Congress’ Definition of R&D: Why

Designers Qualify for the Research Tax

Credit

Presented by:

Dawson Fercho, EA

Corporate Tax Advisors, Inc.

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Dawson Fercho, Founder-Partner

▪ IRS Enrolled Agent- Admitted to practice before the

Internal Revenue service

▪ 20 years of consulting experience Small and Mid-size

businesses.

▪ 14 Years exclusively focused on the Federal Research

Tax Credit & 179D Energy Efficiency Deduction.

▪ Co-Founder of Corporate Tax Advisors, Inc.

▪ Responsible for all areas of client service and

overseeing CTA’s marketing and business

development.

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Agenda

➢ Overview of the R&D tax credit

➢ The definition of R&D under current law

➢ Review examples of the credit computation

➢ Important tax rules to consider

➢ Types of industries and activities that qualify for the R&D credit

➢ Financial risk required in R&D activities

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Section 41: Credit for Increasing Research Related Activities

• Permanently Codified January 1, 2016.

• Initially established 1981- Reagan Administration.

➢ Generates immediate cash flow by minimizing current tax liability

• $1 for $1 tax credit- usability to pay down Federal Tax Liabilities, *State Tax Liabilities

• Congressional Intent: Reducing the high-cost of U.S. Labor.

• 4 Year Look. I.e. 2015-2018.

• Open to All Tax payer entities- Sole, S. Corp, C. Corp, PSC, Partnerships etc.

• Except non-tax paying entities. I.e. Fully owned ESOP (S. Corps), Non-Profit.

• Primarily Direct Labor Expense Drive.

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Be Aware

The Research and Development (R&D) tax credit is one of the most substantial

incentives under current U.S. tax law for the A/E industry. Unlike a standard

deduction, it is a dollar-for-dollar credit against your tax liability.

Design Life Magazine 2015

-Innovation begins with a design

- Designers are by nature and profession, innovators

- Innovation is seeing what is not working and initiating change

I.E. How many designers does it take to change a light bulb? Does it have to be a light bulb?

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What’s on a CFO’s MIND

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What Does this Actually Mean?

At 10% At 20% At 30%

Pretax margin Pretax margin Pretax margin

Cash flow from R&D Tax Credit 50,000 50,000 50,000

Estimated tax rate 26% (federal & state) 26% 26% 26%

Revenue required to generate cash flow created by R&D credit 675,676 337,838 225,225

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High-Level Estimate- Mental Calculation

1) Determine Average Annual Direct Labor Expense

2) 25% X’s Director Labor Expense = Qualified Research Expenses

3) 7.5% X’s Qualified Research Expenses = Annual net Federal Tax Credit

4) #3 X’s 3 =‘s Total Federal Credit Benefit for Open Tax Years 2016-2018

5) #4 X’s 15% to 25% = Potential State Research Tax Credit Benefit

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Qualifying Research Expenses

➢WAGES

▪ Typically largest component

▪ Calculate the % of employees’ qualifying

time/hours

▪ Multiply this % by annual wages per W-2

➢ SUPPLIES

▪ Expendable materials consumed

➢CONTRACTOR COSTS

▪ Same pro-rata rules as above

▪ Only 65% of qualifying costs eligible

Salaries and Wages

Supplies

Contract Costs

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IRC Section 41- Congresses definition of R&D: The development of a new

or improved business component. I.E. New or improved Design

“Four-Part Test”

Qualified Research Expenditures

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The “Four Part” Test

Part 1: Development of New or Improved Business Component (DESIGN)

Six categories:

▪ Products (tangible or intangible),

▪ Process,

▪ Software,

▪ Techniques,

▪ Formulas,

▪ Inventions

Attempting

New/Improved

Business

Component

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The “Four Part” Test

Appropriate

and final

design

Part 2: Elimination of a Technical Uncertainty

Endeavoring

to discover

information

uncertain at

outset

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The “Four Part” Test

Principals of science -

engineering, physics,

chemistry, biology, or

computer sciences

must be applied

Relying on Principles of!

