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The R&D Tax Credit - A Strategic Tax Advantage


Welcome and thank you all for joining us today for this executive webinar, sponsored by navigator business solutions. Today, we'll be discussing the R and D tax credit. And what types of business activities may qualify leading today's discussion is Al Lenac. Founder of Manufacture Results. Al is a self-proclaimed "nerdy-engineer" whose focus is to work with clients on uncovering the activities that qualify as well as the expenses associated with them while not being disruptive to daily operations of the business, his industry experience and knowledge of a variety of products and processes allows him to be a good translator for clients and their CPAs while being fully aware of IRS oversight and guidance related to credit. Finally, your tax professional or CPA is a critical component in putting your strategy together and seeing if or when the R and D tax credit can be a value to you. If you have any questions along the way, please type them into the GoToWebinar control panel. So we can address them at the end of the presentation and discussion with that, Let me turn it over to you Al.

Sean. I want to thank you very much for this opportunity to you as well as Ralph Hasson and the folks at navigator overall for this opportunity. And so it's always some thankful for this because it, it just shows that you're, you're not just doing you know, you're selling their systems or anything. You're really truly looking at a way of training or sending the good word out to your client base. So quick agenda here, and we've set aside about 20 minutes or so to just give you a quick review of what the R and D tax credit is all about. We're going to talk about qualified activities and the expenses that are associated with them as well as things to consider. As, Sean had originally mentioned, the CPA is a critical component of the year, so I'm not a financial person.

I am a nerdy engineer and that's where my background is. So I'm focused again on those activities and expenses. And then we're going to go over a little bit on the examples or give some examples of things that might like sort of jog your memories or your thoughts on what might be qualified activities and areas to pursue regarding the R and D tax credit. So quick history now, I'm not gonna read all these bullets. Don't worry about that. But the key takeaways are just a little understanding about this R and D tax credit is that it's been around since 1981. It was actually the Reagan administration that started it, and it was meant for fostering growth, innovation and innovation throughout the United States. And the manufacturing sector specifically. Now, there has been a few things keep in mind, it's never been lapsed.

And there have been a few more recent things that have occurred for in both 2015 and 2017. And for tax year 2022, there'll be some changes that are potentially going to happen as well. So I'll dig into that a little bit further. So what is the credit keep in mind, this is a credit it's much more powerful than a deduction. Most of my CPA friends out there will explain that much better than I would, but it is powerful as being credit. Again, it is a credit based on your expenses and expenditures it's available for all types of corporations, C-Corps S-Corps, LLCs Partnerships also keep in mind, that's not for non-for-profits, wouldn't be able to take advantage of this because they're not paying taxes. The credit is basically going to come out of this IRS form 6765 that's where your, you would file for that, or that's the form that you would use.

And you can, if you've never taken, you can take the credit every year. If you've never taken the credit, you can certainly go back three years and amend three years from your filing date. If you had used all the credit, so let's say you had a hundred thousand dollars in credit, you only had $50,000 in taxable expenses or your taxes. And in essence, that additional 50,000 would then be carried forward and you can carry that forward for 20 years. And so that's why this is part of an overall strategy within your tax parameters. It's not, it's not necessarily a silver bullet, it's, it's more or less an ointment to the sting of paying taxes in many cases. So a few things that occurred in, in more recent history is that it's now permanent. So before it used to be extended and it never was removed from the tax code or from tax law, but now it's actually written in the tax code.

So law, and so it would take an act of Congress to get rid of this. Also this term alternative minimum tax or AMT has come up quite often. Now, now it's no longer a concern. So whether you're in AMT or not an AMT, you'll still be able to use the credit. Also in 2015 start-ups. So this in by definition is those that are less than five years old and have less than 5 million in revenue can take the credit to offset the FICA portion of their payroll taxes up to $250,000. So what that really means, though, you can take the credit normally to offset any tax liabilities, but most startups don't have tax liabilities, and they are, usually running without a profit scenario. And so the government looked at this and said, why don't we allow them to at least offset the FICA portion of their payroll taxes?

