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Understanding Research & Development Tax Credits in KY

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This presentation was on understanding research and development tax credits in Kentucky and presented at Techfest Louisville 2017.

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Understanding Research & Development Tax Credits in KY

  1. 1. Real Solutions. Real Relationships. Beyond the Numbers. Research & Development Tax Credit: Overview & Opportunities
  2. 2. Real Solutions. Real Relationships. Beyond the Numbers. Learning Objectives • Understand the history of the federal credit • Understand the functional components to the R&D Credit computation • Understand new rules & regulations surrounding the credit (PATH Act) • Understand Indiana and Kentucky incentives for research and development activity
  3. 3. Real Solutions. Real Relationships. Beyond the Numbers. Identifying Opportunities Does your company…. • Develop new or improved products • Conduct process improvement initiatives • Employ engineers, scientists, chemists, programmers, technical personnel • Design new tools, molds or prototypes • Develop or enhance software • Customize machinery & equipment • Conduct trial runs or experiments
  4. 4. Real Solutions. Real Relationships. Beyond the Numbers. RESEARCH & DEVELOPMENT TAX CREDIT – HISTORY
  5. 5. Real Solutions. Real Relationships. Beyond the Numbers. History – Legislative R&D Tax Credit Origin – Introduced in the Economic Recovery Tax Act of 1981 – Initial Purpose • Economic Stimulus • Global Competitiveness – Credit for ‘Increasing Research Activities’ – Tailored to reverse the decline in U.S. Research Spending – Research credit has expired 8 times and has been extended 15 times – PATH Act: Significant Changes
  6. 6. Real Solutions. Real Relationships. Beyond the Numbers. Introduction to the R&D Tax Credit • What is the R&D Tax Credit? – Tax credit provided by the IRS to companies that focus on innovation, experimentation, research & development – Activity-based incentive – Dollar-for-dollar reduction in the company’s federal tax liability – Benefit is generally 5 cents to every qualified dollar – Many states also have R&D tax credits – 1-year carryback and 20-year carryforward
  7. 7. Real Solutions. Real Relationships. Beyond the Numbers. Who Qualifies? • Credit is available to various types of industries… – Consumer and industrial products (Manufacturers/Contract manufacturers) – Energy production – Software development – Food and beverage – Distribution – Construction/Engineering firms
  8. 8. Real Solutions. Real Relationships. Beyond the Numbers. What Qualifies? To qualify, must first identify a business component from one of the following: Product Process Software Technique Invention Formula
  9. 9. Real Solutions. Real Relationships. Beyond the Numbers. Areas of Focus -New product development -Product enhancement - Activity can be new to taxpayer, NOT to industry and still qualify (evolutionary not revolutionary) -Process improvements - R&D process - Manufacturing process -Software development - Software for sale, lease or license - Internal use software
  10. 10. Real Solutions. Real Relationships. Beyond the Numbers. Permitted Purpose Technological in Nature Elimination of Uncertainty Process of Experimentation The activity relates to a NEW OR IMPROVED FUNCTION, PERFORMANCE, RELIABILITY, OR QUALITY of a business component (i.e., product, process, computer software, technique, formula, or invention) which is to be held for sale, lease, license, or used in a trade or business The activity performed must FUNDAMENTALLY RELY on principles of: physical science; biological science; computer science; or engineering The activity must be intended to discover information to eliminate uncertainty concerning the CAPABILITY OR METHOD for developing or improving a product or process, or the APPROPRIATENESS OF THE PRODUCT DESIGN SUBSTANTIALLY ALL of the activities must be elements of a PROCESS OF EXPERIMENTATION to resolve the technical uncertainty, documented by explaining: the alternatives considered and attempted, testing performed on the alternatives, test results and analysis &R D The Four-part Test to Qualify Activities
