Create the Perfect Format to Bill Client for Research and Development

Format to bill client for Research and Development

welcome to our research and development tax credits webinar pbkg was established in 1999. we have offices across the u.s including illinois pennsylvania arizona ohio georgia new york texas and pasadena california where we are headquartered we provide turnkey tax solutions to cpas and businesses our engineers and tax experts have performed thousands of tax projects resulting in hundreds of millions of dollars in benefits for our clients our team is a diverse mix of tax professionals attorneys engineers and economists from various disciplines this combination of talent allows us to be the best at what we do and maximize results for our clients abkg is a preferred provider for thousands of cpas across the country now i'm going to introduce our speakers for today michael mourini is a director with kbkg and advises clients on tech related to federal and state research and development tax incentives he has over 20 years of experience working on tax reviews ranging from sophisticated multi-year claims different consulting projects he has advised numerous fortune 500 clients across a variety of streets including aerospace and defense manufacture culture pharmaceutical communications industrial products consumer goods software technology and energy water pc is a senior manager with work into the research credit department she has eight years of consulting experience providing r d tech credit services to companies ranging from architectural and engineering food and beverage software development cosmetics manufacturing automotive and aerospace and defense she received her bachelor's of science in biology from the university of california san diego now i'll turn it over to our speakers for the presentation here's agenda with the items we're going to cover on this webinar we'll start with a brief legislative update next we'll discuss the r d credit opportunity then we'll cover the tax definition of r d activity we'll explain the two federal calculation methods and walk through a couple examples to show the mechanics then we'll wrap up discussing task planning and audit strategies finally i would encourage you to submit your questions in the chat box and we will answer as many as we can go let's get started the section 41 credit for increasing research activities was originally enacted in 1981 at the time it was a temporary code section and stays as such until it was permanently extended as part of the path act of 2015. the section 41 credit is a federal statute however most states offer some form of research credit that borrows from the federal statute although there are billions of dollars worth of research credit claims every year in the united states there are still billions of dollars of credit that go unclaimed this is primarily due to many taxpayers not being aware of the credit or not quite understanding it this webinar will attempt to clarify some of the nuances of the r d tax credit the path fact made three very important changes to the r d tax credit first and foremost the r d credit has now been permanently extended allowing taxpayers that have traditionally taken advantage of the credit can continue to do so the second big change is that the r d credit can now be used to offset a portion of payroll taxes for qualified small businesses and lastly qualified businesses can now use the r d credit to offset alternative minimum tax effective for tax years beginning after december 31st 2015 qualified small businesses can now use up to 250 000 of research credits to offset a portion of their payroll tax a qualified small business is defined as a person or entity with less than five million dollars in gross receipts and no gross receipts before the five year period ending with the current period for example if a taxpayer wanted to make the election in 2020 the taxpayer could not have had gross receipts prior to 2016. if the taxpayer had gross receipts in 2015 this particular taxpayer could not make the election in 2020 additionally taxpayers cannot make the election for more than five years please note gross receipts are not required in order to make the election therefore a company that has no gross receipts but does have payroll taxes and a research credit can make the election if a company is not a partnership or s corp only the amount of the r d credit carry forward can be applied to offset the payroll tax the election starts the first quarter after the federal return is filed if a taxpayer files their 2020 tax return in march of 2021 the election will apply to payroll taxes beginning in the second quarter of 2021. startup companies in a multitude of industries are great candidates for the payroll tax offset for example startup fintech biotech and software development companies should review their potential as it pertains to research credit generally these startup companies are in a taxable loss position and not generating a tax liability now the credit can be used to offset the payroll tax expense and generate a large cash benefit here is an example of how the payroll tax election can help a qualified small businesses in this example a software developer began operations in 2019 the company is made up of 15 individuals and did not receive any gross receipts until 2020. in 2020 the company had eight hundred thousand ingress receipts qualify wages of two million dollars resulting r d credits of 200 000 and a payroll tax liability of 125 000. this company will file their tech 2020 tax return in march of 2021. prior to pathfact this taxpayer could have claimed the research credit but will not have been able to use any of the credits until they had taxable income due to the path act they will be able to offset the qualified portion of their payroll taxes in the second quarter of 2021. any unused credits will be carried forward to subsequent quarters until fully utilized the amt provision in the path act is equally as valuable to taxpayers prior to pathfact research credits could not be used to offset alternative minimum tax taxpayer and amt were forced to carry their credits forward until they