The document presents an overview of the Research and Development (R&D) tax credit, discussing its eligibility criteria, qualifying activities, and the requirements for proper documentation. Key speakers, Raj Rajan and Michael Silvio, emphasize the importance of substantial documentation in light of increased IRS scrutiny and provide advice on identifying opportunities related to R&D activities across various industries. The agenda includes technical rules, qualifying activities, practical aspects of record-keeping, and current case law developments.

1. R&D Tax Credit – Don’t Leave Money
on the Table
Presented by
Raj Rajan, JD MBT
Managing Director, CBIZ MHM, LLC
Michael Silvio, CPA
Managing Director, CBIZ MHM, LLC

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5. Circular 230 Notice
Any tax advice contained in this program is not intended to
be used and cannot be used for the purposes of avoiding
any penalties that may be imposed by the Internal Revenue
Code.
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6. Agenda
• Technical Rules
• Qualifying Activities, Processes and Costs
• Identifying Opportunities and Industries
• Practical and Regulatory Aspects of Proper
Recordkeeping
• Current Case Law/Legislative Developments
• Summary/Key Takeaways
• Questions
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7. Michael Silvio, CPA
Michael Silvio is Managing Director with CBIZ MHM, LLC. He leads the San Diego and Orange
County offices’ Research & Development (R&D) and Energy Incentives Tax Credit Services Group.
Michael has more than 22 years of experience in public accounting and tax and has served a variety
of businesses in the manufacturing, construction, professional service and not-for-profit industries.
Michael’s primary focus is in R&D tax credit and tax incentives areas. He has conducted over 350
research credit studies for numerous companies in various industries, and has served as a
representative before the IRS and state taxing authorities to support and defend numerous research
credit claims for taxpayers.
He also has experience in financial accounting, reporting and management, auditing, and individual
and business income tax. Michael has supervised compilations, audits and reviews for various
clients, including small and medium sized businesses, in addition to providing income tax planning,
consulting and compilation services.
Michael is a CPA certified in California. He is a member of the American Institute of Certified Public
Accountants and the California Society of Certified Public Accountants. He has a Bachelor of Arts in
business administration with an emphasis in accounting from California State Polytechnic University
in Pomona. Throughout his career he has authored several publications and conducted numerous
presentations on current tax legislation, R&D tax credit, energy incentive issues and other tax related
business incentives. He has also spoken to organizations such as the California Society of CPA’s, the
National Association of Manufacturers, the R&D Credit Coalition in Washington, D.C., and the
American Bar Association.
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8. Raj Rajan, JD, MBT
Raj Rajan is a Senior Manager at CBIZ MHM, LLC. and the national technical lead on the
research and development tax credit. He has over 11 years of professional experience
working exclusively with research and development tax credit studies.
He has conducted over 350 research credit studies for numerous companies in various
industries. In these engagements, he has been involved in analyzing and substantiating a
variety of issues emerging from the research and development tax credit. He has
performed such services for a wide range of clients including large publically held
companies to small privately owned businesses.
Prior to joining CBIZ MHM, Raj worked for two of the big 4 public accounting firms as well
as another large national firm, performing R&D credit analysis for companies ranging from
Fortune 500 companies to small and mid-sized companies. He has also taken the lead on
defending numerous research credit claims for taxpayers before the IRS and state taxing
authorities.
Raj has a Bachelor’s degree in Business Marketing from the University of Tennessee,
Knoxville. He also has a Juris Doctorate (JD) from University of San Diego School of Law,
and a Master of Business Taxation (MBT) from the University of Southern California.
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9. Technical Rules
9

