Though the Research & Experimentation Tax Credit (or the R&D Tax Credit, IRC Section 41) expired on December 31, 2011, it is expected that it will be extended for 2012 (or beyond) as it has been the last sixteen times. In anticipation of the extension, BridgehouseLaw is working with highly experienced tax accountants Habif, Arogeti, & Wynne, LLP to bring you this brief summary.
The R&D Tax Credit, available to a variety of industries including engineering, software, pharmaceuticals, and automotive, is a federal tax program originally established in 1981 to encourage American investment in innovation by alleviating certain expenses. Among its benefits, a business can amend its prior 3 years of tax returns as well as reduce past, current, and future annual federal tax liabilities, creating an immediate source of cash. Furthermore, taxable income is not necessary to benefit from the credit nor does the credit depend on company size or the success of such research.
To qualify, the company seeking the benefit (1) must assume the financial burden of R&D expenditures (2) which must be conducted in the United States and (3) entitle the company to substantial rights in the results of such activities.
Expenditures of R&D activities are considered the reasonable costs a company incurs for activities intended to provide information to help eliminate uncertainty about the development or improvement of a product. Uncertainty exists if the information available to the company does not establish how to develop or improve a product or the appropriate design of a product. R&D expenditures are dependent on the nature of the activity to which the expenditures relate, but not the nature of the product (or improvement) being developed, nor the level of technological advancement matters when making this determination.
R&D expenditures generally include all expenditures incident to the development or improvement of a product including expenditures in obtaining a patent, such as attorney’s fees expended in making and perfecting a patent application. R&D expenditures do not include expenditures for quality control testing, advertising or promotions, consumer surveys, efficiency surveys, management studies, research in connection with literary, historical, or similar projects, or the acquisition of another’s patent, model, production, or process, for example.
Typically, a company must choose to deduct or capitalize R&D expenditures in the first year it incurs such expenditures. If a company fails to choose the method for the first taxable year in which it incurs such expenditures, a company cannot choose the method by which it will treat R&D expenditures for subsequent taxable years if it fails to elect a method for the first taxable year unless the company obtains the consent of the Commissioner.
Claiming R&D tax credits does not automatically lead to an audit as tax returns are randomly selected, however, a company should nevertheless implement expenditure methodology with specific documentation guidelines for R&D activities, for projects at the business component level, qualified wage expenditures by business component as well as creating centralized document storage and management. Finally, key personnel or a single manager should be appointed to oversee the compliance requirements.
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Reinhard von Hennigs