By Jacob Wood, JD

Manufacturers claim the lion’s share of R&D tax credits annually – over $7.5 billion in the most recent year for which data is available. This dollar-for-dollar federal credit can be claimed yearly and used to offset tax liability. It allows companies to hire new employees, expand their technologies, and finance other business objectives. Some states have their own version of the credit, further boosting the possible benefit.

If you work in the finance department of a manufacturing facility, or you advise someone who does, you need to know how to access this credit.

Manufacturing Is a Good Fit for R&D Tax Credits

Problem-solving is an important dimension of the manufacturing industry, and the activities undertaken to develop, refine, and improve products are exactly what the R&D tax credit was designed to reward. But beyond creating and improving products, manufacturers are increasingly focused on making production faster, more cost-effective, and more sustainable. Process innovation also may translate into qualifying R&D activity.

Any manufacturer – no matter the size or the type of producer – may qualify. If they are solving problems, they’re likely eligible for the R&D credit.

Qualifying for the R&D Tax Credit

The R&D tax credit is an activities-based credit, and most manufacturers qualify just by performing their day-to-day activities. If you develop or improve a product or process, you likely perform qualifying research activities (QRAs).

To officially be considered a QRA, an activity must pass a four-part IRS test (which is generally an easy task for a manufacturer).

PART I: New or Improved Business Component – The activity must be related to developing or improving the functionality, quality, reliability, or performance of a business component.

√  Manufacturers develop and improve products and processes all day long.

PART II: Elimination of Uncertainty – The activity must be undertaken for the purpose of eliminating some uncertainty, such as the following:

• Can I make a brand-new product?
• What will the new product design look like? How can I make it?
• Can I improve an old product? Is this even feasible?
• Can I improve the process by which the product is made?
• How can I incorporate new features and functions into an existing product/process?

√  Questions like these are at the heart of the manufacturing industry.

PART III: Process of Experimentation – The activity must involve some kind of experimentation designed to resolve uncertainty. This may include the following:

• Evaluation of alternatives
• Hypothesis testing
• Systematic trial and error
• 3D modeling or simulations

√  It’s all about the iterative process.

PART IV: Technological in Nature – The activity must be based on a hard science, such as engineering, physics, chemistry, etc.

√  For most manufacturers, scoring 100% on this test is more likely than not.

Activities that Qualify for the Credit

Although most manufacturers would ace the four-part test, let’s look at which specific activities actually qualify. Remember, a qualifying activity can be geared toward product or process design/improvement. So, I’ll consider those separately.

Product-Related QRAs – Manufacturers commonly qualify for the R&D tax credit by developing a new custom product or improving the design of an existing product. The following are likely to be considered QRAs:

• Designing, constructing, and testing prototypes and pilot models.
• Utilizing computer-aided design (CAD), computer-aided manufacturing (CAM), or computerized numerical control (CNC) tools in design.
• Designing and developing custom tooling for product manufacture (electrical discharge machining, grinding, milling, assembly, quality check).
• Determining optimal placement of equipment.
• 3D modeling.
• Evaluation of flat blank layout possibilities.
• Custom fabrication.
• Testing alternative materials to improve product performance.
• Trial production runs that allow teams to check for and address production issues.
• Creating and implementing specialized technologies, such as artificial intelligence or machine learning.
• Meetings in which the three Fs of design are discussed – form, fit, and function.
  -- To qualify for the credit, each F must be discussed.
  -- Form: shape, size, dimensions, weight of the part/product.
  -- Fit: ability of the part to connect to or interact with another part.
  -- Function: action that the part is intended to perform.

Process-Related QRAs – Activities intended to improve the production process (speed, efficiency, cost) are also generally considered QRAs. Many manufacturers qualify for the R&D credit by evaluating process improvements, including the following:

• Designing and developing cost-effective operational processes.
• Designing and evaluating process alternatives.
• Evaluating and determining the most efficient flow of material.
• Increasing manufacturing capabilities and production capacities through new technologies.
• Improving procedures to advance assembly line speed.
• Developing/updating processes to meet evolving regulatory requirements.
• Redesigning a manual process into an automated one.
• Experimenting with new or improved packaging techniques to optimize size, reduce cost, design reusable boxes or custom dividers, etc.
• Experimenting with methodologies to minimize environmental impact.

You may be wondering, what if your research activity didn’t succeed? Or, what if you met the aforementioned criteria and conducted quality research, but at the end of the day you were unable to make your process more cost-effective? That’s okay. Research doesn’t have to be successful to qualify for the credit.

What Can Manufacturers Claim Toward the R&D Tax Credit?

Qualified research expenses (QREs) are those expenses related to QRAs. QREs are what may qualify for the credit, and they fall into four categories: supplies and materials, employee wages, third-party contractor payments, and cloud hosting expenses.

Here’s a closer look at the most common QREs.

