R&D Credits… Don’t Let Your Research and Development Costs for Pharmaceutical and Diagnostic Technologies Sit on The Shelf When You Can Turn Them Into Cash Flow
When developing a new pharmaceutical or diagnostic equipment, companies typically incur substantial costs for salaries, supplies, laboratory, contractors and a myriad other expenses.. While deductible, these costs may not benefit early- stage start- up companies from an income tax perspective and only serve to increase net operating losses that MAY be deductible in future years.
Under IRS Code §41 (“Section 41”), however, many of these expenses can be converted into federal (and state) tax credits, to be used as a dollar-for-dollar offset against income tax liability or, as of 2016, used to reduce the employer’s portion of the payroll tax.. In California, the benefit is even higher than the federal benefit.
The R&D Tax Credit was created in 1981 to encourage domestic R&D activities, and, since the subsequent elimination of two statutory requirements, many middle market companies are taking advantage of these credits. In fact, more than half the credits are claimed by companies with less than $10,000,000 in annual gross receipts.
To determine what kinds of activities qualify, it helps to use the “Four-Part Test”:
- Permitted Purpose: the activity must be intended to improve a business component’s (product or process) functionality, performance, quality or reliability;
- Technological in Nature: the activity must fundamentally rely on “hard science” principles: chemistry, biology, engineering, computer science, metallurgy, mathematics, etc.;
- Elimination of Uncertainty: the activity must be intended to discover information to eliminate technical uncertainty concerning the capability or method for developing or improving a product or process, or the appropriateness of the business component design; and
- Process of Experimentation: all the elements must be part of a process of experimentation evident in developing one or more hypotheses, designing and conducting experiments to test and analyze these hypotheses, refining or discarding those hypotheses to design the business component, or modeling/simulation/trial-and-error testing.
Companies developing pharmaceuticals or diagnostic testing equipment will easily pass the requirements of The Four-Part Test, as will many software developers, for example. Additionally, most medical testing facilities, chemical compound developers, developers of new drug applications or delivery methods, regulatory testing methods, process automation or species/medical device development will also generally qualify.
Procedurally, as a product or process is developed and modified in time, activities directly and indirectly related to that development will qualify. Virtually anyone’s contribution can be quantified and combined with other Qualified Research Expenses (QREs), to be converted into federal and state tax credits. The contributing activities are quantified by assigning participation percentages to participating employees; actual costs for supplies; and 65% of contractor costs. For every $1,000,000 in QREs, the taxpayer receives $50,000 to $65,000 in federal tax credits. California’s program is equally lucrative.
Beware of potential hurdles to taking advantage of these credits such as: Net Operating Losses (NOLs); Alternative Minimum Tax (AMT); control group issues; contract risk or rights issues; and the existence of passive shareholders in the company, to name a few.
Your CPA or R&D Consulting experts will be instrumental in advising you in these technical areas. Fortunately, due to a 2014 court case, recordkeeping requirements are minimal and estimates of employee participation are entirely acceptable. Often, W-2 records, payroll reports, and standard supplies and contractor invoices are enough to complete a project. Proper documentation, however, is essential to taking full advantage of the credit.
By far, most of our work will involve documenting projects, activities and responsibilities in light of statutory and case law in order to capture and retain the maximum amount of credit. Combining R&D Credit expertise with a well- designed accounting system is the key to maximizing these tax benefits.
Joe Markunas, CPA is a Partner at CFOS2GO and leads their Life Sciences and Healthcare practice group which is dedicated to serving the accounting, financial, consulting as well as interim and permanent staffing needs for companies in these and other industries. Additionally, Joe has conducted successful accounting and consulting engagements for clients in industries as diverse as manufacturing, ecommerce, agri-business and import/export to name a few.
Stuart Burlingham is a Director at SourceHOV Tax, a national specialty tax consulting firm of 75 professionals serving CPAs and their clients since 1983. Their R&D Tax Credit practice was established in 2006 and team experience averages 12 years. SourceHOV Tax will perform an initial evaluation at no charge, a fixed-fee proposal and include unlimited audit presentation through appeals, if needed.