Part 3: Technological

in Nature

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The “Four Part” Test

Part 4: Process of Experimentation

Evolution of Design,

Trial and Error

Evaluating one

or more

alternatives

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What is R&D per Congress? The “Quick Test”

Question #1

➢Did you do any conceptual thinking on a technology

based problem?

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What is R&D per Congress? The “Quick Test”

Question #2

➢ Did you attempt the above in an effort to make something

better?

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Types of Qualifying Activities

Design ideas that stretch current engineering expertise;

▪ Use of 3D modeling;

▪ Integrate alternate materials

▪ Improved acoustical qualities;

▪ Alternative water flow/plumbing systems;

▪ Alternative electricity conduction systems;

▪ Improving lighting;

▪ Improved ventilation;

▪ Alternative heating and cooling systems;

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Types of Qualifying Activities- Engineering

➢ Alternative structural design;

➢ Waste and toxic waste disposal processes;

➢ Product and material transportation systems;

➢ Integrating environmental impact studies; and

➢ Integration costs related to designing co-dependent features.

➢ Material Strength Testing

➢ USE of CAD/CAM to evaluate various configurations

➢ Reviewing two or more site layouts to identify the best solutions

➢ Performing roadway simulations to determine the effect on traffic patterns

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Types of Qualifying Activities: Architecture

➢ Developing unique energy efficient features

➢ Designing master plans

➢ Developing schematic designs

➢ Developing planning and elevation drawings

➢ Designing a functional site plan to incorporate or

overcome various environmental concerns

➢ Developing construction documents

➢ Designing and developing building facades

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Types of Qualifying Activities: Architecture

▪ Designing unique water treatment plants to optimize plant capacity or efficiency

▪ Designing innovative sanitary sewer systems for new residential communities

▪ Designing unique water pipeline and ancillary systems

▪ Designing innovative lateral force resistant systems for buildings

▪ Implementing dampening systems for buildings to account for dynamic loads

▪ Designing marinas to meet unique structural and load requirements

▪ Typically designing and developing activities (CAD,CAM)

▪ Typically not surveying or project management activities

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Regulatory Changes

➢ The requirement to disclose contemporaneous

record-keeping (timesheets) was eliminated in

December of 2003, along with the Discovery Test.

➢ There is significant case law supporting a

taxpayer’s ability to estimate how much time is

spent on Research & Development

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Funded Research

➢ Fixed Price Contracts

The nature of fixed-price contracts puts financial risk on the taxpayer

➢ Pure Time and Materials and Level of Effort

Typically viewed as funded, but there are a few exceptions

➢ Cost Plus/Time and Materials Contracts

Although no inherently financial risk, the terms comprising Cost Plus

and time and Materials Contracts may be balanced amongst the parties

to determine which is responsible for incurring the cost, and thus the

financial risk, to complete the final deliverable

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Q&A

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Contact Us

Dawson Fercho

913-461-6179 direct

dawsonf@corporatetaxadvisors.com

If you have any questions please contact:

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➢ Total QREs are computed

➢ Base Amount is calculated – this is the difference in the two methods

➢ Regular Credit Method – Fixed base percentage multiplied by average gross receipts

➢ Alternative Simplified Credit (ASC) Method: one half of the average of prior three years QREs

➢ Costs above the base amount are multiplied by the credit rate, either 14% or 20%

➢ Result is “tax-effected” by the 280C election or the taxpayer’s actual tax rate

How is the R&D Credit Computed?

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Example Regular Credit Computation

Section A - Regular Credit 2013 2014 2015 2016 2017 2018

Line 1 Certain amounts paid or incurred to energy consortia (see instructions)

Line 2 Basic research payments to qualified organizations (see instructions)

Line 3 Qualified organization base period amount

Line 4 Subtract line 3 from line 2. If zero or less, enter -0- - - - - - -

Line 5 Wages for qualified services (do not include wages used in figuring the work opportunity credit) 548,798 594,347 763,298 1,004,874 1,167,237 1,225,599

Line 6 Cost of supplies - - - - - -

Line 7 Rental of lease costs of computers (see instructions)