And then finally in 2022, there is a five-year amortization of research expenditure. So what that means in 2022, if this holds up what'll happen is instead of taking the credit in full each year, you'll have to divide it out by five years. That's, that's yet to be seen if this is going to hold through or it's going to actually come through, but keeping in mind, because it is going to be pressure-filled for the CPAs to figure out how to do this, and we're along the way to help them out through that process. So the focus is on the federal credit. I mean, that's really where I come to, or that's really where we really focus in with our clients is you want to take it for the federal credit, those rules, and those regulations are, are, are meaningful. They've been there for year in and year out. But there was also 35 states out there where I've researched credit incentives. So that's a long for the ride as well. It's icing on the cake. And, that certainly is something that if you're doing the credit from the federal side, pay attention to whether you can take advantage of it from the state side as well.

Quick question on how you've heard of it, Sean, I think you said you're going to throw a quick Poll out there, or there we go. So one quick question, we want to know if you've ever heard of the credit, the folks out there. And so what we typically have seen and I'll keep in mind I'm typically going to be working with those clients in, let's say that a hundred million and below space and really more in the 50 million and below space. So we've, we've got about 20% from, my anecdotal information, about 20% of the folks out there have heard about the credit and roughly about half of them take the credit. And so I often think about why is that so few of them that are taking the credit and it's often that it's confusing and it's, it's complicated to them. And many CPAs also, when you think about your tax professionals for them, this is not a standard item that most of their clients would be taking advantage of.

So it's off the beaten path. And honestly, that's where folks like me have, that's why we have jobs. There's also this feeling out there that it's a very time-consuming process. So part of listening to this process or listening to this webinar, I hope for you to feel a little bit more comfortable and removing some of the confusion, getting a little bit more of a comfort level of how much time it should take. And, and the fact that some folks feel like maybe it just doesn't feel right, like this is a loophole I'm going to get audited. And, those types of issues come up. So certainly there's always a chance of an audit, but we like to kind of review that with your, with the clients and get an understanding of, of where we're coming from on this and how we're really minimizing the risk. We want to take a very realistic approach.

So Al on that poll, everybody has actually heard of the credit.

That's, so I'm going to have to change that slide. So telling me that, and, you know, so I'll go real quick back on that, actually. So that's great. I'm glad we got that feedback. So it's funny I've been doing this for just under 10 years at this point and in the early stages I used to just ask people, oh, so you've never heard of the credit. Let me explain what it's about and now I'm more or less asking people. So what have you heard about the tax credit? So I'm going to change this slide moving forward, and I appreciate that feedback. And everybody who's out there who, who mentioned put a thing out on the poll for me, you get a gold star for the day. So I thank you for that. So let me simplify. So now that in fact, I know that you've heard about, at least this let's simplify it a little bit.

So typically when, when we're working with a client, I like to get a sense of what the internal definition is of research and development to you. And from that we like to get then where the definition internally is for you and how the IRS defines research and development. There's four tests for an activity to qualify as research and development. And then from those qualified activities, we peel off the qualified expenses keeping in mind that we need the support from the CPA, and you want an overall picture. And I keep saying this over and over again, but really you want an overall picture of how this affects your total tax picture or your overall tax strategy. So many times this definition of research and development, it's a poor use of terminology. And I often will tell people, yes, it's called the research and development credit, but perhaps it should be called the innovation credit.

That's really, if I was king for a day that would be one of the thoughts for me would be to say research, you know, let's call it the innovation credit. And I'm sure a lot of folks would say, why are you focusing on the research and development credit? If you're king for a day, isn't there anything better for you to do, but let's just go with this. So forecast qualified activity. This is where you start, you start off to see whether something's a qualified activity. That's number one. What are you doing? What's the business component. Are you trying to do something new? Is it going to be improved? Is there a functionality here? Is it a cost savings? Is there a quality improvement, automation? These are all business components. Also keep in mind, it doesn't need to be new to the world.