10. The Federal Research Credit : Technical
Aspects Governed by IRC Sections 41 and 174 of Internal Revenue
Code
• Federal credit is 20% of qualified costs in excess of base
limitation for activities performed with U.S.
• Various states have varying credit provisions relating to
qualified costs in excess of base limitation for activities
performed within the state
Methods of calculation:
•Traditional Method
•Alternative Simplified Credit (Fed only)
Reduced credit can be elected (IRC 280C)
• Fed: Can be carried back 1 year and carried forward 20
years (except for 2010 when, under specific circumstances,
the carry back is 5 years)
• States: Certain states have varying carry forward provisions
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11. Base Limitation Issues
– The base limitation is the threshold (floor) that a
company must exceed in current qualified research
costs in order to be eligible to take the research
credit
– The base limitation is formula driven and cannot be
less than 50% of current qualified research costs
– The base limitation is typically the ratio of a
company’s prior years’ (which can include various
years) qualified research costs to gross receipts
multiplied by the company’s average annual gross
receipts (net of returns and allowances) for the four
years prior to the year of the credit
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12. The Research and Development Tax Credit-
First Test
• The Section 174 Test (IRC 174)
– In Connection with a Trade or Business
– Discover information to Eliminate Uncertainty-Experimental in
Nature
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13. The Research and Development Tax Credit-Second Test
New or Improved Business Component Technological in Nature
The activity must relate to a new or The activity performed must fundamentally
improved product or process that rely on principles of:
improves the component’s: • Physical science
• Function • Biological science
• Performance • Computer science
• Reliability • Engineering
• Quality
Technical Uncertainty Process of Experimentation
There must be uncertainty concerning the Substantially all of the activities must be
capability to develop, method of elements of a process of experimentation
developing, or appropriate design of a to resolve the technical uncertainty. To
new or improved product or process at the document this process we must explain:
outset of the project.
•The alternatives considered and attempted
•Testing performed on the alternatives
•Test results and analysis
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14. R & D Credit Scope Limitations
To take the credit, it must not be “funded;” This involves
two concepts:
 The business must be at risk on its investment in the
research and
 The business must retain substantial rights in the
results of the research
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15. Qualifying Activities, Processes and Costs
15

16. The Research Process: Qualifying Activities
Concept
Product or Process
Research and Development Activities
Design/Engineering
Innovation/Experimentation
Prototyping and Testing
Foreign Outsourcing Domestic Outsourcing
Design Design
Fabrication/Prototyping Fabrication/Prototyping
Manufacturing Manufacturing
Finished Product or Process
Released to Production
Pr oduct
Pr ocess
New Pr oduct Development
New Manufactur ing Systems
Pr oduct Enhancements
New Pr oduction Equipment
Pr oduct Impr ovements
Pr oduction Changes
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17. Qualifying Activities
• New Product Development- expenses related to the
creation of new products that previously did not exist.
Includes any pilot model, process, formula, invention,
technique, patent or similar property.
The definition also includes products to be used by the
taxpayer in its trade or business as well as products to be
held for sale.
• Product Improvements- expenses related to the significant
redesign of products, i.e. functionality. This does not
include product redesign and changes related to
appearance, individual market or customer tastes if these
changes do not change the functionality of the product.
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18. Qualifying Activities
• Process improvements- expenses related to improving the
way that products are made. This includes efforts to
reduce production costs by using different materials,
increasing automation or making changes to use less
energy. This also includes creating or designing R & D
and production equipment, tools and dies.
• Software Development-Software must be developed and
sold, licensed, etc. to customers. In this case the software
is the product being sold. Software must be used in an
activity that constitutes qualified research, or Software
must be used in the production process.
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19. Exceptions
Expenses That Do Not Qualify:
 Ordinary testing or inspection for quality control
 Efficiency surveys
 Management studies or activities
 Consumer surveys
 Advertising or promotions
 Acquisition of another’s patent, model, production or
process
 Research in connection with literary, historical or similar
projects (social sciences),
 Management function or techniques developed for
internal use
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20. Exceptions
Activities that do not Qualify:
 Activities not directed at functional aspects of a product
(typically, this includes expenses relating to style, taste,
cosmetics, etc.)
 The adaptation of existing business component to a
particular requirement or customer need where no
uncertainty element exists (Custom product
development does qualify, I.e. job shop, etc.)
 Duplication of an existing business component (reverse
engineering)
 Routine data collections
 Funded Research (I.e. by grant, contract or other)
 Research performed outside of the United States
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21. Costs Included
 Wages, excluding any fringe benefits, of employees
directly engaged in the research, or that provide direct
supervision or support of the research. This amount can be
found on line 1 of the form W-2.
 Supplies, excluding land and depreciable property. These
supplies must be consumed in the performance of the
research activities. Certain overhead costs can be included
such as rent and utilities and telephone expenses.
 Outside services incurred during the research process.
Only 65% of these costs are eligible for the credit. These
costs include outside consultants, software programmers
and engineers, outside tool and die makers, etc.
 Only costs related to activities performed in the United
States and U.S. possessions qualify for the credit.
21

