Looking for write-offs in all the right places.
By Mark E. Battersby
Few specialty fabric professionals seem to be aware that many of their business activities constitute “research” under current tax rules. Your business could be sitting on a lot of ignored or overlooked research and development (R & D) tax credits and deductions.
Research and experimentation expenditures have long enjoyed a unique status in our tax laws, but it took the American Taxpayer Relief Act of 2012, the so-called “Fiscal Cliff” tax law, to resurrect the unique tax credit, a direct reduction of a business’s tax bill equal to a percentage of the money spent on research. Although the tax credit had expired at the end of 2011, the new law extended the often difficult-to-understand research credit through December 31, 2013.
R & D costs are usually expensed and written off as incurred, except for material and equipment costs and intangibles purchased from others, which are capitalized. As an expense deduction, however, R & D expenditures only reduce the income on which the operation’s tax bill is based. Today, a unique R & D tax credit is available that can reduce a business’s tax bill with a credit equal to the amount of any increase in qualified R & D expenditures.
To be included as qualified R & D costs, the operation’s expenditures must be of a technological nature, involve experimentation, and aid in a new or improved product or process. (Market research and normal product testing costs are not considered research expenditures.) Also excluded for R & D purposes are efficiency studies, trial production runs, market tests and management studies.
The cost of obtaining a patent, including attorneys’ fees paid or incurred in making and perfecting a patent application, do qualify as research or experimental expenditures. Unfortunately, the costs of acquiring another’s patent, model, production or process do not qualify for either the tax credit or as a routine, deductible business expense. A purchased patent may, however, qualify as a Section 197 intangible asset, and can be amortized with the cost written off over 15 years.
One of the options available to specialty fabric businesses involves treating R & D costs as a current business expense and deducting them on the annual tax return. Tax deductions lower the amount of taxable income, which in turn lowers the amount of taxes paid by that business.
Failure to claim a tax deduction for R & D costs in the first year when paid or incurred means that permission from the Internal Revenue Service (IRS) is necessary in order to deduct them in later years. Also, once the choice or election is made to deduct these costs, that can’t be changed without the permission of the IRS.
“Amortization” allows a business to deduct a portion of the cost every year over a period of years. When it comes to R & D expenses the cost is deducted in equal amounts over 60 months or more. Amortization applies only to capitalized amounts, must be paid or incurred by a trade or business, and cannot be simultaneously claimed as a current business expense.
The research tax credit
The research credit, or research and development credit as it is often labeled, may be claimed for increases in business-related research expenditures. While it applies only for research in the clinical sense, many of the small businesses it was designed to help have shied away from the complex rules. But the potential of reaping a share of the $14.3 billion in tax savings may entice more companies to investigate this credit.
In general, the R & D tax credit consists of the sum of three separately calculated components:
- 20 percent of the excess of qualified research expenses for the current tax year over a base period amount;
- 20 percent of the basic research payments made to universities and other qualified organizations (available only to regular “C” corporations);
- 20 percent of the amounts paid or incurred by a business in carrying on any trade or business to an energy research consortium for qualifying energy research.
Qualifying for the credit
Anyone who has spent time and energy to improve a product and make it better, faster and more cost-efficient has probably incurred research costs that qualify for the R & D tax credit. In order for any activity to qualify, a business must be able to show that it is qualified research.
This usually means that: the research must have been undertaken to eliminate uncertainty concerning the development or improvement of a business component; the reseach must have been undertaken for the purpose of discovering information that is technological in nature; or the research is intended to be useful in the development of a new or improved component of the specialty fabric products business (also known as the business component test).
A “business component” is defined in the tax regulations as any product, process, computer software, technique, formula or invention that is to be held for sale, lease, license, or used in a trade or business of the taxpayer. The regulations also state: “Substantially all of the research activities must constitute elements of a process designed to evaluate one or more alternatives to achieve a result where the capability or the method of achieving that result, or the appropriate design of that result, is uncertain as of the beginning of the taxpayer’s research activities.”
Regardless of the label placed on the expenditure by the business, the IRS can challenge it—despite the fact that neither lawmakers nor the IRS have spelled out exactly what constitutes research. They do know, however, what should be specifically excluded as qualified research:
- The ordinary testing or inspection of materials or products for quality control
- Efficiency surveys
- Management studies
- Consumer surveys
- Advertising or promotions
- The acquisition of another’s patent, model, production or process
- Research in connection with literary, historical or similar projects
In the case of certain software developed for internal use, taxpayers must meet the requirements of an additional three-part “high threshold of innovation” test.
Records and documentation
Under the tax laws, a business must retain records “in sufficiently usable form and detail” to substantiate that the expenditures claimed are eligible for the R & D credit. The business must also clearly establish full compliance with all of the relevant statutory and regulatory requirements. Failure to maintain records in accordance with these rules is a basis for disallowing the credit.
Nowhere in the tax rules does it stipulate that the involvement of a degreed engineer, chemist or physicist is necessary to qualify for an R & D write-off or tax credit. It may take some engineering expertise to prepare documentation that can stand up to the IRS’s rigorous methodology, but an accountant can usually help define the activities that constitute research.
The complexity of the law may require professional help for those pursuing R & D write-offs or tax credits. Rather than being deterred by this, specialty fabrics professionals should keep in mind that once they determine the extent of their qualified R & D activities, they can reap the financial rewards and tax savings both in the current tax year and for many years to come—or at least until the tax rules expire or are changed.