It just needs to be new to you. So test one. And by the way, three out of four, isn't good enough. You have to pass all four tests. So test one business component. What are we doing? Test two is the technological uncertainty. In other words, how are we going about of this? So is there more than one solution that we see ahead of time? We're not sure of what the outcome's going to look like. So it's sort of like you're jumping into the pool without really knowing the temperature. So that's the technological uncertainty test. And we also want to make sure is there financial risk associated with it? In other words, you're not being funded or paid. It used to be called government work. Many times if you're being paid regardless of the outcome, or if you're being funded on a grant, regardless of the outcome, that's called funded research and it won't pass the four tests that actually test number two gets disallowed.

So you wouldn't be able to take the credit in that instance. So what are we doing? Test one, what are we doing? How are we going about it? And then the, the extra area that they want to now take a look at a little bit further is to say, was there a process of experimentation or was there an iterative approach to solving the business component? And that in the real world means things like revision levels on drawings, change orders and the like of changes that occur along the way. And then the final test is basically the technological uncertainty, or I'm sorry, is it technological in nature? And so that fourth test basically means, and this is kind of the glue. Are you using the engineering sciences, whether that's the physical sciences, engineering, computer sciences to solve the problem.

So it's, four tests. I sometimes equate it to it's a marathon and you have four hurdles to jump depending on what type of business you are. Some of those hurdles are a little bit higher than others. Some of them are very low and might be even considered speed bumps, but four out of four, you got to pass. And that's how you start off with a qualified activity. I'm a kind of qualified activity. Think about that. Here's just a few examples of things that don't qualify. So I've highlighted the words, research and development in these examples, because again, that's where some of the confusion comes in. So market and consumer research is not R and D research and development credit worthy tax credit worthy it's research, but it's not worthy of the tax credit by the IRS rules. And it has more to do with the fact that in that case, generally speaking, the engineering sciences aren't being used when it has to deal with things with seasonal design or taste or statics and things of that nature.

One of the other ones that I get a lot is on recruitment of employees. Well, we had to do a lot of research and the type of employee we want that unfortunately also typically does not qualify I've yet to seen any examples of that truly clap qualifying. So then when you're thinking about these qualified activities, I like to sort of just give you a few buckets. This is some of the IRS's terminology regarding this. So you've got an essence classic research and development. This is products that no one's ever tried before. We, haven't attempted this before. We're going to try it's new to the world. Sometimes you have contingent research and development that often happens like with a machine builder where they they've made certain machinery in the past, but now there's a certain component. Maybe there's a new material that we're trying.

Maybe there's something that we're now loading robotics into it. We're using machine electronic machine controls or certain computer language that we haven't tried in the past. So there's the contingent R and D unplanned research and development would be, I think, many, actually many of the clients right now that I'm dealing with, they have material shortages. So there's unplanned research and development. And the fact that now they're trying to substitute materials, they've got to retest requalify and redesign. And so that would fall into the category of unplanned research and development. And then finally many times the unsuccessful and abandoned projects along the way, the expenses associated them can also apply for the research and development tax credit. They don't all have to be losers. There's an expectation that you have winners along the way, because in the essence, you're, this credit goes off of your taxes.

So it's assumed that you're going to be profitable. So the losers are sometimes very good highlights because everything that could've gone wrong did go wrong on those examples, but it doesn't have to be. So just I'm going to hit through just real briefly. When we're talking about companies too, it's usually products, we consider products, processes, and software. So I'm just going to hit real briefly on some of the examples of that. So product development, this is just a, you know, this is the classic and most clients who take advantage of the R and D tax credit fall into this category. So if you're the type of business that is doing a lot of product design engineering, you have to do a lot of sampling or prototypes, a lot of refinements along the way. It's very likely that you would fall into that product development category and, a high, high likelihood of being able to take the tax credit.

Then you fall into the process. There's others who fall into this process development area. And again, if you're a product company, you might have process development as well. So these might be machine improvements where you're looking to reduce waste, decrease costs. Automation again is a big one in this area. And it changes to existing processes, might count. Contract manufacturers typically fall into this category as well where they're not making, they're actually not designing the product, but they have to design and develop the process. So there is research and development along the way. So we've talked about product, we talked about process, and then you have software. So when we're talking about software, there's two steps to software. You have what they call the IRS calls. This non-internal use software. So non-internal use software are the folks that are selling the software itself.