22. Identifying Opportunities and Industries
• What to look for
• Specific costs to include
• Specific activities to include
• Contemporaneous Documentation
22

23. How to Identify and Qualify Opportunities
• Have you spent significant dollars in developing new products or processes or
machinery in order remain competitive or an industry leader?
• Do you anticipate an increase in research activities in future years?
• Do you hold any patents for new products, processes or technologies?
• Have you paid tax in recent years?
• Do you employ engineers, chemists or programmers?
• Are you coming off NOLs or NOL carryovers that have been fully utilized and needs a
way to reduce current and future taxes?
• Have you completed a recent sales transaction and has a taxable gain on the sale of
the company or division?
• Have you developed a unique and novel website?
• Have you made any of the following changes to the production process related to
cost efficiencies, including: new ingredients, materials, increased automation,
reduced energy consumption, new ways to manufacture products that incorporated
the use of new materials?
23

24. R&D Activities By Industry
Industry R&D Activity
• Adhesives Formulation development, V.O.C. requirements, prototypes, testing
• Aerospace High tolerance, design and prototyping, testing
• Apparel Process engineering, design, fade resistance after washing, fabric strength and durability
• Automotive High tolerance, design and prototyping, customer specifications, testing
• Agriculture Seed coating/development, equipment development, organics and organic pesticides
• Biomedical/medical devices Design, development, bioengineering, clinical engineering, prototyping, testing, process
improvements
• Biotech/Pharmaceuticals Listed and generic drugs, clinical trials, FDA requirements, testing, prototyping, process
engineering, inactive and , active ingredient determination
• Defense High tolerance, software development, engineering, design, development, prototyping, testing
• Energy/alternate fuels Resource processing/extraction technologies, formulations, development, testing, prototype
• Engineering: environmental, Structural design, abatement, remediation, waste disposal, infrastructure design and
Civil, architectural development
• Equipment Design, development, prototyping, testing, engineering
• Financial services Software development activities
• Food mfg/processors Formulations, process improvements, ingredients, shelf life, pH, packaging
• Furniture Engineering, materials development, process improvements,
• Healthcare products Formulations, pH, process improvements, prototyping, testing
• High tech Engineering, process improvements, design, prototyping, testing
• Life science Development, genetics, testing, biological testing, cell theory, process engineering
• Lubricants Formulations, V.O.C., viscosity, pH, prototyping, testing, process improvements, Milspec
• Paper products Materials development, process improvements, design, development, prototyping, testing,
packaging
• Software Developers Concept/idea generation, programming, alpha and beta testing, functional enhancements/development,
version changes, not “debugging”
24

25. Historical R&D Credit Capturing Industries
• Biotech/Pharmaceutical
• Biomedical/Medical Devices
• Software development (for sale, lease or license)
• Automotive Industry
• High Tech
• Aerospace
• Oil and Gas
25

26. R & D Credit: Industry Opportunities-Biotech
• Drug development issues
• Generic drugs can be included
• Phased and Clinical trials are involved
• FDA approval issues
• Drug delivery methods (proprietary)
• Supplies are involved
• Chemical and molecular make up needs to be analyzed
• Inactive vs. Active Ingredient issues
• Results of trials, ingredients lists, documents provided to
FDA for approval
26

27. R & D Credit: Industry Opportunities-Software
• Software concept design
• Software programming
• Alpha and Beta Testing
• Supplies are virtually non-existent
• Will involve software programmers either as employees
or outside consultants
• Rights and risk issues;
• Flowcharts, revision notes ,functional specification
documents, computer code
• Not all software development activities quality (including
coding) 27

28. R & D Credit: Industry Opportunities-High Tech
• Component and product development
• Process/manufacturing improvements
• Supplies are usually involved
• First run or prototype costs involved
• Usually involves engineers and specialized
expertise
• Usually complex products being developed
• Schematic drawings, test results, component
drawings 28

29. R & D Credit: Industry Opportunities-Job
Shops
• [Build to print]; Mold Makers (Injection Molders);
Precision Products; etc…
• Clients can include medical device product companies
and aerospace product companies
• DFM (Design for Manufacturability)
• Developing tooling and fixtures, CNC programming, CAD
design and simulations, integrating new equipment, lean
manufacturing, process improvements, etc…
• Manufacturing process development work
• Supplies can include bought/sold mold costs (TG
Missouri case) and samples for clients validation. 29