Supplies and Materials – This is where the bulk of the expenses lie for most manufacturers, and the bigger and heavier the item you manufacture, the higher the costs will be. Qualified supplies/materials may include the following:

• Custom and unique equipment or tooling
• Mold costs
• Small- or large-scale test batches
• Materials used to develop and test prototypes and pilot models
• Materials consumed or scrapped during process development

Note that machinery/equipment purchased as a capital investment for the business is depreciable and may not be claimed as qualified supplies under the R&D credit.

Wages – Employee wages may qualify for those actively engaged in the research, as well as those involved in supervising or supporting the research. The following job titles are illustrative of the types of positions eligible:

The “80% Rule” or the “Substantially All Rule,” is a taxpayer-friendly provision. If 80% of the work performed by an employee is related to QRAs, 100% of the wages paid to the employee may be captured as QREs and included in the credit calculation.

Third-Party Contractor Wages – Payments made to third parties for services such as modeling, laser-cutting, testing, etc. may be claimed toward the credit, as long as the third-party is based in the United States. Note that only 65% of these payments may be claimed toward the credit.

How to Claim the R&D Tax Credit

Manufacturers can claim the R&D credit by filing IRS Form 6765, Credit for Increasing Research Activities. Taxpayers must provide “sufficient documentation” to support the amount of QREs they are claiming. The IRS does not specify what constitutes “sufficient documentation,” so the nature of the documentation will vary by type of manufacturing. In general, the more documentation you can retain and provide the better. Here are some examples of helpful documentation:

• Payroll information for employees directly involved in R&D and for employees or managers supervising them.
• General ledger reports indicating which costs and supplies were related to R&D activities.
• Copies of contracts and invoices paid to third-party contractors.
• General documents that demonstrate the research process and progress: design revisions, test results, blueprints, drawings, emails, presentations, meeting minutes, etc.

Credible employee testimony is also helpful in substantiating the R&D tax credit claim, especially in conjunction with documentation.

There is an additional documentation requirement established by Memorandum No. 20214101F, Minimum Requirements for an R&D Claim. This memorandum states that for each product or process, the claimant must identify:

• All research activities performed.
• All individuals who performed each research activity.
• All the information each individual sought to discover.

In short, you need to be able to demonstrate who worked on what, when, why, and how. There are different ways of gathering this information. At Capstan, we create flow charts for each activity according to employee or department.

How Large Can the Credit Be for Manufacturers?

The amount of the credit depends on the value of the QREs, not on company size or overall revenue. The more a company spends to innovate, the more it can potentially save, regardless of size or scope.

The R&D tax credit offers up to 10 cents in benefit for every qualifying dollar identified. Not everyone receives the full 10 cents for every dollar spent, but a good average is about 7.9 cents for every dollar. So, if you have $1 million in QREs, you could receive about $79,000 in credit, with the potential to reach the maximum of $100,000.

And that’s only the federal credit. If there is a state version of the credit, the benefit could be significantly more (even doubled in states like California).

Let’s consider an example.

At Manufacturer A, let’s say 20% of employee wages qualify as QREs – that’s $1 million. Then, let’s imagine that $1 million of supplies/materials also qualify – that’s $2 million in QREs, translating to nearly $160,000 in federal credit annually (using the 7.9 cents on the dollar average.) In states such as California and Indiana, that number could double. With that dollar-for-dollar credit, Manufacturer A could hire a new employee, pay down debt, or reinvest in improving technology.

Remember, the value of the credit depends on how much a company is spending on R&D, not on the size of the company. The credit can be extremely lucrative for small manufacturers that invest heavily in their qualified activities. Manufacturer B has only half the gross receipts of Manufacturer A. However, they could get a similar credit if they spent more on R&D.

If 40% of Manufacturer B’s employee wages qualify as QREs, that’s $2 million right there. Depending on the types of activities performed, typical savings can range anywhere from $50,000 to $5 million through the R&D tax credit.

Next Steps

If you’re interested in learning more about how you might benefit, consult with an R&D tax credit adviser. Others in the finance department might have a recommendation or, if you’re evaluating providers yourself, be sure to ask these important questions.

Claiming the credit requires a strong understanding of the manufacturing industry and how the tax code applies. Your provider will be combing through your manufacturing process start to finish, identifying all QRAs and tying QREs to them. It’s important to select an R&D tax credit adviser with the technical and tax knowledge required to do the job right.

Jacob Wood, JD, is a regional director at Capstan Tax Strategies. He works with taxpayers and accounting firms to provide practical, creative, and customized engineering-based tax solutions. Wood can be reached at jwood@capstantax.com.

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^{Statements of fact and opinion are the authors’ responsibility alone and do not imply an opinion on the part of the PICPA's officers or members. The information contained herein does not constitute accounting, legal, or professional advice. For actionable advice, you must engage or consult with a qualified professional.}