Line 8 Enter the applicable percentage of contract research expenses (see instructions) - - - - - -

Line 9 Total qualified research expenses. Add lines 5 through 8 548,798 594,347 763,298 1,004,874 1,167,237 1,225,599

Line 10 Enter fixed-base percentage, but not more that 16% (see instructions) 16.00% 16.00% 16.00% 16.00% 16.00% 16.00%

Line 11 Enter the average annual gross receipts (see instructions) 4,078,975 4,186,317 4,356,011 4,651,306 5,527,812 6,606,799

Line 12 Multiply line 11 by the percentage on line 10 652,636 669810.65 696,962 744,209 884,450 1,057,088

Line 13 Subtract line 12 from line 9. If zero or less, enter -0- - - 66,336 260,665 282,787 168,511

Line 14 Multiply line 9 by 50% (.50) 274,399 297,173 381,649 502,437 583,619 612,799

Line 15 Enter the smaller of line 13 or line 14 - - 66,336 260,665 282,787 168,511

Line 16 Add lines 1, 4, and 15 - - 66,336 260,665 282,787 168,511

Line 17

Are you electing the reduced credit under section 280C?

If "Yes," multiply line 16 by 13% (.13). If "No," multiply line 16 by 20% (.20) and see the

instructions for the statement that must be attached. Members of controlled groups or

businesses under common control; see instructions for the statement that must be attached - - 13,267 52,133 56,557 33,702

XYZ, Inc.

Federal Form 6765

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Section B - Alternative Simplified Credit 2013 2014 2015 2016 2017 2018

Line 18 Certain amounts paid or incurred to energy consortia (see line 1 instructions)

Line 19 Basic research payments to qualified organizations (see line 2 instructions)

Line 20 Qualified organization base period amount (see line 3 instructions)

Line 21 Subtract line 20 from line 19. If zero or less, enter -0- - - - - - -

Line 22 Add lines 18 and 21 - - - - - -

Line 23 Multiply line 22 by 20% (.20) - - - - - -

Line 24 Wages for qualified services (do not include wages used in figuring the work opportunity credit) 548,798 594,347 763,298 1,004,874 1,167,237 1,225,599

Line 25 Cost of supplies - - - - - -

Line 26 Rental or lease costs of computers (see the line 7 instructions)

Line 27 Enter the applicable percentage of contract research expenses (see the line 8 instructions) - - - - - -

Line 28 Total qualified research expenses. Add lines 24 through 27 548,798 594,347 763,298 1,004,874 1,167,237 1,225,599

Line 29

Enter your total qualified research expenses for the prior 3 tax years. If you had no qualified

research expenses in any one of those years, skip lines 30 and 31 - 548,798 1,143,144 1,906,442 2,362,518 2,935,409

Line 30 Divide line 29 by 6.0 - 91,466 190,524 317,740 393,753 489,235

Line 31 Subtract line 30 from line 28. If zero or less, enter -0- 548,798 502,880 572,774 687,134 773,484 736,364

Line 32 Multiply line 31 by 14% (.14). If you skipped lines 30 and 31, multiply line 28 by 6% (.06) 76,832 70,403 80,188 96,199 108,288 103,091

Line 33 Add lines 23 and 32 76,832 70,403 80,188 96,199 108,288 103,091

Line 34

Are you electing the reduced credit under section 280C?

If "Yes," multiply line 33 by 65% (.65). If "No," enter the amount from line 33 and see the line

17 instructions for the statement that must be attached. Members of controlled groups or

businesses under common control: see instruction for the statement that must be attached. 49,941 45,762 52,122 62,529 70,387 77,318

XYZ, Inc.

Federal Form 6765

Example ASC Credit Computation

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Tax Considerations - AMT

➢ Effective for tax years beginning after 1/1/18, corporate AMT has been repealed. C corporations can now use research and development credits that would have otherwise been limited by AMT.

➢ As of 1/1/16, private entities under $50 million in average revenue can use research and development credits against AMT. Larger entities cannot.