  11. 11. Real Solutions. Real Relationships. Beyond the Numbers. Examples of Qualified Activities • To advance the design of an existing product or process • To correct significant design defects, obtain significant cost reductions, or enhanced function • Design, construction and testing of pre-production prototypes and models • Conceptual formulation, design and testing of possible product or process alternatives • Launch activities involving a new component/process • Design time, tool design and testing, prototype building, etc. • Engineering efforts to develop new plant processes • Technical redesign of an existing plant layout, resulting in substantial production gains • Efforts to solve production problems where there was uncertainty as to the best solution • The design and testing involved in improving the configuration or altering the composition of an existing product/process to increase efficiency or decrease cost
  12. 12. Real Solutions. Real Relationships. Beyond the Numbers. Examples of Non-qualified Activities • Research done outside the United States, the Commonwealth of Puerto Rico, or any possession of the United States • Research in the social sciences, arts, or humanities • Ordinary testing or inspection of materials or products for quality control • Market and consumer research • Advertising or promotion expenses • Management studies and efficiency surveys • Changes related to cosmetic, taste, style or seasonal design • Acquisition or improvement of land or of certain depreciable or depletable property used in research • Acquisition of another person’s patent, model, production, or process • Research funded by another person, or any governmental entity, by means of a grant or contract • Research conducted after commercial production • Research for the adaptation of existing business components • Research for the duplication of an existing business component
  13. 13. Real Solutions. Real Relationships. Beyond the Numbers. Example – Uncertainty Test • In a recent exam involving a large engineering firm, IRS engineer disallowed all but 2 projects under his theory that since taxpayer consulted existing engineering guidelines, manuals, etc. the information needed to resolve the uncertainty was “available” to the taxpayer. • IRS engineer relied on Reg. §1.174-2(a)(1), which states, in part: “Uncertainty exists if the information available to the taxpayer does not establish the capability or method for developing or improving the product or the appropriate design of the product.” • Is the engineer correct?
  14. 14. Real Solutions. Real Relationships. Beyond the Numbers. Example – Uncertainty Test • Answer: NO • IRS engineer misapplied the “available information” rule. • The available information only provided the method to the taxpayer, the information did not resolve uncertainty regarding capability or appropriate design.
  15. 15. Real Solutions. Real Relationships. Beyond the Numbers. Software Development • Software as a saleable product • Internal use software – must meet additional three-part “high threshold of innovation test”
  16. 16. Real Solutions. Real Relationships. Beyond the Numbers. Software Development • Software not considered to be internal use software: – Developed for sale, lease or license to customers – Used in production process – Used in conducting qualified research – Embedded in hardware for sale – Used in providing computer services to customers – Used to interact with third parties or to allow third parties to initiate functions or review data on the taxpayer’s system
  17. 17. Real Solutions. Real Relationships. Beyond the Numbers. Internal Use Software – Definition • Software that is developed by (or for the benefit of) the taxpayer is primarily for internal use if the software is developed by the taxpayer for use in general and administrative functions that facilitate or support the conduct of the taxpayer’s trade or business. • “Primarily for internal use” depends on the intent of the taxpayer and the facts and circumstances at the beginning of software development.
  18. 18. Real Solutions. Real Relationships. Beyond the Numbers. High Threshold of Innovation Test • If internal use software, may still qualify for R&D credits if: 1) It is intended to be innovative, • As measured by a reduction in cost, improvement in speed, or other measurable improvement that is substantial and economically significant. 2) Has significant economic risk, and • Did the taxpayer commit substantial resources to the development, and there is substantial uncertainty, because of technical risk, as to whether the resources can be recovered within a reasonable amount of time? 3) Is not commercially available • The software cannot be purchased, leased, or licensed and used for the intended purpose without modifications that would satisfy the innovation and significant economic risk requirements.
