Episode 004: Learning the Ropes of R&D

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The good news is that many companies that put forth an effort to improve their own products and processes are eligible to receive the R&D Tax Credit, which can boost their bottom lines. The bad news is that some companies never even know it.

Floyd Holliman, CPA, Member in the Firm’s Tax Division and leader of the Firm’s Specialty Tax Services Group, joins Kim and Paul to discuss the R&D Tax Credit, what the credit used to be. what it is now, what products and activities could make your company eligible to benefit from it and what common pitfalls companies face.

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What types of projects are eligible for the R&D Tax Credit?

Any type of company spending time and money to improve a product or process that involve a science

New products, product improvements, new processes, process improvements, new formulas or techniques

What types of expenses can qualify?

Employee wages – those doing the research, as well as supervision of research and support staff

Outside Contractors

Supplies consumed in the R&D process – prototypes, etc.

Can development done under contract with a customer qualify?

Yes, these types of arrangements with the customer can also qualify for the credit.

Are there any additional considerations when R&D is done under contract with a customer?

There has to be financial risk incurred

  • A fixed fee contract shifts more risk to the developer and is typically easier to qualify as opposed to a cost-plus or time & material contract

Some rights in the technology being developed must be retained

Have there been any developments over the past few years that make this a good time to take a fresh look at eligibility?

Some previous hurdles are no longer in place –

  • Some companies are eligible to use the R&D Tax Credit against not only income tax but also payroll tax.  This can be helpful for companies with losses that are not paying income taxes.
  • The R&D credit can also be used against the alternative minimum tax
  • Internal-use software that is developed now is easier to qualify as long as the software facilitates interaction with customers in some way
  • Tax Reform has made the R&D credit more valuable for each qualifying dollar spent
  • Additional state cash savings in most states are available for research performed in the state

If a company determines that it has qualifying activities in previous years, can credits from prior years be captured?

In some cases refunds can be claimed for past years

Also, any unused credits can be carried forward for up to 20 years

In closing, are there any questions that a company should be asking itself to determine if it may be missing out on the R&D Tax Credit, and thereby overpaying its taxes?

Do you have R&D employees on staff?

Do you hire contractors for research?

Are you at risk for the projects that you are developing?

Are you developing or improving a product or process?

Commentator [00:00:00]           

Welcome to the Wrap, a Warren Averett podcast for business leaders designed to help you access vital business information and trends when you need it so you can listen, learn, and then get on with your day time is tight. That’s why our advisors have wrapped up today’s most timely topics into a podcast with actionable advice. Now let’s get down to business.

Paul Perry [00:00:22]              

Hey Kim, how are you today?

Kim Hartsock [00:00:23]              

Hi Paul. I’m good.

Paul Perry [00:00:24]     

Good to see you.

Kim Hartsock [00:00:25]            

I know it’s good to see you.

Paul Perry [00:00:26]     

Glad to be back for another, a Wrap podcast conversation.

Kim Hartsock [00:00:29]

Yeah, it’s always fun to, to record these episodes.

Paul Perry [00:00:32]       

Yeah, we’re having a good time. We’ve got a really good topic today. R&D tax credits. A lot of organizations out there know a little bit about it. Maybe they don’t, but today we brought, uh, Floyd Holliman, one of our partners in the Tax Department here at Warren Averett to kind of talk a little bit more about R&D tax credits.

Kim Hartsock [00:00:48]    

And for those who don’t know, R&D, that’s research and development.

Paul Perry [00:00:53]    

Thank you very much, Kim. Always correcting me and I appreciate it.

Kim Hartsock [00:00:56]

We CPA’s love these acronyms and shortcut words. Don’t we?

Paul Perry [00:01:00] 

I think when you start they give you three things, a ruler, a 10 key and an acronym list

Kim Hartsock [00:01:07]

and a joke book. Right? Because we are great at telling jokes. Yeah. Right. So welcome Floyd. Thank you. We’re excited to have you here. Yeah.

Paul Perry [00:01:16]  

So as it relates to research and development credits, R&D tax credits, you know, what are y’all seeing in the marketplace from a business perspective? What, what is, what are companies, what do they know about and what do they truly don’t know about R&D tax credits that they need to know about.

Floyd Holliman [00:01:30]       

So a lot of companies think you have to be in a lab, maybe wearing a white lab coat to qualify for the R&D credit. And that is not the case at all. Um, the credits been around since 1981 and you’d be surprised to know how many companies do not think they have a chance at qualifying for the credit. So they leave a lot of money, a lot of money on the table. They pay a lot of taxes. They may not have to pay.