➢ For C corporations, the repeal of AMT also means that any carryover credits that were pre-2016 credits limited by AMT, will not be limited by AMT any longer.

➢ Companies that did not take the credit in prior years due to AMT, need to re-examine whether they should go back to prior years to generate credits to carry them forward, with no AMT limitation.

Note:

C corporations are still subject to a usage limitation. Credits can only be used to offset the tax of 25% of the tax over $25,000.

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➢ Tax rates have decreased under the TCJA

➢ New Qualified Business Income Deduction of up to 20%

➢ The research credit is still very beneficial for pass through entities

➢ The credit can be generated at the entity level and pass through on the K-1s to the shareholder.

➢ The credit can offset tax on income generated from the activity that generated the credit.

➢ Includes both K-1 and W-2 income for S Corps and SE income for LLCs

Tax Considerations – Pass Through Entities

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➢ 280C(c)(3) Election – More value for Pass-Through Business Owners

➢ IRC 280C(c)(3) provides taxpayers with the ability to take a “reduced” R&D Tax

Credit and forego the M-1 add-back.

➢ With the reduction in the corporate rate from 35 percent to 21 percent, the

280C(c)(3) “haircut” also drops to 21 percent. As a result, pass through business

owners will see an even greater benefit by making this election.

➢ We now have a greater spread between those two rates, hence a greater 280C

benefit.

➢ Fiscal year taxpayers must calculate the 280C election for the tax year including

January 1, 2018, under a “blended rate” outlined in IRC 15(e).

Tax Considerations – Net Credits

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➢ Section 199 -Domestic Production Activities Deduction (DPAD) provided a deduction for domestically produced products. This deduction has been repealed as of 1/1/18. This deduction could be up to 9%.

➢ NOL - Under the previous law, Net Operating Losses (NOLs) were allowed to be carried back two years and carried forward 20 years. Under the TCJA, NOL’s are limited to 80% of taxable income and cannot be carried back. However, they can be carried forward indefinitely, starting in 2018.

➢ What does all this mean? With the Sec. 199 deduction and the NOL carryback repealed, the R&D Credit is a better tax savings opportunity. With no Sec. 199 deduction to reduce income, R&D credits will be needed even more to offset taxes. With no NOL carrybacks available to reduce taxes, R&D credits can be still be carried back or utilized currently to reduce taxes.

Tax Considerations – Section 199 and NOLs

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C Corporation Taxable Income Offset

➢ Nondeductible expenses such as life insurance premiums

➢ Shareholder stock redemptions

➢ Section 179 expensing versus regular depreciation

➢ Cash basis income swings

➢ Long term debt retirement

Tax Considerations – C corporations

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➢ The tax rate for C corporations has been reduced to 21%, many companies are

discussing whether or not to convert their S corporation.

➢ Companies need to consider the implication that this will have on existing S

corporation carry over credits before they do this. S corporation credits are utilized

at the individual level.

➢ Any existing S corporation credits remain at the individual level and cannot be used

to offset the 21% C corporation tax.

➢ A planning idea may be to compare the amount of the carry over credits and the

potential tax savings that will be foregone to the reduction in the tax going from a

top individual rate to the 21% rate.

➢ Careful consideration is needed before converting, as there are many other issue to

consider.

Tax Considerations – Choice of Entity

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Tax Considerations – Payroll Tax Offset

➢ Qualified Small Business

A Qualified Small Business (QSB) is any company with less than 5 years of revenues and less than $5 million in current year revenues that has R&D expenses. This definition and the associated benefit has be retained under the TCJA. Retaining this for QSB’s provides a tremendous benefit for start-up businesses.

➢ The rules for payroll taxes are:

• The maximum offset amount is $250,000 per year

• Credits will offset FICA tax (6.2%) employer portion only

• Credits can start to be utilized in the quarter following the filing of the entity

income tax return that generated the credit.

• Credits must be claimed on an originally filed, timely return.

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Q&A

36

Contact Us

Dawson Fercho

913-461-6179 direct

dawsonf@corporatetaxadvisors.com

If you have any questions please contact: