Podcast | R&D Tax Credits

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Transcript

Andrea Sardone
In today’s episode, we will discuss a little-known hidden gem called R&D (Research & Development) tax credits, an incentive the government provides to encourage businesses to invest in innovative activities. Joining me today will be one of our senior tax partners specializing in this area, which is not well known but offers a big opportunity for an organization’s economic growth.

Our guest today is Dan Chenoweth. He is a senior tax partner who is passionate about helping his clients plan for new operations, figure out ways to increase efficiency, and minimize tax to increase cash flow and maximize growth. Virginia Magazine (https://uvamagazine.org/) has twice awarded him their Super CPA recognition. Dan’s start in accounting was untraditional, with an undergraduate degree in psychology. Finding a job was a challenge.

So he contacted a temp agency and was assigned to filing papers in the accounting department. He loved the work, and the employer hired him as an accounting clerk. The accounting bug bit him, and he returned to graduate school to get his graduate degree in accounting. Soon thereafter, he returned to graduate school to obtain his degree, and many happy clients were to follow.

Hi, Dan.

Dan Chenoweth
Hey, Andrea. How are you? The running joke with that story is that I use my psychology degree more than my accounting degree.

Andrea
Thanks for joining us today. As you know, working with you involves a lot of psychology when dealing with many human behaviors, so I think you are well suited to it. So, let’s talk about R&D tax credits.

Dan Chenoweth
The IRS says that R&D tax credits are designed to encourage businesses to increase their spending on research and experimental activities. And so they’re tax credits designed to encourage businesses to innovate. It’s an interesting part of tax law. Like you, it fascinates me.

There’s an incentive that I think is under-publicized. Understanding that the definition of R&D is not necessarily as narrow as you think. I think it becomes something we need to discuss and ensure we’re checking that box with our clients. These are credits. That’s one thing that some people don’t understand. It’s not a deduction. This is not something that gets a dollar-for-dollar reduction from your tax. And in this case, it reduces your income tax, but a portion can also go against your payroll taxes and even alternative minimum tax.

And if you don’t know what I mean when I say alternative minimum tax, you need to consider yourself lucky because that’s a topic for another podcast. But not me. Somebody else, please.

But no, the credit’s usually four to 7% of eligible expenses, and I’m sure we’ll talk about that. It’s something that, if you missed it, we’ve got three years to go back and recoup. There are no special rules against amending prior returns to claim the credit. Then, I find it interesting that if I’m starting a new business and trying to get it off the ground and doing all kinds of research and development, I will need to continue to claim these credits. I’m not going to be able to use them. I don’t have tax to offset yet, but you can carry this credit forward for 20 years. So if we’re in the startup phase, we still want to do it because we’re gonna bank it, and we’re going to use it when we turn the corner. So, all around, it’s a great credit. It’s been around since 1981. And so we’ve been dealing with our new tax credits for a long time.

Andrea
I think it’s interesting that you can go back, but then you can also go forward 20 years. So banking these…. what does that mean? So you apply for them, and then they’re registered?

Dan Chenoweth
We can get into more details, and maybe we’ll just go through that now. Once we determine if you qualify, we will start doing what’s called the “study.” We will do a study to see what your expenses were and if they qualified. We come up with documentation that we have available to file with the return or present if the return is scrutinized. And yeah, we’re off and running once we do that. It can be claimed year over year as long as you have an R&D expense offset. We also probably talk about what types of businesses generally qualify.

Andrea
Well, that’s my next question. So is it like technology businesses, or can it be any type of business?

Dan Chenoweth
Anybody can qualify for any for-profit business, but to be practical, it’s any business developing a new product. Let me go down that path now, and we’ll get back to the actual specifics of the business. To figure out if you qualify, there’s a four-part test. You have to pass four parts of the test. The first is section 174 (https://www.irs.gov/businesses/audit-techniques-guide-credit-for-increasing-research-activities-i-e-research-tax-credit-irc-41-qualified-research-activities).

