A Guide to Qualifying R&D Activities, Documentation and Real-World Examples for Manufacturers

Manufacturers are constantly striving to improve their products and processes to remain competitive in an ever-changing marketplace. To help incentivize this innovation, the federal government offers a research and development (R&D) tax credit to eligible companies. This credit can provide significant savings for manufacturers, but it can also be complex and challenging to navigate. This article will explore the R&D tax credit, its benefits and changes to the credit that manufacturers need to be aware of.

What is the R&D Tax Credit?

The R&D tax credit is a federal tax credit that encourages businesses to invest in research and development activities. It was first introduced in 1981 and has since been expanded to include more industries and types of research. The credit is available to companies that incur expenses related to developing new or improved products, processes or software. It is a dollar-for-dollar reduction in the company’s tax liability, meaning it can result in significant savings for eligible companies.

Where is the R&D Tax Credit Applicable?

You may qualify for R&D tax credits if your manufacturing company or operation:

  • Creates new processes, products, apps or software.
  • Improves or automates processes, products or software.
  • Develops prototypes, designs, models or other simulating tools.
  • Designs tools, molds or equipment.
  • Evaluates alternative materials or approaches.
  • Hires outside consultants to do any of the above.

How do I Qualify for a R&D Tax Credit?

To qualify for the R&D tax credit, the activity must meet all four requirements:

  • Be technological in nature.
  • Identify a specific goal or objective.
  • Seek to eliminate uncertainty.
  • Follow a process of experimentation.

What Documentation Is Necessary for the R&D Tax Credit?

When claiming the R&D tax credit, it’s essential to have proper documentation to support the qualifying R&D activities and expenses. Taxpayers should retain all formal and informal documentation created during the R&D process to support their claim. The following are examples of documents that taxpayers should retain:

  • Project descriptions or plans
  • Design revisions
  • Test logs and reports
  • Notes, presentations and emails
  • Records of employee time and wages
  • Documentation of supplies and materials used in R&D activities
  • Documentation of contractors and subcontractors involved in R&D activities
  • Documentation of any third-party research conducted on behalf of the company

Documentation should be created and maintained when the R&D activities are performed. This will help ensure the R&D tax credit claim is supportable and will stand up to scrutiny by the IRS.

How Much can my Manufacturing Company Save with R&D Tax Credits?

The amount a manufacturing company can save with the R&D tax credit depends on several factors, including the company’s size, the amount of qualifying expenses and the effective tax rate. Companies can generally claim a credit of up to 20% of their qualifying R&D expenses. For example, if a company spent $100,000 on qualifying R&D activities, it could claim a credit of up to $20,000. However, there are some limitations and restrictions on the credit, so it is important to work with a tax advisor to determine the exact amount of savings a company can expect.

Additional Opportunities Related to R&D that Are Often Missed

In addition to the R&D tax credit, there are other opportunities for manufacturers to benefit from their R&D activities. These include:

  1. Cost segregation studies: A cost segregation study can help manufacturers identify assets that can be depreciated over a shorter period of time, resulting in significant tax savings.
  2. State R&D tax credits: Many states offer their own R&D tax credits in addition to the federal credit. These credits can provide additional savings for eligible manufacturers.
  3. Grants and other funding opportunities: There are a variety of grants and funding opportunities available to manufacturers who are engaged in R&D activities. These can provide additional resources to support innovation and growth.

Changes to Kansas R&D Tax Credits

Under the new legislation, Kansas companies with qualified R&D activities within Kansas are now eligible to receive a 10% tax credit instead of the previous 6.5% credit. Application of the credit remains the same as prior years, with the credit being spread over the current and following three tax years. Usage of the credit is limited to 25% of the credit per year. For all taxable years commencing after Dec. 31, 2022, the credit is 10% of the difference between the actual qualified research and development expenses for the year and the average of the actual expenditures made during the year and the two previous tax years. Kansas will have its’ own calculation on form K-53, but as a rough estimate 10% of federal credit amount will now be allowed as a Kansas credit.

Taxpayers without a Kansas tax liability may sell their R&D credits, which may be transferred to any person and be claimed by the transferee as a credit against the transferee’s Kansas income tax liability in the tax year when it was transferred.

Case Study 1: Manufacturer A

Manufacturer A is a mid-sized manufacturer specializing in developing custom machinery for other manufacturers. They recently invested in R&D activities to improve their product design process and increase efficiency in their manufacturing operations. They spent $250,000 on qualifying R&D expenses and could claim a federal R&D tax credit of $50,000, resulting in significant tax savings. In addition, they worked with their Adams Brown tax advisor to identify other opportunities related to their R&D activities, including a cost segregation study that identified additional depreciation opportunities for their assets. Manufacturer A was able to save an additional $20,000 in taxes through this study.

Case Study 2: Manufacturer B

Manufacturer B is a small manufacturer who began working with the Adams Brown team last year. Their work is very specialized in nature with developing customized prototypes. In a review of the prior tax returns, Adams Brown tax advisors identified they had not been taking advantage of the R&D Credit, but would likely have qualified for the credit based on the nature of their work. The R&D team interviewed Manufacturer B and performed R&D credit studies for the prior three years. The tax returns were amended for the prior three years (since the tax years were still within the statute of limitations), to capitalize on the R&D credit. Through this process, Manufacturer B saved $27,000 – $36,000 in tax dollars per year and will potentially generate additional savings annually going forward.

Questions?

Every manufacturing company has unique goals, values and resources that impact R&D activities. Developing a customized project plan is crucial to identify, calculate and support your company’s R&D credits and activities.

By working with a knowledgeable tax advisor and taking advantage of the latest changes to the R&D tax credit, manufacturers can maximize their tax savings and invest in the future of their businesses. With a tailored plan in place, you can ensure you’re capturing all eligible R&D expenses and credits while staying compliant with IRS regulations.

Contact an Adams Brown advisor if you have any questions about R&D qualifications.