Kim Hartsock [00:01:57]   

It’s, it seemed to me that this really started gaining momentum about, I dunno, 10 years ago, but you, so it’s kind of surprising that it’s been around so long, and I’m asking this off the cuff by the way, but what was kind of the main reason for it to gain such popularity and momentum when it did?

Floyd Holliman [00:02:15]  

So, yes, there has been a lot of developments over the last few years, but going back in time like you’re doing, there were some changes in the past when it first came out, you had to discover something new in your field, something completely revolutionary in your field of whatever your field was something that no other company was doing. Uh, it’s called the discovery test. Well, the court case came out, I want to say around 2004 that eliminated that. It just has to be something new to your company. Okay. Technology that your company is developing, it does not have to be a, a worldwide revolutionary new technology that’s being developed.

Paul Perry [00:02:54]     

Sure. So as technology changes over time and, and grows, then, then obviously we’re going to see those times are when the R&D tax credits are kind of heightened. And maybe when technology took a shift and 15, 20 years ago, it really kind of took off in that direction.

Floyd Holliman [00:03:13]

Yeah, that, that’s a good point. Yes. And, and, and we, and keep in mind though, pretty much any industry you can think of we probably have done a study for, but by and far the majority are in the technology and manufacturing industry. So yes, as technology’s taken off. So has R&D credit.

Kim Hartsock [00:03:30] 

So we talked about the projects that are eligible. So new products, products improvement, new processes, process improvements, new techniques, but what types of expenses qualify?

Floyd Holliman [00:03:42]       

Sure. So wages of those people doing research and development that you may, that on staff that you have in your company and that’s doing R&D those wages can qualify. Um, as well as people who supervise those people doing the research and development, their time can qualify too. And a lot of time that’s a higher salary that’s been paid. Sure. And then third, the last part is going to be support workers. So if you’ve got someone doing R&D and you’ve got some workers that are directly supporting that person, their time can count toward the credit as well. So you’ve got three layers there, supervision, R&D and the support people.

Kim Hartsock [00:04:21]    

So you really get triple benefit on the person that’s doing the actual research and development. Yeah, that’s great. Are there any other types of expenses?

Floyd Holliman [00:04:32]   

There are. So if you’re paying an outside contractor to do R&D, You can also capture that time as well. Um, so as long as it’s in the United States, so it has to be in the US um, and then the third type of, uh, the expanse you can capture are supplies that are used up in the R&D process. So let me give you an example. We see this mostly in manufacturers that are developing a new product. So they may develop a prototype to test that new product. So the supply cost that goes into building that prototype can also be included.

Paul Perry [00:05:05]

That’s where it stops. It doesn’t. Once it, once the prototype is done, I’ve created the new product. That’s where the supply costs stop.

Floyd Holliman [00:05:11]    

That’s where the supply cost stops unless that comes back. That product comes back through the R&D cycles. So if you gotta improvement on that product, then you can come back and you can capture it again for that improvement.

Kim Hartsock [00:05:25]    

So what about development that you’re doing under a current client contract? Does that get to qualify?

Floyd Holliman [00:05:32]

So it does, it does. So let me clarify that. Okay. So let’s say I’m a software company and I have a software that I sell to the market. It’s already been developed, it’s on the market. And I have a customer that comes to me and says, I like your software product, but I’d like it to do a different functionality. And they, and you enter into a contract with that customer to develop additional functionality. So yes, in that case that can qualify. Okay. But there are some additional, there are some additional hoops you have to jump through when you’re under a contract like that. And so one of the things you want to look for is what do, what did the terms of the contract look like? You want that typically a fixed fee contract is going to shift some of the risk to the developer and that’s what you want. That’s what the IRS wants to see. So a fixed fee contract is gonna have a better chance at qualifying for the credit than let’s say like a cost plus arrangement or even a time and material arrangement would definitely not qualify. Okay. Well that’s good to know. Yeah.

Paul Perry [00:06:38]  

So if a company that has been through an R&D tax credit in the past, the study, what are some of the pitfalls? What are some of the things you see where people are doing it? Mm, that’s probably not the right way. What are some of those, those bigger issues you’ve seen?

Floyd Holliman [00:06:53]    

Well, that’s and, you asked that just at the right time because one of the biggest issues that we run into as a, coming in and doing a study behind someone else and and seeing that they’ve been taking those contracts that they shouldn’t be taking. There were some court cases, a couple of over the last, I guess three to five years that dealt directly with this. So, uh, you really need to look at those contracts. If you’re doing, uh, R&D under contract with a customer, to make sure it qualifies.

Commentator [00:07:18]      

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Kim Hartsock [00:07:31]

So say someone looked into these R&D credits six years ago and they didn’t qualify. Has there been any new development that would give them a reason to take another look at this?