  19. 19. Real Solutions. Real Relationships. Beyond the Numbers. Costs Eligible for the Credit Qualified Research Expenses (“QREs”) • Wages – Box 1 W-2 Wages for those employees involved in: • Direct Performance of Research/Development • Direct Supervision of Research/Development • Direct Support of Research/Development • Supplies – Raw materials used in the research or experimentation process – Expenses relating to tangible personal property of a non- depreciable nature – Must be used or consumed in the research process • Contract Research – Research conducted on behalf of the taxpayer (paid consultants, engineering firms, etc.) – Payments must not be contingent upon the success of the research – Taxpayer must retain substantial rights to use the research results
  20. 20. Real Solutions. Real Relationships. Beyond the Numbers. Research Credit Keys to Success Permitted Purpose Technological in Nature Eliminate Uncertainty Process of Experimentation Wages ‒Qualified Research ‒Direct Support ‒Direct Supervision Supplies Raw materials used in research Contract Research Research performed on your behalf Sample Documents •Project List(s) •Time Tracking • Prototype Designs •Test Results & Analysis •Project Schedules/Timelines •Meeting Minutes •Executive Presentations •Project Summaries •Customer Contracts •Engineering Notes •Project Budgets •Requirements Documents •Email Correspondence Projects Costs Documentation
  21. 21. Real Solutions. Real Relationships. Beyond the Numbers. Documentation is Key to Success • Maintaining documentation is a key component of claiming the R&D tax credit & sustaining upon audit • IRS requires that each business component satisfy the 4-part test • Documentation should be maintained to help support and substantiate: 1) Qualifying activities AND 2) Costs associated with qualified activities
  22. 22. Real Solutions. Real Relationships. Beyond the Numbers. Examples of Documentation for Activities • Test results of experiments • Hand sketches, design concept drawings, CAD designs showing the evolution of product designs • Presentations & summaries to management, the board of directors, review committees or other similar groups regarding research projects, activities, expenditures and the credit • Meeting minutes, notes, or other similar recordings from budget, board of directors, managerial or other similar meetings concerning research activities • Project authorizations, budgets or work orders that initiated the research project • Internal authorization policies for approving a research project • Project summaries, progress & milestone reports and project notes (informal) • Email correspondence describing technical challenges
  23. 23. Real Solutions. Real Relationships. Beyond the Numbers. RESEARCH & DEVELOPMENT TAX CREDIT – CALCULATION METHODS
  24. 24. Real Solutions. Real Relationships. Beyond the Numbers. Traditional Credit Calculation – Overview • Generates a credit of 20% of qualified research expenses (QREs) in excess of the base period amount. • Reduced Credit is 13% of QREs over base period amount. • Base Period amount cannot be less than 50% of qualified research expenses for the credit year.
  25. 25. Real Solutions. Real Relationships. Beyond the Numbers. Traditional Credit Calculation – Base • Product of the taxpayer’s fixed-base percentage and average annual gross receipts for the four tax years preceding the credit year. • Fixed-base percentage is the ratio of qualified research expenses to gross receipts over the 1984-1988 period.
  26. 26. Real Solutions. Real Relationships. Beyond the Numbers. Traditional Credit Calculation – Base Illustration Tax Year QREs GRs QRE% 1984 10,000 1,000,000 1.00% 1985 10,000 1,100,000 0.91% 1986 10,000 1,210,000 0.83% 1987 10,000 1,331,000 0.75% 1988 10,000 1,464,100 0.68% 50,000 6,105,100 0.82% Tax Gross Year Receipts Average 2012 100,000,000 2013 110,000,000 2014 121,000,000 2015 133,100,000 2016 116,025,000 Fixed-base percentage = 116,025,000 x 0.82% Fixed-base percentage = $951,405
  27. 27. Real Solutions. Real Relationships. Beyond the Numbers. Traditional Credit Calculation – Start Up • For taxpayers incorporated after December 31, 1983 • For taxpayers with fewer than 3 years of QREs and gross receipts between January 1, 1984 and December 31, 1988 • Traditional Method vs. Start Up Method
  28. 28. Real Solutions. Real Relationships. Beyond the Numbers. Traditional Credit Calculation – Start Up Base • Fixed-Base Percentage remains at 3% for each of the taxpayer’s first 5 taxable years Gross Fixed Fixed Base % QREs Receipts QRE % Base % Calculation 1 2016 10,000 100,000 10.00% 3.00% 2 2017 10,500 110,000 9.55% 3.00% 3 2018 11,025 121,000 9.11% 3.00% 4 2019 11,576 133,100 8.70% 3.00% 5 2020 12,155 146,410 8.30% 3.00% 6 2021 12,763 161,051 7.92% 1.42% 1/6 of 4,5 7 2022 13,401 177,156 7.56% 2.70% 1/3 of 5,6 8 2023 14,071 194,872 7.22% 3.95% 1/2 of 5,6,7 9 2024 14,775 214,359 6.89% 5.14% 2/3 of 5,6,7,8 10 2025 15,513 235,795 6.58% 6.26% 5/6 of 5,6,7,8,9 Tax Year
  29. 29. Real Solutions. Real Relationships. Beyond the Numbers. Traditional Credit Calculation – Mechanics 2016 Qualified Research Expenses Qualified Wages 50,000 Qualified Supplies 10,000 Qualified Contract Research 5,000 Total QREs 65,000 Fixed Base Amount 50,000 A Difference 15,000 B 50% of Qualified Expenses 32,500 Lesser of A or B 15,000 Multiply by 13% 13% Regular R&D Credit 1,950 Fixed Base % 1.00% Average Gross Receipts 5,000,000 Fixed Base Amount 50,000
  30. 30. Real Solutions. Real Relationships. Beyond the Numbers. Alternative Simplified Method – Overview • Generates a credit equal to 14% of the current year QREs that exceed 50% of the average QREs for the 3 preceding tax years. • 280C Election on the original tax return allows taxpayer to claim 65% of credit. • If taxpayer elects ASC and no QREs in any one of the 3 preceding tax years, then 6% of current year QREs.