came out of amt eligible small businesses defined as averaging less than 50 million dollars in gross receipts the previous three years can now use the credit to offset amt for tax years beginning after december 31st 2015. this provision is similar to a previous small business provision enacted in 2010. one item to note is that amt reduction is not available to publicly traded companies prior to path act taxpayers that had an emt liability could not use a research credit to offset taxable income in this example the taxpayer generated a research credit of 300 000. their tax liability is made up of 158 000 of regular tax liability and 23 000 of amt liability which amounts to 181 000 of total tax liability this taxpayer could not use any of their credits in 2015 and were forced to carry their entire r d credit forward for the tax years beginning in 2016 the taxpayers and amt are now able to use the research credits to offset their tax liabilities in this example the taxpayer generated 331 000 in research credits their tax liability is made up of 188 000 of regular tax liability and 31 000 at amt which results in 219 in total liability applying the section 38 rules as well as the new rules surrounding the path act allows the taxpayers to offset about 178 000 of tax liabilities prior to passback this taxpayer would have had to carry their entire research credit forward as a result of the new rules this taxpayer will offset a large chunk of their tax liability and carry forward access credits by eliminating the amt's tentative minimum tax for corporations the law allows a research credit to reduce a taxpayer's liability down to 25 of the amount of net regular tax liability that exceeds 25 000 a limitation imposed by section 38. for example 100 888 000 minus 25 000 equals 163 thousand multiplied at 25 percent is at 40 about 40 000 total tax liability after the credit so let's dig into what is the r d credit opportunity uh the r d credit is a general business credit and as such it provides a dollar for dollar reduction in a taxpayer's income tax liability the credit is subject to irc section 39 carry back and carry forward rules so as such any unused credits can be carried back one year first and then forward for up to 20 years for federal purposes the credit is available to corporations and individual business owners as well as pass-through entities such as s-corps or partnerships and in the case of those pass-through entities the benefits flow through to the individual shareholders on each shareholder's respective k-1 so here's a chart that represents the total amount of the federal r d credits claimed since 2005. it's estimated that over 19 billion dollars of r d credits will be claimed by companies in 2020. and here's a chart that represents the size of those businesses that are claiming the r d credit roughly 87 of companies claiming the credit have revenues in excess of 100 million dollars while the remaining 13 percent is split between companies with revenues less than 100 million and less than 10 million respectively now there's no cap on the amount of the credit at the federal level so we encourage you that if you have a client or if you are a business that can benefit from the r d credits make sure that you're aware of this benefit and with changes resulting from the path act as a lease outlined we anticipate that more small and mid-sized businesses are going to be claiming a larger share of this pie going forward so now would be a great time to revisit this with your clients make sure that they're aware of the opportunity and not missing it now the federal r d credit offers roughly six and a half cents for every dollar spent on r d activities in addition to the federal credit many states also offer an r d tax incentive as well mostly for r d taking place within the state and these are only a few examples the methodologies vary but most follow the federal definition as well as the federal calculation with various with variations on the credit rates the refundable nature of the credit as well as any carry back or carry forward provisions and as of this year these are the states that currently offer an r d credit most of these states offer a credit on the same qualified expenses claimed for the federal credit and may be claimed in addition to the federal credit so if you or your clients are conducting r d within any of these states make sure you're looking into the state r d tax benefit as well something to note here arizona and illinois both extended their credits arizona through december of this year through december 31st and illinois through december 31st 2026. oregon's credit has expired as of december 31 2017 so its r d credit applies to only to open tax years and most recently virginia extended its credit through january 1st 2025 and it also increased the total amount of the credits available now r d credits can be found in almost any industry there is this is just a list of some of the industries where research credits are readily identified basically if your client is developing something new or improving an existing product or process regardless of the industry they are conducting r d activities eligible for the credit now this slide shows the most popular industries where companies are taking advantage of the federal r d credit it's probably no surprise that manufacturing leads this list followed by software developers in and then engineering and scientific services so you'll see that the the vast majority of the r d credits being claimed are in those top three industries so if you if you or your clients fall within any any of these industries on here there's there is a a benefit to look into now this slide shows a short list of some of the studies we've conducted and i don't show you this slide to brag i really want you to pay attention to this slide more than any others to to to just see are your clients or are you as a business doing any of these types of activities because if you are these are the industries and these are the activities that we have been successfully been able to claim for the r d tax credit so let's go through some of some of these uh starting at the top with formulations so