R&D Tax Credits Face Higher Scrutiny

For corporate taxpayers, claims for Research and Development (R&D) tax credits are being regarded by the Internal Revenue Service (IRS) as a “Tier One” priority under its new Strategic Initiative, meaning those claims will be carefully examined to determine their validity.

That stance reflects the latest shift in treatment of R&D credits this decade. Although the R&D credit was introduced in 1981 to promote greater investment in research and experimental activities, it did not gain broader appeal until December 2001, when the Bush administration proposed regulations making it easier for companies to qualify for the credit. These proposed regulations, which included relaxed documentation requirements, were ratified by the IRS in January 2004.

More than $5 billion in federal R&D credits are granted annually. That volume has prompted the IRS to question whether abusive accounting tactics might be contributing significantly to that growth in R&D tax credits. Whether those concerns or the IRS’ requests for detailed supporting documentation are justified or not, manufacturers filing for R&D tax credits face scrutiny. Withstanding that scrutiny requires being aware of R&D tax credit eligibility requirements and maintaining necessary documentation.

Eligibility and Criteria

R&D credits are often associated with the development of microchips, pharmaceuticals or other products requiring immense engineering or scientific resources, but they also aid manufacturers of all sizes in improving efficiency, productivity and quality.

A gear manufacturer, for example, may contract an engineering firm to evaluate whether automated material handling equipment can be designed, built and retrofitted on decades-old machinery. Such retrofitting then enables the manufacturer to realize substantial productivity gains without having to purchase much-newer machinery.

R&D tax credits can also be applied toward developing prototypes or models, reliability testing, feasibility analyses, environmental testing and other manufacturing concerns. Manufacturers must be able to prove, however, that the claimed expenses directly relate to the R&D activity.

Large manufacturers involved in government contract work already routinely document such expenses. A company designing and building mobile artillery weapons for the U.S. Army, for example, uses a project-based accounting approach that captures and defines each R&D cost incurred in developing and producing those guns.

The R&D tax credit is generally equal to a qualified expense that is 20 percent higher than a “base period amount” that would be considered normal annual R&D spending. Qualified expenses may include wages paid to an employee or supervisor, purchases of necessary supplies, necessary hardware and software support, and 65 percent of needed contract labor. A manufacturer may also claim 75 percent of the costs paid to a qualified scientific consortium.

The IRS then allows taxpayers to use one of several formulas based on gross receipts and previous tax years to determine the precise R&D tax credit amount. Taxpayers may also use the recently introduced Alternative Simplified Tax Credit when filing for an R&D tax credit.

Whether R&D tax credit claims will continue to face elevated attention levels remains to be seen. For now, companies seeking R&D tax credits should expect increased IRS scrutiny, including requests for accurate, relevant documentation that supports those claims.

Mark Walker, CPA, is a Tax Partner for Weaver and Tidwell, L.L.P. He can be reached at mdwalker@weaverandtidwell.com.

Sidebar - R&D Tax Credit - Internal Revenue Code
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