So these are software developers, or it's maybe part of a system, a system, a product, the machine function, something of that nature. So the idea there is there you pass, you have to go through all four tests, just like you would with anything else when you're selling it. And the software is customer facing, or it's interactive with the customer. There's a another section. And this is one I don't talk about as much, but I like to bring this up from, because we are with an ERP company as we're presenting this. So there's also internal-use software. And in this case, internal use software has a higher threshold. So there's three additional tests that need to be required and they're foggy. So, you know, what is the definition of high threshold of innovation? What is a significant economic risk? How did we look at commercial availability?

These are things that you want to lean upon your R and D tax credit practitioner to see if you pass those tests or how that would be reviewed by the IRS. And how does the CPA accept that as well? So typically out of the box software, doesn't count the takeaway here is out of the box software. Isn't typically going to count, but sometimes the special coding. So think about going into the code of the software and redesigning it or rewriting it. Those are the areas that are going to count. So now we've qualified for these activities and expenses. Once we have this qualified activity, then we can peel the expenses off. Note, the expenses don't need the pass, the four tests. It's the activities that need the pass, the four tests from the activities. We pull the expenses for categories of expenses, totally coincidental four categories four tests and four expenses.

But if that helps folks remember, that's fine major majorly, or mainly we talked about, or we look at the W2 box one or the taxable wages, that's the bulk of most expenses that we run into that qualify. Then you're also going to have some of the consumed supply expenses outside contract and expenses count as well. So those need to be folks that are based in the USA. And then there's a fourth that's called leased computers or your cloud develop environment. That's really based more for the software development folks out there. So when we talk about wages, this would be an example of what you would look at. The IRS wants to get a sense of our clients conducting research and development. Are they supervising it or are they supporting it all three of those categories count, but we talk about the activity and then those who count for it, you'll have some folks that'll be 0% like an administrative assistant.

And then you might have some folks that are higher. So by rule, if anybody's quoted at 80%, they're a hundred percent of their salaries would then go towards the credit. They call that the substantially all rule be in mind, we want to be cognizant and we don't want to suddenly I call it. Sometimes people get what I call R and D tax credit fever. We're starting to go through the allocations and suddenly they want everybody to be at 80%. And because the credit is going to be higher while we have to be, you have to be very careful and aware of that. And there's tools that we use to, to give a real realistic review. So passes muster with the IRS and that your CPA would feel comfortable with, the allocations as we come up upon it with the clients. So those are wages predominantly.

I spend most of the time on that conversation on that area, because that's really where most of the heavy expenses come, especially out of north America here in the U.S. so then you also have consumed material expenses. So think about if you have prototypes, you got scrap materials, lab supplies, soft tooling assets that are depreciable or not eligible, but we do like to talk about soft tooling and those types of expenses. Cause sometimes the expenses of the materials isn't that what's so expensive or isn't where the major expenses are, but consider the employees involved that have to do that work were involved there. And so that's where folks like maybe maintenance people that wouldn't be thought of as R and D tax credit folks or allocated to the R and D tax credit. That's where those types of folks might need to obtain a little bit of a higher allocation.

So quick hit that was the consumer material or consumed material expenses. Then you have contract expenses. So if you're hiring out third-party testing services outside processors these do need to be based in the United States and roughly speaking. So if you had a hundred thousand dollars in expenses in this case about $65,000, or I shouldn't say about a hundred thousand dollars expenses, $65,000 of expenses goes towards the credit you get minimized on, on the credit is reduced for outside contractors. This is sort of the government's way or reduce the double dipping that occurs. And also just keep in mind. So a hundred thousand dollars in expense, generally speaking is about a $10,000 credit. That's not a bad rule of thumb number to go by as a quick go-round from, what what's the bang that you'll get for your buck,

