The design, testing, and manufacturing of these products could all potentially qualify for the credit.
Some examples of credits claimed include:
- Heat sink manufacturer with $15 million in revenue generating a $900,000 credit
- Software security and manufacturing firm with $20 million in revenue generating a credit of $235,000
- Medical start-up with $0 in revenue generating a $250,000 credit
What Activities Qualify for the R&D Tax Credit Within the Hardware Industry?
The hardware industry can be simplified into the following categories: engineering and design, testing, and manufacturing.
Engineering and Design
- Design of components used in super computers—chips, circuit boards, and more
- Medical devices, such as braces, tools, and specialized equipment
- Heat sinks used to cool components in complex or high-speed processor applications
- Display modules in aircraft and other aviation applications
Testing
- Performance batch testing for new components for a computer manufacturer
- Stress, heat, and other mechanical testing to verify the component meets performance standards for the application
Manufacturing
- Process design to accurately and efficiently produce new components and hardware
- Design improvements to an existing line to increase through-put of the production line
- Evaluation and testing of new specialized equipment to increase the efficiency of a facility’s production line
Which Expenses Qualify for the R&D Tax Credit?
The R&D credit may be a highly beneficial opportunity for companies in the hardware industry. The tax savings provided from the credit can be used to invest in new equipment or hire highly technical personnel.
Examples of Qualified Research Expenses
Taxable wages paid to employee personnel who conduct qualified research during the year are considered qualified research expenses. Applicable personnel includes engineers, technicians, quality assurance, and managers who design, test, and produce new products for the company.
Relevant examples include:
- Engineers developing autonomous vehicles or new circuit boards for cell phone manufacturers
- Mechanical and process engineers developing new procedures to increase the efficiency of manufacturing new products
- Technicians testing prototypes to develop design improvements
- Contractor and third-party vendors performing qualified research on behalf of the company
- Supplies and prototypes developed for new products—including testing supplies consumed or destroyed during the development of a new product
The success of a prototype doesn’t determine the eligibility of a supply cost. The more a company fails to produce a working product is better for capturing those expenses for the credit.
How Is the R&D Tax Credit Calculated?
To be eligible for the credit, R&D activities must meet IRS criteria known as the four-part test to:
- Demonstrate you’ve attempted to eliminate uncertainty about the development
- Establish you underwent a process capable of evaluating alternatives
- Prove your experimentation relies on science
- Demonstrate the research intended to create a new or improved business component
Completing the steps to pass the four-part test may sound overwhelming and can drain precious time and resources should your business pursue it on your own. Claiming credits incorrectly can also result in the loss of credit and possibly penalties from the IRS.
Learn the step-by-step approach for claiming the R&D tax credit in our article.
How Long Can R&D Tax Credits Be Carried Forward?
If the federal R&D credit can’t be used immediately or completely, any unused credit can be carried back one year or carried forward for up to 20 years. Each state has its own carryover rules.
In addition, previously filed tax returns can typically be amended for up to three years to claim the R&D credit retrospectively, providing an avenue to recoup previously paid taxes.
New or small business may be eligible to apply the R&D tax credit against their payroll tax for up to five years. The R&D credit is available both at the federal and state level.
What Are the Limitations of R&D Tax Credits?
There are no strict limitations on R&D tax credits when claiming federal credits for a given tax year in terms of a dollar limit. The main factor companies should consider when claiming the R&D credit is whether or not they can utilize the calculated credit amount for a specific tax year. As mentioned, unused federal credits can be carried forward for up to 20 years.
However, the payroll offset option is limited to $500,000 per year for the first five years a company has gross receipts if the company has less than $5 million in gross receipts for each year.
How Does Your Company Apply for These Credits?
If you think your company may qualify for the R&D credit, the first step is to collect preliminary information about your company’s potential qualified activities.
The relevant information is used to develop an estimate of the credit benefit your company could receive as well as identify other R&D-related tax planning opportunities—so you can make an informed decision about whether an R&D credit analysis is worthwhile for your company.
How Do the Capitalization Requirements for Internal Revenue Code Section 174 Expenses Impact the R&D Credit?
The Tax Cuts and Jobs Act of 2017 (TCJA) made significant changes to the way businesses can deduct research and experimental (R&E) expenses. Beginning in the 2022 tax year, businesses are required to capitalize and amortize R&E expenses over five years for domestic costs and 15 years for foreign costs. This change means that businesses must now capitalize R&E expenses, including any software development costs.
Capitalization of R&E expenses doesn’t affect the amount of expenses that can be claimed for the R&D tax credit. The R&D tax credit is still calculated based on qualified research expenses (QREs), which are a subset of R&E expenses that meet certain criteria. This means hardware companies may still be able to claim the R&D tax credit even if they must capitalize and amortize a portion of their R&E expenses over a longer period.
We’re Here to Help
To learn more about R&D tax credits, see Five Misconceptions about R&D Tax Credits—and if Your Company Qualifies, or request a complimentary credit benefit estimate to see how much your company could save. You can also reach out to your Moss Adams professional.
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