That is the 174 test. It’s the expenses that have to be incurred with the business and represent R&D costs. If we are trying to develop a new product or process, it’s fairly esoteric. It’s almost easier to say what doesn’t qualify when you look at that list. Quality control that’s not research and development: consumer surveys, advertising, none of that qualifies. Acquiring a patent from someone else that doesn’t qualify. And then, interestingly, soft sciences don’t qualify. So it’s got to be hard sciences in nature. It’s got to be engineering, computers, physics, chemistry, and biology.

The second one is discovering technology information tests, meaning you’ve got to rely on what I just said: the biological sciences, engineering, computer science, the hard sciences, etc. The only other part that needs to be mentioned is a safe harbor and that if I’m pursuing a patent, I’m automatically in. Anything you do that you will patent is research and development. So that’s a good little thing to remember.

So now we’re on hurdle number three, which is the business component test. And that’s when you must develop some type of product process software. There’s got to be a component you will add to your business.

The last hurdle is the process of experimentation. This blends in with the first one that I went over. You need to show that you’re going through the steps of doing research, finding alternatives, testing those alternatives, finding uncertainties, and figuring out the uncertainties. There’s got to be a scientific process that you’re following. It’s my experimentation. We all learned that when we were in biology class in college: following that process and developing something new.

Andrea
So, okay, but then do you have to show what was achieved, or is it just the process?

Dan Chenoweth
It’s the activities. So you don’t have to show that we did this and we produced this. It focuses on our activities to obtain X. Maybe we didn’t. Maybe we went to develop a new product, and it failed. But the activity was there when we researched to reach that point. And so that’s where the focus is. And then speaking of that, a good thing to lump in here is what expenses qualify.

We have to look at wages first to get to our 5% to 7% of expenses. So anytime you’re paying an employee in the US, it is very important…. it can’t be a foreign employee, it has to be a US employee, and those wages qualify 100%. If the person is 50% research, 50% something else, you take half the wages. So anything that we’re paying, that’s obvious. Any supplies that we are buying to develop the new product or whatever.

Those are all things that we can deduct. Now, thirdly, and this is where it gets a little interesting, is contractors. If I’m hiring someone else to come in and conduct research with me, we can still take it, but only at 65%. So we only get a little bit of that. The one caveat there is renting computer ability. For example, you can take all that if you’re using AWS or Google Cloud. That’s fairly common now, so they’ve allowed that not to be lumped in with that contractor limitation. And so that’s the three main avenues we’re going for. Contracted expenses, supplies, and wages.

Andrea
So let’s just say I have this company. I have a business and hire somebody to work with me on building the better mousetrap, right? And so I can take the credit up to 60% of the cost of that contractor’s work.

Dan Chenoweth
Well, no, but using the mousetrap example, if the person you hire is fully devoted to developing that mousetrap, 100% of their wages qualify. The wood, the metal, the machine to bend the metal, all supplies, expenses, and all deductibles. And then, if you hire a third party to come in and take care of the mice you use in your experiment, they’re limited to 65%.

Andrea
Okay, that will tell me whether or not it’s a better mousetrap. So how do they get started? How would anybody take advantage of this?

Dan Chenoweth
I think that’s where you need a good CPA. A good consultant that’s going to ask the question. If you hear this and ask the question, I think that’s it. Usually, with a phone call, I can start figuring out whether we need to pursue this in 10 or 15 minutes. What are you doing? How much are you spending? I mean, that’s always a big part of it. If you’re spending $50,000, it’s probably not worth your effort. But if you’re spending $600,000, we have something to look at here.

Once we get to that point, we can dive deeper. And I mean, in a couple of days, we’ll know the likely benefit. Then, the credit studies will take a couple of weeks. Much of it’s just gathering the documentation and generating the report so that we feel comfortable and ready to fill out the form and claim the credit.

Andrea
So is this something that is part of the tax code? Is it something that Congress or the IRS would have to say, yes, we’re renewing it? Or since it’s been around, you said, since 1981, is there any threat that it would ever go away?