30. R & D Credit: Industry Opportunities-Food
• Food processing (including manufacturing for others)
and product development
• Formulations and ingredients should be analyzed
• Cost of ingredients
• First batch run costs
• Usually involves food chemists
• Recipe lists
• Test result documents including: Ph, shelf life, taste
30

31. R & D Credit: Industry Opportunities- Apparel
• New or improved leather and dye formulation treatments
• Design activities related to construction and structural
integrity
• Functional improvements to weaving techniques
• Testing of colorfastness issues and tensile strength of
garments
• Testing for dimensional stability
• New or improved material usage and manufacturing
process
31

32. R & D Credit: Industry Opportunities-
Architectural and Engineering
• Design and Build or Engineering Procure and Construct
contracts
• Design issues
– Unique project requirements
– Site issues
– Environmental issues
– Codes associated with structure and energy
• Integration of all subcomponents (HVAC systems,
materials, designs)
• Trinity case
32

33. R & D Credit: Industry Opportunities-
Architectural and Engineering
• Development of unique energy efficient features
• Unique characteristics of the project site
• Implementing alternative energy technologies
• Designing for environmental issues
• Designing for sustainability and space utilization
• Harsh environment design and testing
• Incorporating new materials and new technology
• Look for industry design awards (or even applications for
industry awards by the client)
33

34. Practical and Regulatory Aspects of Proper
Record Keeping
34

35. Best Practices: Documentation and
Substantiation
• Four Primary Areas of Concern in this Area
(according to the IRS)
– High-level estimates
– Biased judgment samples
– Lack of nexus between the business component
and qualified research expenses (QREs)
– Inadequate contemporaneous documentation
35

36. Tier I Internal Revenue Service Issue
• R&D Credits have become a Tier I issue with the Large
and Mid-Sized Business Division of the IRS
• There will be more audits with a higher level of scrutiny
• Agents must adhere to following guidelines now:
– IRS Industry Directives and Guidelines
– R&D Audit Technique Guide (Released May 30, 2008)
– Notice 2002-44
– Use of R&D Technical Advisors
• Four Primary Areas of IRS Concern
– High-level estimates
– Biased judgment samples
– Lack of nexus between the business component and
qualified research expenses (QREs)
– Inadequate contemporaneous documentation
36

37. Tier I Internal Revenue Service Issue
Potential remedies to combat the Tier I issue and to document and substantiate
credits taken:
• Establish Procedures and Tools for Capturing and Maximizing Future Credits
• Revisit Fixed Base Percentage determination
• Have researchers/client personnel spend time documenting how they arrived at the R&D
percentage qualifications used in determining the qualified research expenses
• Break out time into appropriate categories—by person.
•Attempt to identify the largest projects that individual cost centers
work on. Try to support this determination with work plans, payroll
records, etc.
•Reliance on the recollection of a department head should be
your last resort.
•For documentation, use material originally prepared for non-tax
reasons, if you can. Engineers are often “pack rats.” You might be
surprised at the type of details that they retain.
37

38. Prequalify Your R&D Costs and Employees
• Need to identify which employees are part of the R&D
process.
• Start with the employees performing R&D services
• Identify the Not-so-Obvious employees (CEO, Sales
persons, Production)
• Supplies
• Outside Contractors
38

39. Proper Record Keeping
• The ideal methodology to support proper record keeping
is:
Contemporaneous
Documentation
39

40. Current Case Law
40

41. Research and Development Tax Credit- 2009 -2011
 A number of important court decisions were handed down in the
past 50 months.
 The majority of these decisions were victories for the taxpayer
 Some of the areas that these cases provided guidance included:
• Level of documentation
• Internal Use Software Tests
• Supplies expense and depreciable items
• Discovery Test
41

42. Union Carbide v. Commissioner, TC
Memo 2009-50 (March 10, 2009)
 1994-1995: IRS allowed majority of projects but disallowed 106 “new”
research projects not included in original claim
 Court agreed to look at 5 of the106 projects and analyze the taxpayers fixed
base percentage. Court found 2 of 5 projects to qualify
 The IRS has regularly opposed the use of “extrapolation” and “employee
recollections” as a methodology to determine qualified research
expenditures, however the Tax Court in Union Carbide accepted the validity
of such methods.
 The Tax Court confirmed that taxpayers are entitled to determine a close
approximation of qualified research activities and expenditures by oral
testimony and interviews supported by documentary evidence.
 The court indicated that it will apply the Cohan rule to accept a taxpayer’s
evidence and oral testimony.
42