so to speak. So Contract expenses is the third category. Fourth is lease computer expenses. This is a throwback from 1981 where folks would lease out lab time on the IBM mainframe. But ultimately nowadays people might be using AWS or Amazon web services to lease the time on the development site. This isn't hosting expenses, this is development site expenses. And again, we, we worked through that with our clients to get an understanding, if it makes sense for them to to take advantage of this, some expenses that don't qualify off the shelf software materials and final construction. I like to also mention overhead expenses that often gets asked. I get asked about that one employee benefits, rent, those things don't count. And then also patent lawyer fees and actual cost of ISO certification or certifications in general. They typically don't count, but there might be projects within getting the patent or projects, there is certainly work that gets before you file for the patent. That's going to count. So it's not the patent lawyer fees themselves or the ISO certification itself, but some of the work to get there

will count. You want to make sure you have supporting documentation along the way for this? As I said earlier, it's form 6765. That's where the financials come from. You do want to have some backup as the, how the heck did we come up with that documentation or how heck did that calculation how was it created and also some written technical documentation, as far as the qualified activities go. So you can have project reports and all, but ultimately the IRS is going to want to see, how did I do these project reports and how do they relate to the forecasts? So IRS is going to ask questions. Should there be an audit. And as, I understand it, or as, or as our history shows, you got about a 1% chance of, of an audit. And, but nonetheless, we do want to make sure that we're covered.

So you want to make sure that there is a nexus between qualified research expenses, that that's like a buzz word. We really want to know the nexus between the expenses and the activities. We want to make sure there is documentation, the aware about bias, judgment samples. That's the concern from them. And that has a lot to do with the contingency agreements that might occur if you're working with a tax practitioner like myself. So we work for, I work strictly on a fixed fee basis. You, want to be careful about folks that might be working on a contingency or a not to exceed contract from the IRS's perspective, they feel like that,, that can be a concern. So this is where I, I'm going to go over a few examples showing I'm not sure how close good I am on time. So I don't know if you want me to run through examples really quickly on this thing or whether I should be answering some questions at this point. Well, let's

We're, we're only about we started a minute or two past the hour. We're at about 23 minutes. So if we take two minutes to pop through a couple of examples and then address a couple of questions.

Perfect. All right. So literally, just about, if you noticed just about everything I've talked about, it's very broad and really, if you get anything from this presentation, I would prefer that you just think about what is a qualified activity. If you can get to a qualified activity and those four tests I've done my job here. So just about every industry that that's imaginable can, can take advantage of the credit when we're talking about biomedical devices think about trials, pilot runs, considered development that isn't funded via grants and, and also like methods, you know, method changes of delivery method changes of drugs they often apply to because the chemistry has to be changed in those cases and the chemical industry overall. I know many, many materials right now are on allocation. So I'm considering material substitutions that need to be tested and reviewed.

When we're talking about distribution and logistics. This was, this is not as common as it once was because now the out of the box software is, is very powerful, but consider when if you have some required software where you have multiple softwares that need to speak to one another and some extra code needs to be written in order for that to happen, or if there's some kind of software changes that are required to prevent cyber issues or to increase in the processing speed. So I often see language being rerun or something being rewritten and some testing that needs to occur just for the fact of processing speeds, want to be done more faster, just faster. Let's say that within the electronics industry here, we'll see both, we'll see projects, both on the product process and software side.

You'll see that throughout, when we talk about food. That's a good one, just to kind of mention, because in many cases, people don't think about food as research and development, but in many cases there's needs to change out ingredients. So maybe you're removing ingredients to remove allergens. Gluten-Free, and sugar-free are big pushes nowadays as well as increasing of shelf life. So when you need to improve shelf life and change the chemistry of a product that can count my, my microbrews out there too, there's certain things that occur where they have to change things if they're going to go to canning instead of bottling. So those are also potential R and D areas that people don't think of as research and development in the classic internal stated method, machinery will count. So machine builders are often overlooked because they build the machine and then they don't realize that maybe there's a robotic material handling process at the end of the line or the beginning of the line.

Maybe they're adding a vision system along the way. Maybe the controls are changed from air logic to electronics. When we're talking about the medical device industry consider again, prototypes and material changes that are associated to gain improvements. So those are just broad kind of things. But one think about if you're a business that's doing a lot in prototypes, you're testing a lot of materials and you're doing a lot of trials that way. It's very likely that you've got research and development tax credit, viable expenses the plastics in the rubber industry. Again, keep that in mind, material changes often affect processing times and the general chemistry of the compounds involved, and then also packaging. So I like to bring up packaging last because this is often overlooked. And something as simple as just changing over changing a box is not necessarily simple for many industries.