Dan Chenoweth
No, I don’t think there’s any threat that it’ll go away. And it’s funny enough, I wasn’t going to bring it up in this conversation, but it’s probably worth bringing it up. We’re in a strange era with R&D tax credits right now because you could deduct your R&D expenses for the longest time and claim the credit, which you still can. But in 2017, with the tax law change, there was a, and I don’t know if it was intentional or unintentional, but there was a part of that law that required that we amortize R&D expenses. If you choose to claim R&D, you’ll have to claim the credit, and you’ll have to amortize your expenses over five years. And oftentimes, if somebody is just now becoming aware, and you start analyzing it, there’s not a great benefit. There is an eventual benefit.

The one caveat is that if you’re in that startup phase and claiming a loss, that’s one area where it’s true. That law is going to be corrected and changed. Congress has said they’re going to change it. When will they get it attached to something that passes and gets signed? So everybody is waiting with bated breath this year, an election year, for it to happen finally. That will open up the doors for many new credit claims, and we’re waiting on that.

So it’s a good time to have this conversation, and it’s a good time for business owners to ask their CPAs whether or not they have any activities that will qualify for the research and development credit.

Andrea
We talked with Lori Roberts a few days ago about PTET and SALT. We learned that every state has different tax laws. Is this a federal program, or is it a state program?

Dan Chenoweth
That’s a great question. It is a federal program, but many, many states, Virginia included, have their own R&D credit that goes right along with it. So if you’re claiming it for federal, there’s a good chance you’ll be able to do the same on your state tax return.

It depends on the state, and it usually goes because states want to generate economic activity. Research and development are key components of that. You want to attract the businesses that are doing research and development. So, states are usually very friendly to federal law in this regard.

Andrea
So the pandemic changed a lot of things. Are you seeing an increase in these claims in R&D tax credits? Because people decided I’m going to start my own business, or I’m going to do my own thing?

Dan Chenoweth
That’s interesting. It’s like the answer to that is no. It goes back to that conversation we had a minute ago about the change in law, which now requires you to amortize your expenses. It really put a wrench in the R and D process. Everybody is continuing to claim it year after year, but the new claims have slowed because of that.

And so that’s kind of what I was saying. If someone approaches and says yeah, we’ve got $600,000 of R&D expenses, and I’ll come back and say, oh, you’re eligible for X number of dollars of credit, but you can’t deduct your $600,000 in one year. They often say that doesn’t sound like a good deal to me. Do I have to spread that $600,000 over five years? And so it has created a real issue in the research development world. Currently, right now, there is a bill in Congress that has the fix, and when the fix goes through, it’s going to open the doors, and I’m pretty certain it’s going to open the doors backward and forward. So, we’re waiting. When that happens, it’s going to get really exciting. For accountants, it is exciting. That’s what we’re waiting for.

Andrea
I think you guys are exciting. I get to work with you all the time, and I always have the best conversations with you. I think it’s actually exciting. I think saving money or getting offsets is also exciting. I want to go back when you made the distinction that it’s not a deduction; it’s a credit. You hear that people will write off expenses, so that’s a deduction.

Dan Chenoweth
It is, yes.

Andrea
So, can you please go back a little bit and flesh that out a little bit more?

Dan Chenoweth
That’s a great point. For example, I’m paying the wages for somebody to do the research and development. I’m buying the supplies. The wages and the supplies are deductions on my tax return. They’re deducted against the money that I make. I’m still gonna claim those deductions. Now I may have to amortize them. That’s taking it a little too far but simplifying it. I’m deducting wages, I’m deducting supplies. Now I can take the wages and supplies and claim a credit of five to 7%. So it’s almost like a double benefit. I get to deduct them and then I get to qualify for the credit at the same time. The best way to explain the tax credit is if my business made a million dollars and I’m a corporation, I will have $210,000 in tax. If I claim a $50,000 research and development credit, my $210,000 in tax goes down to $160,000.

