the massive research effort behind the blockbuster drugs marketed by the likes of Pfizer, Merck, and Bristol-Myers Squibb. Rather, the company captured the credit for duplicating an existing medicine by starting with the known active ingredient listed on the label, and conducting research to isolate the unknown inactive ingredients.

To be sure, qualifying for the R&D credit also takes some research into the corporate books because of how the credit formula is structured. Here’s how it works: The tax credit is a dollar-for-dollar reduction in tax liability that is applied to incremental R&D spending. Currently, three credits are available for activities that qualify as research under IRS rules, ranging from 3 percent to 20 percent of the incremental spending.

The “traditional” 20 percent credit is applied to the different between a company’s current R&D expenditures and its calculated historic R&D spending baseline. (The baseline cannot be less than 50 percent of the qualified research expenses.) The baseline formula takes into account R&D spending as a percentage of revenue. So, in effect, as revenues rise, R&D spending has to rise to qualify for the 20 percent credit.

The alternative incremental research credit (AIRC), which slides between 3 percent and 5 percent, also is tied to revenue and applies to the excess amount between current R&D expenses and the historic baseline spending. But the baseline is calculated going back to the 1980s, when the rule was enacted. So it often takes companies that are not aware of the credit endless person-hours to hunt down the expenditures. The new Senate proposal repeals the AIRC, so considering it may be a moot point if the R&D credit provision passes muster with lawmakers.

The final tax break, the alternative simplified credit (ASC), is a 12 percent credit that under the Senate proposal is slated to rise to 14 percent. The ASC is available to companies that record R&D expenses exceeding 50 percent of the average qualified R&D spending over the three years before the year the credit is claimed.

The best way to take advantage of the government’s largess is to “capture the credit as it happens,” counsels Silvio, who is a CPA. “Change your general ledger, identify and document what expenses qualify for the research credit, and move the expenditures into a general ledger account,” he says. In that way, he explains, the finance staff doesn’t have to sift through historic accounts to reconstruct the R&D effort. Silvio notes that the IRS will allow some estimates in the calculations, but for the most part, it wants “the real numbers.”

In the end, “if the CFO works with the technical guys, the engineers, scientists, and chemists, to identify the R&D expenses, the company will have a very defendable credit.”