43. U.S. v. McFerrin, 570 F. 3d 672 (5th Circ
June 9, 2009)
 IRS disallowed credits due to “lack of documentation” and
“discovery test”
 Lower court upheld IRS’ denial of research credits
 The Fifth Circuit Court of Appeals vacated the district court
ruling and remanded it back to lower court
 The Fifth Circuit noted and further confirmed that the 2004
final regulations should be applied retroactively to research
credits and removed the “discovery test”.
 The Fifth Circuit said that lower could should have accepted
estimates and should have looked to oral testimony and
institutional knowledge of the employees
43

44. TG Missouri v. Commissioner, 133 T.C. No. 13
(November 12, 2009)
 Manufacturer of Injection molded products paid third parties to developed
production molds for them. They modified these molds and then sold them
to their customers as part of the contract to manufacture the products
 Taxpayer took entire mold costs as R & D supplies-IRS denied the
treatment saying molds were depreciable property and reduced the R & D
credit
 The court held that production molds purchased from third parties, and later
sold to customers, were not assets subject to depreciation and that the
taxpayer properly included costs of the molds as supply expenses in
determining its research credit.
 The tax court rejected the IRS’ position on depreciable property and supply
expenses by holding that the molds were not property of a depreciable
nature “in the hands of the taxpayer”.
 Need to provide substantiation as to which molds are ultimately sold. 44

45. Shami v. Commissioner, T.C. Memo 2012-78
(March 21, 2012)
• FSI, which manufacturers hair, skin and nail products, was successfully able to
claim that R&D was performed at the company and employees in the following
departments were involved in the development effort:
– Lab
– Production
– Quality Control
– Executive/Management
• Under Audit, the IRS agreed that 456 out of 460 designated employees
performed qualifying research activities
• However, the owner and a high ranking executive were excluded by the IRS due
to lack of documentation. The company, relying on the Cohan rule, decided to
take this issue to tax court.
• The argument that the tax court rely on the Cohan Rule to estimate time for
these high ranking employees failed. The tax court determined that there was
no reasonable basis to make an estimate given a lack of sufficient testimony
and documentation. 45

46. Current Development-Legislative Update-R&D
Credits
• Research and Development Credit expired on 12/31/2011
• Senate Finance Committee current bill “markup”
• President Obama and Governor Romney want to make the credit
permanent
• Credit can only be used to offset regular tax, not Alternative Minimum Tax
(AMT) except for 2010
• Loss companies can elect to refund accumulated AMT or R&D credits in
lieu of electing bonus depreciation on equipment purchases
• Contingent Fees cannot be charged for R & D Studies (IRC Circ. 230)
• Imposition of 20% Erroneous Claim Penalty by IRS- IRC Section 6676
46

47. Summary/Key Takeaways
– The R & D Credit has broad application to a number of industries. You should
look at your company’s activities to determine whether you may qualify
– Remember, the 2010 tax year is a good year to take credits because they can
offset AMT
– Seek to implement a system of controls and procedures to capture qualifying
activities and costs contemporaneously throughout the year
– Remember, a great deal of eligible companies are still not taking advantage of
the research credit
– Many favorable court decisions have been handed down recently cementing
further that this credit is available and valuable to taxpayers
– Just because there is no current credit for 2012, don’t let that stop you from
reviewing this benefit. There are three (and sometimes four) years open by tax
statute that companies can likely go back and take advantage of
– Watch for current “extender” legislation in the post election, “lame duck” session
of Congress during 2012
47

48. YouTube Link
To view our CBIZ BizTips Youtube Video on R & D credits,
please click here.
48

49. QUESTIONS?
49

50. Upcoming Webinars
To view other upcoming CBIZ MHM webinars, please click
here.
50

51. CBIZ MHM, LLC Contact Information
Raj Rajan
Managing Director
 949.727.1327  rrajan@cbiz.com
Michael Silvio
Managing Director
 858.795.2071  msilvio@cbiz.com
51

52. Thank You