A credit reduces the actual tax that I have to pay. This credit is not refundable. It’s not like a PPP loan or something like that, where the government’s not going to write you a check for your research and development tax credit. But, under that scenario, I paid in tax $210,000 throughout the year. My tax bill would have been $210,000, but because I claimed the $50,000 credit, now I will get a refund of my tax of $50,000.

So you could end up having tax refunded, particularly if we qualify and go back in time for three years; we can go back and amend those returns and get refunds of prior tax paid. So, and that’s where this goes down a little bit of a rabbit hole. One of my favorite things to do as a CPA is to help people manage cash flow by saving on taxes or other avenues. And this is a great one because if we miss this, now we have an opportunity to maximize this and use it to reduce our tax and increase our operating capital.

Andrea
How often have you had an experience working with a client, and they come forward and say, wait a minute? Did you try this, and did you kind of go back?

How often does that happen? Every day?

Dan Chenoweth
Every day, all the time. That’s my life. Honestly, that’s one of the perks of being a partner in an accounting firm. By the time it gets to me, it’s at the end stage, and then I’m interacting with the client, and we’re looking at the finished product and looking for ways to decrease the tax.

I’m always in that kind of consultative space. And so this is just one of the tools we have throughout the firm. We have other experts in various areas that you can use. Like Lori and state taxes, making sure we’ve got all of our bases covered with this R and D tax credit because it’s one of those things where if you miss it, it’s like landing on the right space of monopoly. You know what I mean? There’s money that I can have. It’s not going to cost you a lot, and you’re probably going to get money back. And so that’s why it’s usually good news with tax credits.

Andrea
It’s usually good news. Okay, that’s good. So you may have said this, but how long does it take?

Dan Chenoweth
Give me a month—three to four weeks, I think. But most of the time, it’s going back and forth regarding what documentation we need. That’s probably the most of it. And then the work will take a couple of weeks. It’s not a long process. When you get to the Virginia credit, sometimes that one can get dragged on later, even requiring extensions, but the federal credit is a fairly straightforward process.

Andrea
Well, that’s good. All right, so I will see if I can summarize what I learned today and what our listeners have learned. This is a program designed to foster innovation. It’s designed to foster innovation, maybe enhance competitiveness, and spur economic growth by rewarding businesses that endeavor in research and development. And they don’t necessarily have to produce something. It’s just that they get credit for trying, basically, right? If they qualify, okay. They can be used for research, technological advancements, and product development. And it can go either backward three years or forward 20 years. That’s so cool.

Dan Chenoweth
Yeah, we can go back and claim it for three years. So that’s generally what you can do. If I claim the credit, but I can’t use it because I lost money, that’s when I can take it back a year and forward 20. You can apply to anyone, but the real beauty is in that startup phase. It’s probably easy if you’re developing a new product, trying to take it to market, and financing your operations through bank loans or issuing stock for equity. Whatever it might be, it’s easy not to think about this because your taxes are not an issue. But if you just consult your CPA or have a good consultive CPA, that will look at this and say, hey, let’s do this now. Let’s spend the money we need to claim this credit now. It went several years down the road. It’s going to have a real material impact on the amount of tax you have to have to pay.

Andrea
That’s great. So you mentioned there’s pending legislation, and we talked to Charles Dean Smith about some of that legislation. I’m assuming that you guys are watching this stuff like a hawk, and our blog is probably our best place to go. We send out all sorts of alerts on this. So there’s probably gonna be some movement here somewhere, right?

Dan Chenoweth
I think it’s what passed the House, and it’s waiting to go before the Senate. Nobody knows when for sure. I get daily emails, and I’ve checked them every few days. I’m trying to see if anything’s happening, but yeah, we’re watching it, that’s for sure.

Andrea
Cool. Well, all right. I think this has given people enough to think about it. You’re available to consult with these guys if that happens. Well, Dan, thanks for your time today. I know this is a very busy time, so you were very generous with us. Have a great weekend.

Dan Chenoweth
All right, you too, Andrea. Thanks.