  31. 31. Real Solutions. Real Relationships. Beyond the Numbers. Alternative Simplified Method – Mechanics 2016 Qualified Research Expenses Qualified Wages 50,000 Qualified Supplies 10,000 Qualified Contract Research 5,000 Total QREs 65,000 Prior 3 Years QREs 2014 Tax Year 60,000 2013 Tax Year 50,000 2012 Tax Year 40,000 Total Prior Year QREs 150,000 Average of Prior 3 Years 25,000 Current Year QREs 65,000 Average of Prior 3 Years 25,000 Difference 40,000 Multiply by 14% 14% Gross Research Credit 5,600 280C Reduction 65% Reduced Research Credit 3,640
  32. 32. Real Solutions. Real Relationships. Beyond the Numbers. RESEARCH & DEVELOPMENT TAX CREDIT – RECENT DEVELOPMENTS
  33. 33. Real Solutions. Real Relationships. Beyond the Numbers. Credit Now Permanent • § 121(a)(1) of the Protecting Americans from Tax Hikes Act of 2015 (“PATH Act”, P.L. 114- 113, 12/18/2015) • Repealed former §41(h) effective for amounts paid or incurred after 12/31/2014 • Effects: – Permanent extension – Retroactive extension to last date of termination
  34. 34. Real Solutions. Real Relationships. Beyond the Numbers. Small Business Opportunities • AMT offset – PATH Act added an amended version of §38(c)(4)(B)(ii) providing for the allowance of R&D credit amounts for use to offset AMT for eligible small businesses • Payroll tax offset – PATH Act added new §41(h) addressing treatment of R&D credit for qualified small businesses
  35. 35. Real Solutions. Real Relationships. Beyond the Numbers. AMT Offset for Eligible Small Businesses • Eligible small businesses can offset regular tax and AMT with R&D tax credits. • Eligible small business defined under §38(c)(5)(C) as: • A corporation that is not publically traded; • A partnership; or • A sole proprietorship F The average annual gross receipts for the 3 prior taxable years does not exceed $50 million. IF
  36. 36. Real Solutions. Real Relationships. Beyond the Numbers. Payroll Tax Offset A qualified small business Corporation or Partnership Other (non- corp/pship) Person Gross receipts are less than $5 million for taxable year No gross receipts for tax years before 5-year period ending with tax year Gross receipts are less than $5 million for taxable year No gross receipts for tax years before 5-year period ending with tax year Only use aggregate gross receipts person receives for his trades/businesses
  37. 37. Real Solutions. Real Relationships. Beyond the Numbers. Payroll Tax Offset may elect to Form 6765 Annually with return Specify the amount Made on entity level
  38. 38. Real Solutions. Real Relationships. Beyond the Numbers. Payroll Tax Offset • Applies against §3111(a) 6.2% tax on employee wages for employers who have employees (“payroll taxes”) • Eligible for first calendar quarter that begins after the taxpayer filed the return and Form 6765 • The credit cannot exceed the payroll tax for any calendar quarter • Any excess can be carried forward to the next calendar quarter • Payroll offset is not taken into account for determining payroll tax deduction, but is still treated as a credit for purposes of §280C offset payroll taxes
  39. 39. Real Solutions. Real Relationships. Beyond the Numbers. Payroll Tax Offset • Limitation on amount of credit applicable for offset: – May not exceed $250,000 – Cannot elect to offset payroll tax if the taxpayer has elected to do so for 5 or more preceding tax years with a portion of the R&D credit.
