What the R&D Four-Part Test Means to Manufacturers

Jun 5, 2018 3:58:14 PM

manufacturersBillions of dollars of Research and Development (R&D) Tax Credits are claimed by small and mid-sized businesses every year. However, despite increasing government incentives to encourage manufacturers to claim the credit, many don’t. As a result, they are paying more than their fair share of taxes — leaving money on the table that could be reinvested back into the business to be more competitive, grow faster, and be more profitable.

“I am amazed how many manufacturers do not realize or understand the IRS’s definition of R&D tax credits,” says Benjamin Rashlager, former president of WSI Industries. “If you make or improve a product or process, either for yourself or your customer, you have activities that qualify for the R&D Tax Credit.”

Qualifying Activities

Qualifying activities often begin early in the manufacturing process when sales personnel collaborate with customers and prospects to understand their specific needs and requirements. It continues until the product or process is ready for production.

Regardless of what you make or improve from a product or process perspective, activities you perform must pass each of the elements of the Four-Part Test. Bear in mind, the results of your efforts do not have to be successful to qualify.

The Four-Part Test

Once you’ve identified potential qualifying activities, run it through the four-part test to verify. The four parts of the test are:

  • Permitted Purpose. This is the activity intended to make or improve either a product or process that results in improved function, performance, reliability, quality or cost efficiency.
  • Technical Uncertainty. This is the activity intended to eliminate technical uncertainty when developing or improving a product or process related to methodology, design, techniques, formulas or inventions.
  • Process of Experimentation. This is the activity that includes a process of experimentation to eliminate or resolve technical uncertainty. During the process, various alternatives and approaches are evaluated by modeling, simulation, trial and error, prototyping and other methods.
  • Technological in Nature. The process of experimentation must rely on the hard sciences (engineering, physics, biology, chemistry, computer science).

Qualifying Expenses

Activities aren’t the only thing that qualifies for R&D tax credits. The expenses you incur performing these activities also qualifies toward your credit. Amounts paid for employee salaries, supplies, contractor research and computer leasing are all potential qualifying R&D expenses.

In addition to employees directly performing qualified activities, time spent by their first-line managers and supervisors directly supporting them in those activities qualifies as well. Employee expense is typically 85% or more of the total qualifying expense. The remainder is comprised of supplies used in the process as well as contractor expense (U.S. based) that perform qualified activities. For contractor research, 65% of the expense can be claimed. Lastly, the portion of computer leasing and cloud computing expense that directly relates to R&D activities may also be eligible.

Customer Contracts Matter

For companies that claim the credit under contracts with customers or subcontractors, there needs to be proof that your company bears financial risk. And, in addition, you must retain the rights to any intellectual property that is developed. As an example, any work done on a time and materials basis would not qualify.

Ask the Pros

There are many misconceptions about R&D that have caused conservative naturally-skeptical manufacturing business owners to shy away from the credit. However, the playing field will not be level if you are forced to compete against firms claiming the R&D credit. Take a little time, have an open mind, and explore the potential difference the R&D credit can make for your company.

Remember, the R&D Tax Credit is a particularly complex and a frequently changing piece of the federal tax code. It may be best to work with a company that is knowledgeable of your industry and understands the R&D Tax Credit to ensure you’re receiving your fair share of the credit.  

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