So there might be additional testing that needs to occur for that reason. Sometimes printing on a matte paper versus a glossy paper is very challenging for some of my clients out there. And so there's research and development that's available for them to take advantage for on the expenses that they take, both in the raw materials that might be consumed along the way, and the people that are involved in the processes. So that being all said I want to thank everybody for the attention and I'm open to any questions that might be coming along.

Okay. Al, we have a couple of questions. So if there, if there are people in the audience that have additional questions, please just type them in and we'll add them to the list. I've got a couple already queued up here. Let's see. One is are contract manufacturing activities eligible for the tax credit.

Yeah. So that, that's a great one. And so the quick question to that is yes, they're eligible. Then the next question is, but we have to make sure that the activities pass those four tests, as I said. And so what happens with contract manufacturers? They don't often control the product design, but they typically do have to control the way it's made or they have to develop some kind of a process. We would ask a couple of questions just on who controls the intellectual property or IP, but typically speaking contract manufacturers and the way they manufacture a product or the way the process goes about, they are going to be able to take advantage of the R and D tax credit.

Okay. And then let's see, oh, here's an interesting one. My CPA didn't want to take the tax credit. What should I know?

Oh yeah, that's a good one. So listen it's actually often a good sign if your CPA doesn't want to do it. Cause that, that typically means that that CPA isn't doing the credit often there may be uncomfortable about it. So I always see that as a good sign if the CPA's not taking the credit. But we do want to make sure that, so first of all, that's where, you know, have a call with me. It takes about an hour for a quick short assessment to get a sense of, do you have qualified activities? Let's get a quick sense of what those expenses are from that. You get some numbers, then you review that with your CPA. And in essence, you say, okay, I've got a $10,000 credit. I seem to be eligible for a hundred thousand dollars credit. Then review that with Mr. or Mrs. CPA and saying, listen I've got this credit. Can I use this? Would it make sense? Because in some cases your tax, your tax situation might not warrant taking the credit. And that that happens. It's not a problem.

I it's, it's getting the conversation started to dig deeper. So

It's again. Yeah, exactly. And really it's meant to, you just want to have that it's another arrow in your quiver. So it's just full of how does this fit or does it fit within your overall tax strategy that that's all it is. It's a tax planning tool.

And then I don't see any new ones. I've got one last one that is very relevant to what navigator actually does. What ERP implementation or integration type activities are eligible for this? You mentioned the software development.

Yeah. Yeah. So that's perfect. Yeah. And that's, that's, that's very it fits in with what we're talking about here. So when it comes to the ERP the, off the shelf buy doesn't count that that's where that that's not going to count that's off the shelf. But there might be some customization work and some coding that needs to be done that if it's based out of the USA would typically count we would want to review if it's called. So if you recall earlier, I mentioned you have, non-internal use software and you have internal use software. So ERP is in many cases are considered internal use software. So we would just do a quick review on that to see, you know, the, the pass, those additional threshold tests of innovation, economic risk and the availability of other commercial, you know, the commercial availability out there.

But certainly, it's something to take a look at behind the scenes on all of this. You're getting back about 10 cents on the dollar. So you also want to be reasonable about as far as, are you going to get enough bang for your buck or a, is the, is the juice worth the squeeze? I think someone called me once. I kind of stuck with me on that one. So we want to take a realistic approach again, R and D tax credit. That's all I do all day long. We know that the clients or prospects and the folks out there, it's not, you know, it's so low on their priority list. So my job is let's give you a realistic picture. Let's see if it makes sense for you. Navigator also wants to work with their clients and make sure that it makes sense for them. And in the meantime, not to be disruptive of the overall business and if it makes sense, great, let's see when and how it works. If it doesn't, you've done your due diligence, you put it in the file. And next year, when you review tax planning, or whenever you do your standard tax planning sessions, it becomes one more item to check off on the box.

Al Lenac, Founding Member
Manufacture Results LLC

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