if if you're formulating either new organic foods spices beer or wine if you're experimenting with new ingredients and new processes or techniques you can claim the r d credit for those activities does in manufacturing the design and testing of new prototypes or experimenting with new processing techniques in order to gain a competitive advantage those activities qualify as well in software development whether it's developing a software for back office applications video games mobile or web applications or computer animation those activities can qualify as well uh defense contractors can qualify you know so it's a misconception that if the government is paying you for the r d that you are performing that you don't qualify for the credit based off of those expenses and that is simply not true so if you're a defense contractor developing about developing parts for systems or ships or planes or vehicles those activities can qualify also pharmaceuticals if you're a pharmaceutical company developing drug formulations or conducting testing for humans or animals those activities qualify as well and then in the mining industry whether it's developing innovative extraction techniques or delivery processes for the oil and gas industries those activities qualify for the credit as well so next elise is going to discuss what activities and who qualifies for the credit elise thanks michael so often when a reference is made to research and development taxpayers think about lab codes and test tubes in reality the r d credit tests are much broader in application and provided we need the following tests we have an opportunity to claim the tax credit for activities to qualify for the research credit there are four tests that need to be met these tests are applied at the business component level it's important to note that a business component can be a can be defined as a product a process technique a software or a formula the first test is called technological in nature the project must fundamentally rely on the hard sciences such as physical science biological science computer science or engineering the second test is permitted purpose this has to do with objective behind the research the objective must be to improve the functionality performance reliability or quality of a new or existing business component the third test is called elimination of uncertainty at the outset of the project there must be a degree of uncertainty related to the appropriate design of the business component or the capability or methodology for improving the business component the fourth test is process of experimentation which works in hand-in-hand with elimination of uncertainty test this requires that substantially all of the activities must constitute a process of experimentation which is defined as the evaluation of different alternatives to eliminate the technical uncertainty identified at the asset of the project to extend a project meets all four parts of this test we are able to capture the expenses associated with a project towards a research credit generally there are three types of expenses which qualify for the research credit they are wages supplies and contract research qualified wages are generally defined as a qualified portion of an employee's w-2 box one amount qualified supplies are items that are used and consumed in the research process for example materials used in prototypes supplies cannot be capital in nature therefore taxpayers cannot qualify land or machinery or equipment additionally general administ administrative expenses such as travel meals and entertainment and telephone expenses cannot be captured as a qualified supplies qualified contract research are 65 of the payments made to third parties for purpose purposes of qualifying research so now that we know what qualifies it's important to understand who qualifies there are three levels of qualifying activities for employees the primary level will be the individuals that are engaged in the qualified research these are the individuals that are working directly on the project from there taxpayers can capture one level directly above and one level directly below one level above would be the individual that are directly supervising those personnel one level below will be the individuals that are directly supporting the personnel generally any payments made to the third parties for conduct of research on our behalf are eligible to generate research credits it's important to note payments for contract research are subject to a statutory reduction this reduction is 35 percent but may vary depending on the type of organization now we'll go over a few qualified examples for employees direct supervisors can have both direct activities and direct supervision qualified time examples are reviewing technical designs communicating requirements and direct support examples are tesla equipment cleaning by facility maintenance staff compiling research data and creating experimental models the determining factor for qualification is the nature of activity to which expenditure relates qualified activities are applied at the business component level qualifier research activities activities are defined by the four part tests we just went over there is something called a shrink map rule which allows you to apply the qualified activities to the business component as a whole or to shrink it back to the smaller distinct components which make up the product process formula or software examples of qualifying activities can fall under several categories and this is this list is certainly not all inclusive including in this list are activities in the design stages of project including specification design technical design work cad design work and modeling and analysis prototype development which includes the design and construction of test product is also qualified activities testing and experimentation including computer modeling and simulation prototype testing and field tests are also qualified activities it's important to note that success is not required in order to in order for the project to qualify in fact when a development is unsuccessful from technical perspective it makes the uncertainties