Floyd Holliman [00:07:41]

Absolutely. That there have been, uh, over the last few years. Um, one of those is that, um, now companies can use the credit, some companies that qualified that others that are smaller companies cannot use the credit against payroll taxes. That’s, that’s important to companies. A lot of times with the smaller startup technology companies, they’re not profitable, so they’re not paying income taxes. Sure. But usually they all are paying payroll taxes. So a lot of those companies can now use the credit against the payroll tax as opposed to it just being a carry forward. Sure. For future use. That’s one of the things. And, and another thing is, um, alternative minimum tax that credit can now be used to offset alternative minimum tax, which, uh, started in 2016. So, uh, that’s been a positive development for the R&D credit.

Paul Perry [00:08:32]  

Is there any statutory uh, limitations on how far back I can go and look at my expenses and try to gain that credit.

Floyd Holliman [00:08:41]     

So if you’re looking at, if you’re looking at past credit, your past qualifying researches, you can typically go back three years. The statute of limitations is typically opened three years. So you can go back and amend returns. Okay. And, and, and get a refund

Paul Perry [00:08:56]        

With the conversation of statutory limitations. How far can we carry this forward

Floyd Holliman [00:09:00]  

so you can take carry of the credit forward 20 years from the year it was generated. So if you went back, you know, and if you go forward another 17. Yes, correct. That makes sense. That make sense.

Kim Hartsock [00:09:14]  

What about any state savings? Are there any additional state cash savings, um, for states that would participate?

Floyd Holliman [00:09:22]     

So yes, so that’s been another development. It’s been more and more states over the past few years that have been, uh, that have a research credit in some form. Usually it’s based loosely off the federal credit, uh, but as long as you’re doing research and development in that state, there’s a lot of states now that offer the credit. Not all states, but the majority. Yeah. So, and one of the main places that we have locations are Florida, Georgia and Alabama. Well, Florida and Georgia do have the R&D credit to, they have a research credit. Uh, unfortunately, Alabama does not have a credit at this time, but, uh, it’s, it’s been talked about. It’s in the legislature.

Kim Hartsock [00:10:01]   

So what if I’m a company and I have software, but it’s for internal use. Would that qualify?

Floyd Holliman [00:10:08]     

Yes, it can qualify. It’s easier to qualify now than it has been in the past. Uh, so if you’ve got a company that’s developing software that does not sell software, right? They’re developing their software, uh, for some type of benefit to themselves, uh, that can, that’s easier to qualify now than it has been in the past. As long as that software’s being developed to facilitate interactions with a customer, then that software can also qualify it. And let me give an example. So sure. Financial Services Industry, uh, we do some banks where, um, the bank is, are developing software, but obviously that’s not their product that they sell, but they’re developing that software to enhance the customer experience with their website, which is facilitating interaction with the client. So that’s internal use software that you could capture. Um, so yes, so the answer is yes.

Paul Perry [00:11:02]       

And then over the last year we’ve had a lot of conversations about, uh, tax reform. I’m sure tax reform is added into, has taken on R&D credits at some point,

Floyd Holliman [00:11:13]    

actually. Yes. Um, it, it, uh, under the tax reform that came out in 2018, um, now the credit is more valuable. So for every qualifying dollar spent of research and development, that credits a little over 20% more valuable per dollar. So yes.

Paul Perry [00:11:29]      

So it sounds like, it sounds like we’re trying to make companies be more innovative, trying to push them in that direction, incentivizing them, which is going to grow the industry, which is going to grow business. And so innovation seems like it should be at the forefront of all organizations, even if not nothing else from an R&D tax credit perspective.

Kim Hartsock [00:11:48]       

Absolutely. So here at The Wrap, we always like to close with how would you wrap this up in 60 seconds or less for the listener?

Floyd Holliman [00:11:57]     

So I would, I would say to take a look at your company, if you, if you’re paying a employee to do research and development or perhaps if you’re paying an outside contractor to do R&D and you’re at risk for that research and development. In other words, if that goes south, no one is giving you money for it. It’s your money that you’re out of. So, uh, and then lastly, I would say if you’re developing a product or process or improving a product or process, uh, these are questions you need to be asking yourself. And if the answer is yes to these, then I would encourage you to take a deeper look at the R&D credit.

ALL [00:12:36]    

Thank you so much, Floyd for joining us. We appreciate it. Thank you. Thank you very much, Kim and Paul,

Commentator [00:12:42]        

And that’s a wrap. If you’re enjoying the podcast, please leave a review on your streaming platform to check out more episodes, subscribe to our podcast series, or make a suggestion for other topics to cover. Visit us at warrenaverett.com/thewrap


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