Manufacturing companies in Pennsylvania and across the East are facing new challenges as the recovery progresses. Issues like supply chain disruptions and shipping delays are forcing many to adjust production processes, fulfillment dates and pricing. The result is industry companies are faced with ongoing financial difficulties until these issues are resolved. To alleviate the stress, many are searching for new ways to bolster finances which includes leveraging tax credits and incentives. One often overlooked opportunity lies with the federal Research & Development (R&D) tax credit. The credit provides qualifying companies with a dollar-for-dollar credit for qualifying innovation expenses including process improvements, facility upgrades, or the custom production of parts and products. Unlike other federal tax incentives, the R&D tax credit is permanent and allows manufacturers to plan how they use it years in advance. To help clients, prospects, and others learn about this tax savings opportunity, we have provided a summary of the key details below.
R&D Tax Credit Details
Qualifying activities must meet the four-part test: research that is technological in nature, with an intended goal or outcome, part of an experimental or innovative process to create or improve function, performance, reliability, or quality, and intended to eliminate uncertainty regarding a product, process, or product design.
It does not have to be innovative or even meet its intended goal for an activity to qualify. Manufacturers do not have to make a profit and may even lose money during the year, and still qualify for the credit. Not all activities are eligible; the activity must take place in the U.S. and be technological in nature. Studies, surveys, training, and duplicate processes or products do not qualify.
Expenses like taxable wages for employees, supplies, contract research expenses (with limitations), computer or server rental fees, and software development costs can all be allocated to the R&D credit.
It is important to note there are two credit types which include the standard and the simplified credit. Each has its own calculation method, total value, and may be the better option depending on circumstances. In addition to the federal R&D tax credit, Pennsylvania also offers a state level R&D tax credit as well.
Opportunities for Manufacturers to Claim the R&D Tax Credit
There are several activities that manufacturers regularly engage in that qualify for the credit, including:
Digital upgrades and tech innovations
From digitization to automation, many activities that involve technology will qualify for the R&D tax credit. One approach is to take a formerly manual process and automate it. Another way to qualify is to digitize the manufacturing plant with software, artificial intelligence, and machine learning.
The heart of the R&D tax credit is undertaking an experimental or innovative process with a certain goal in mind. If there’s a clearly defined outcome or objective and the purpose is process improvement, the activity probably qualifies. The outcome doesn’t even have to succeed. Projects with a Lean Six Sigma focus may also qualify since the desired outcome is more efficiency.
Facility improvements and upgrades
COVID-19 required some manufacturers to switch gears and mass produce personal protective equipment (PPE). Others had to make do with limited staff, quickly expand operations due to increased demand, or both. Anything that required changes to the facility itself – like adding a new production line or revamping an existing one – probably qualifies.
Sometimes, when processes are innovated to enhance regulatory compliance, the expenses can be allocated to the R&D credit.
Manufacturers can also qualify by designing and testing prototypes and taking an existing product, reimagining it, and releasing a new and improved version. Some manufacturers may even be able to include expenses associated with custom fixtures, tooling, or processes based on customer requests or orders. This is often a missed opportunity for contract manufacturers that may not think to track expenses since they’re making a product for another company.
Smaller manufacturers have another way to qualify for the R&D credit. Eligible companies can offset their alternative minimum tax (AMT) obligations if gross receipts over the last three years have been $50 million or less. New manufacturers can qualify for the tax credit if current year gross receipts are $5 million or less and only go back five years. Start-ups in this case can use the R&D credit against up to $250,000 in payroll taxes.
Manufacturers that think an existing or future project may qualify for the credit should keep meticulous records, including but not limited to:
- Employee payroll records (excluding management)
- The R&D tax credit does not extend to pre-tax payroll deductions, which will need to be subtracted from qualified wages.
- Project lists and notes
- Meeting minutes
- Job descriptions for applicable employees
- General ledger expense details
- Invoices, purchase orders, and contracts
- Previous annual R&D receipts if any
- Related supplies
There are COVID-19 considerations with the R&D tax credit to factor in. For example, the R&D credit cannot be applied to payroll costs that were also subject to a PPP loan or Employee Retention Tax Credit.
The R&D tax credit represents a significant savings opportunity for Pennsylvania manufacturing companies. Since the regulations governing the credit are complicated, it is important to consult with a qualified tax advisor who can assess your situation and provide the needed guidance. If you have questions about the information outlined above or need assistance claiming the R&D tax credit, McKonly & Asbury can help. For additional information, contact Mark Heath, Partner and Director of Tax Services.