associated with a project that much more obvious and we can capture all the costs related to it non-qualified activities include any activities that take place outside of the united states additional examples include any adaptation of an existing business component any duplication or reverse engineering of an existing business component is also non-qualified activities any activities around the social sciences or humanities studies related to efficiencies management operations or profitability is also examples of non-qualified activities any routine data collection routine or ordinary qa testing is also non-qualified activities also funded research the taxpayer must retain at least shared rights to the technology under development and the taxpayer must also be deemed at risk for development it is deemed funded when the taxpayer is paid by customer under time and material terms it is deemed funded research if a taxpayer pays its contractors to perform research on their firm fixed price terms additionally non-qualified activities include activities that take place after the project is ready to be commercially released the following activities are deemed to occur after commercial production pre-production planning pre-production tooling trial production runs any troubleshooting production equipment accumulating data relating to production debugging flaws and business component after it is commercially released all right so we're going to get into now uh how to calculate a credit uh using both of the credit methods available and we're going to talk about we'll do a couple of examples to show you the mechanics of those calculations so first the the r d credit components here so the the federal credit is calculated as the sum of 20 percent of the company's qualified research expenditures or qres over a base amount plus 20 percent of basic research payments these are payments that are made to tax exempt organizations performing research on your behalf such as universities or scientific research organizations plus twenty percent of payments made to an energy research consortium now these are tax-exempt organizations as well they're focused on performing energy research typically funded by a small group of taxpayers with an interest in the results of those of that research now the credit is based on the qualifying activities conducted by the company or uh by those that the company pays to perform research on its behalf this is primarily a wage based credit so think of that when you're doing your scoping as to whether the candidate is a good candidate about 75 percent on average of the credit is generated by employee wages the other is split kind of evenly between supplies and outside contractors the credit is incremental in nature now what that means is that you don't get the credit necessarily on the amount of money you're spending in a given credit year you get the credit based on the difference or the incremental r d spend that you spend in the credit year over the base amount all right we're going to see when when elise talks about the alternative simplified credit method that companies that experience flat r d spend or even slightly decreasing r d spend can still take advantage of the credits using the asc method and that will be discussed as i said later in the presentation so there are two federal calculation methods available the regular credit or the alternative simplified credit the asc now both methods require calculating a base amount which accompanies current r d expenses much must exceed in order to claim the credit at the federal level now for the regular credit this base amount focuses on years 1984 to 1988. if alternatively if the company was not around during that time or if it was not performing qualified qualified research during that time then the base period shifts to activity occurring after 1993 and that's called the startup calculation if you're looking for the instructions on how to do that now for the alternative simplified credit or the asc the base amount involves only the three prior years qualified expenses now the election as to which method you want to choose is made each year on an originally filed tax return once made the company is stuck with that election for that tax year so if the taxpayer wishes to change its calculation method for a future year it can it just needs to be done on that original return however when you are amending a prior year return to claim the r d credit for the first time you can you can select either method at that point now for the regular credit method there are four items necessary to calculate the credit first is the qualified research expenses or qres the second item is the average annual gross receipts for the four prior years the third item is the fixed base percentage which is calculated as the ratio of aggregate qres over aggregate gross receipts for a specific period of time and the maximum fixed base percentage allowed is 16 number four is the base amount so you calculate the base amount by really comparing two different calculations first you to determine the base you compare the two numbers you multiply your average annual gross receipts by your fixed base percentage and then you compare that to 50 of your current year qres and whichever number is greater is your base amount this is the amount that your current year qres must exceed in order to get a credit and then at that point the credit rate is then applied to this amount to arrive at your final credit so this just as an example it's an illustration of a fixed base percentage calculation this assumes a base period in the years 1984 through 1988. which again means that the company was conducting research activities in at least three of those five years during this time period and in our example they're they have qualified research activities and expenses in each of those five years so to calculate the fixed base percentage we total up the qres for these five years and divide by the total gross receipts for the same period and for members of a controlled group of of companies qres and gross receipts for each member of that controlled group must be included in this calculation so i'll