The Research and Development Credit (R&D) can be a very beneficial tax credit for manufacturers and a wide range of industries.

The R&D credit is a federal (and Wisconsin) tax benefit that provides a dollar-for-dollar savings for performing qualified research activities within a business.  This credit falls under IRS section code 41 and is used to stimulate growth in the development of new or improved products and processes in the United States.

Calculation Methods:

There are two different methods in calculating the R&D credit, Alternative Simplified Method and the Regular Method.  The Regular method is calculated by taking the lesser of the current year qualified research expenses (QRE’s) over the prior 4 years average annual gross receipts by the fixed base percentage or 50% the current year QRE’s. The credit is 20% of this result. The Regular Method requires gathering a significant amount of historical information, to be able to properly calculate the fixed-base percentage.

The Alternative Simplified Method is calculated by taking the current year qualified research expenses (QREs) over 50% of the prior 3 years of QREs – the credit is 14% of this result.  This means that in order to calculate the 2024 R&D credit, a company will need to know the 2023, 2022, and 2021 qualified research expenses.

What Types of Expenses are Eligible for the Credit? (QREs – Qualified Research Expenses):

• • Wages (includes amounts for engaging in qualified research, direct supervision, or support of Qualified Research Activities “QRAs”)
  • Supplies
  • Contract Research
  • NOT eligible:
    • Quality control testing
    • Advertising or promotions
    • Consumer surveys
    • Efficiency surveys
    • Management studies
    • Research in connection with literary, historical, or similar projects
    • The acquisition of another’s patent, model, production, or process

Qualified Research Activities (QRAs) Must Meet a Four-Part Test:

• 1. Elimination of Uncertainty: A company must demonstrate that they’ve attempted to eliminate uncertainty about the development or improvement of a product or process. In other words, something that has been changed solely for aesthetic purposes would not qualify.
  2. Process of Experimentation: A company must demonstrate, through modeling, simulation, systematic trial and error or other methods, that they’ve evaluated alternatives for achieving the desired result.
  3. Technological in Nature (The Discovering Technological Information Test): The process of experimentation must rely on the hard sciences, such as engineering, physics, chemistry, biology, or computer science.
  4. Qualified Purpose (The Business Component Test): The purpose of the research must be to create a new or improved product or process, resulting in increased performance, function, reliability, or quality.

When It Comes to Manufacturing:

• Corporations can use this credit against any tax assessed on taxable income.
• Partnerships and S Corporations must file form 6765, credit for increasing research activities to claim the credit. This credit is then carried to the shareholders and partners on their K-1s, where it flows through to be used at the individual level.
• If the business operates in Wisconsin, there is a WI R&D credit, similar to the Federal R&D credit, that can be claimed for any QRE’s that are provided in the state of Wisconsin.
  • The Wisconsin credit is calculated very similarly to the alternative simplified method – and is 5.75% of this result

Examples of Qualified Research Activities:

• • • Developing new or improved products, processes, or formulas
    • Developing prototypes or models
    • Developing or applying for patents
    • Certification testing
    • Developing new technology
    • Environmental testing
    • Developing or improving software technologies
    • Building or improving manufacturing facilities

Items to Keep in Mind when Calculating the R&D Credit

1. The credit uses the prior three years for the average calculation, therefore R&D information is needed for each of the prior three years, even if the credit was not filed for in that year.
2. R&D credit is an “increasing” research credit – so an increase over the prior three years’ averages, creates a higher credit for the current year.
3. Documentation and substantiation are needed for all requirements of the qualified expenses; wages, supplies, and contract research.
4. As a side note, the R&D Credit is completely separate from S174 R&E expenditures and the capitalization requirements that came into law in 2022.

The Research and Development tax credits allow manufacturers to offset costs while fostering innovation and competitive growth. These federal and state credits provide a valuable opportunity to invest in new products, processes, and technologies that drive success. As the industry evolves, maximizing financial incentives like the R&D credit will be essential for staying ahead.

Our Manufacturing Advisors are here to guide you through the complexities of the R&D credit process. Be sure to subscribe to our email list for more insights on strategies to strengthen your manufacturing operations in 2024 and beyond.