  40. 40. Real Solutions. Real Relationships. Beyond the Numbers. Payroll Tax Offset – Example TECHCO, a small tech company founded in 2014, had acquired substantial R&D and payroll expenses in tax year 2015, however no revenue was produced. Since it worked at a loss, TECHCO did not claim any R&D Tax Credit in 2015. Moreover, the small company expects 2016’s activities to be comparable with those of 2015. • TECHCO can secure the $150,000 of credits in 2016 and elect to offset $100,000 against payroll tax liability. • TECHCO can carry forward the remaining $50,000 to offset against future payroll tax liability. Business Form of Taxpayer C-Corp R&D Tax Credit Eligibility 150,000$ Payroll Tax Liability 100,000$ TECHCO 2016 Activity
  41. 41. Real Solutions. Real Relationships. Beyond the Numbers. Payroll Tax Offset – Example TECHCO, a small tech company founded in 2014, had acquired substantial R&D and payroll expenses in tax year 2015, however no revenue was produced. Since it worked at a loss, TECHCO did not claim any R&D Tax Credit in 2015. Moreover, the small company expects 2016’s activities to be comparable with those of 2015. • In 2017, TECHCO began to turn a profit. TECHCO can apply their $200,000 R&D Tax Credit against their income taxes. • TECHCO can apply the remaining $100,000 of credits to offset $100,000 of their payroll tax liability. Business Form of Taxpayer C-Corp R&D Tax Credit Eligibility 200,000$ Income Taxes 100,000$ Payroll Tax Liability 150,000$ TECHCO 2017 Activity
  42. 42. Real Solutions. Real Relationships. Beyond the Numbers. State incentives for research activities
  43. 43. Real Solutions. Real Relationships. Beyond the Numbers. Indiana Research Credit • Very similar to federal credit – Uses federal tax code as foundation for credit – Regular and Alternative Incremental Credit computation options – Differences • Research activities must be conducted in Indiana • No provision to use credits against payroll tax
  44. 44. Real Solutions. Real Relationships. Beyond the Numbers. Other Indiana Research Incentives • Sales tax exemption for “research and development property” – Definition: 1) Property not previously used in Indiana for any other purpose 2) Acquired for the purpose of R&D activities devoted to experimental or lab R&D for new products, new uses of existing products, or improving or testing existing products – Computers, software, office supplies, consumables, hand tools, and repair parts also qualify
  45. 45. Real Solutions. Real Relationships. Beyond the Numbers. Kentucky Research Incentives • Research Facility Credit – Credit for constructing, remodeling, and equipping research facilities in Kentucky or expansion of existing facility: 1) Definition of research follows federal definition 2) Construction costs to build/remodel/expand the facility 3) Credit is equal to 5% of construction costs 4) Equipment-property used to conduct research activity and subject to the depreciation rules (no supplies, repair parts, or replacement property)
  46. 46. Real Solutions. Real Relationships. Beyond the Numbers. Kentucky Research Incentives • Kentucky Enterprise Initiative Act – Refund of sales tax paid on construction materials and equipment purchased as part of an “economic development project” – Same definition for building costs and R&D equipment – Must be a pre-approved project with a minimum $500,000 investment
  47. 47. Real Solutions. Real Relationships. Beyond the Numbers. Contact Us Thank you for attending today! Contact for follow up questions: John M. Rittichier, CPA jrittichier@hsccpa.com 502.882.8484 RSM US Alliance member firms are separate and independent businesses and legal entities that are responsible for their own acts and omissions, and each are separate and independent from RSM US LLP. RSM US LLP is the U.S. member firm of RSM International, a global network of independent audit, tax, and consulting firms. Members of RSM US Alliance have access to RSM International resources through RSM US LLP but are not member firms of RSM International.

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