With changes to the Research and Development (R&D) Tax Credit going into effect for the 2022 tax year, it’s a good time to refresh your understanding of the credit and evaluate whether your company is maximizing this opportunity to reduce its income tax liabilities. Chances are, you may be leaving money on the table. It’s estimated that only one in three companies that qualify for the credits actually apply.

Since it was implemented as a temporary measure to boost the economy in 1981, the R&D Tax Credit has been extended and expanded. As of 2015, it became a permanent part of the U.S. tax code. Keeping up with the changes, including a few taking effect for tax years beginning after Dec. 31, 2021, can seem overwhelming.

To help you determine if and how your business may be able to benefit from this opportunity, here are four key things to know.

1. Manufacturing and distribution companies can qualify for the R&D Tax Credit.

Any company that’s investing in product or process improvement can qualify for the federal R&D Tax Credit, which is a dollar-for-dollar offset against regular income tax liability that can be used to hire additional employees, invest in new equipment or fund other business initiatives. In addition, more than 30 states offer an R&D credit to offset state tax liability.

The main “AH-HAs” to take away from this expanded definition are that any company that invests in product or process improvement can qualify — and the improvements simply need to be new to your company, not the industry. For manufacturers and distributors, this can include activities like process optimization, alternative material testing, and prototyping or modeling.

2. Qualifying is based on a four-part test.

The R&D Tax Credit is designed to incentivize certain research activities by reducing your company’s liabilities. The credit equals a defined percentage of qualified research expenses in excess of a base amount. Qualifying expenses can include the salaries of employees and supervisors engaged in the research, as well as research-related supplies, computer expenses, outside consultants, engineers or programmers.

Qualifying R&D activities must meet a four-part test defined by the IRS:

• Permitted purpose: The purpose of the research must be to create or improve a product or process, resulting in increased performance, function, reliability or quality.
• Elimination of uncertainty: You must demonstrate that you’ve attempted to eliminate uncertainty concerning the capability or method for developing or improving a product or process, or the appropriateness of the product design.
• Process of experimentation: At least 80% of the activities must be elements of a process of experimentation designed to evaluate alternatives for achieving the desired results through confirmation of the hypotheses accomplished by trial and error, testing or modeling, and refining or discarding of the hypotheses.
• Technological in nature: The activity performed must fundamentally rely on principles of physical science, biological science, computer science or engineering.

Examples of non-qualified R&D activities include efficiency or consumer surveys; acquisition of another’s patent, model, production or process; research performed outside the U.S.; and funded research, such as through a grant or contract.

3. Thorough documentation is required.

Another change taking effect in 2022 is related to the supporting documentation that’s required when applying for the R&D Tax Credit. Companies must include a thorough breakdown of all business components related to the credit claim, identifying the research activities and the employees responsible for each activity. In addition, the total cost of employee wages, qualified supplies and contracted research must be submitted. These new requirements also apply if your company is submitting documentation for prior-year credits.

4. Deductions for R&D expenses must be amortized.

Finally, for taxable years beginning after Dec. 31, 2021, R&D expenses not reduced by R&D credits taken must be amortized over five years for domestic claims and 15 years for foreign research. Previously, businesses could immediately deduct these types of expenses in year one. It’s worth noting that an effort is underway asking Congress to repeal the amortization requirement for R&D expenses in order to increase U.S. competitiveness.

How to Optimize for the R&D Credit

Manufacturing and distribution companies of all sizes are eligible to take advantage of the dollar-for-dollar savings available through the R&D Tax Credit if they invest in the development or improvement of products, processes or technology. The manufacturing and distribution experts at CBIZ are here to help you navigate the changes in the IRS guidelines, identify qualifying R&D activities, calculate your credit amount, meet the documentation requirements and, ultimately, optimize the credit for your company.