just emphasize that here that it's not just the companies in this controlled group that are uh performing research that you uh include the gross receipts for it's gross receipts for companies that even aren't doing any research they're still part of that controlled group and that gross receipts will actually raise the bar that you have to clear in order to claim the credit in this regular credit so in this example the fixed base percentage is 2.3 percent so in the next example here we've got a company with a current year r d spend of three million dollars the average annual gross receipts for the four prior years are 75 million we next compare the tentative base amount to the minimum base amount the tentative base amount is 1.7 million which is 75 million times the fixed base percentage of 2.3 percent comparing this to the minimum base amount which is the the three million dollars in qres multiplied by 50 percent we see that the tentative base amount is larger and therefore we use that as our base amount subtracting the base amount from our current year r d spend yields 1.2 million in incremental r d we multiply this by the 20 credit rate to get the gross credit and then again by 79 percent if the irc section 280c reduced credit is elected so let's explain a little bit about what that 280c reduced credit election is it's available for either method the regular credit or the alternative simplified credit but in general if you if you claim a credit that the gross credit let's say if you claim a credit it must be claimed uh that the amount of that credit gets added back to income you pay taxes on that and the the uh the theory is is that the the credit is going to more than offset the amount of the additional tax you would pay anything left over gets applied to that uh to your original tax liability uh on that amended on that amended return now so let me just say this the gross credit must be claimed on an amended return another way of saying that is that the 280c reduced credit is only available on a timely filed original tax return if the gross credit is claimed on either an original or an amended return you must reduce the amount of the company's deductible expenses by the amount of the gross credit so to avoid this it is generally advantageous for companies to elect on an original return the 280c reduced credit which reduces the credit by 21 percent but requires no adjustments to be made for the deductible expenses because the credit and a deduction cannot be claimed on the same r d expense now let's look at alternative simplified credit or asd method the asc is calculated calculated by applying a 14 credit rate to the current er qres that exceed a base amount the base amount is a prior prior three tax periods as such a major benefit to using the ast methodology is that requires much less historical documentation the asc may be a great option for older companies which may not have records to support their regular credits regular research credit base period and big space percentages furthermore companies with large references amounts in recent years could benefit from the esc methodology large amounts of gross receipts increases your regular credit base amount which reduces your credit an important item to note is recent law change allows companies to amend returns to claim the asc where the regular credit required a fixed base calculation and average annual gross receipts the ase method needs only qres wages supplies and contract research for the credit year and the three prior years the base amount is calculated by simply taking 50 percent of the average qres for the three prior years subtracting the base amount from the current year qres and multiplying by 14 is the amount of alternative simplified credits for the current period so in this example we have a company with 3 million of qres its base amount is about 1.1 million that leaves current year qra is available of 1.8 million we then apply the 14 credit rate and get alternative simplified credit of roughly 262 000. if we elect the 280c reduced credit this reduces the credit by 21 to on 207 000. remember the 280c election is only made on an original return and provides an easy way to avoid having to make adjustments to the deductible expenses it also provides you a lower starting point for income when you start your state returns on this slide we have a case study involving a software development company with wage expense of 1 million of which 500 000 qualifies we would expect approximately 50 000 of federal research credits on the next slide we have an example involving a manufacturer their qualifying activities include concept development specification design evaluating alternatives prototype testing and prototype refinement and etc with wage expense of 3 million of which 800 000 qualifies we would expect approximately 80 000 of federal research credit all right so let's wrap up uh so the the as far as tax planning items here i've got a few bullet points here i want to address one we talked about the electing the 280c on a timely filed return you know and in doing so you do not have to reduce your r d expenses another way of saying that is electing 280c on a timely filed return you do not have to add the amount of the credit back to income and pay tax on that you take a reduced credit up front and no no adjustment to our to expenses have to be made now if a client is a flow-through entity and they are not in the highest tax bracket you may not want to elect the 280c so the the election of the 280c being beneficial is something that usually is uh for the highest uh tax bracket so what i encourage you to do is to run the calculation with the 280c and run it without and whichever is is is the best uh solution for your client that's the one that you that you choose don't just automatically assume that the 280c is the is the best option um also if you are in if your if your client is in losses in a in a closed tax year bumping up against a uh an open tax year uh let's use 2016 for example if 2016 17 is an open tax year 2016 is a closed tax year so if you had losses in 2016 there is revenue ruling and guidance that that will allow you to go back to 2016 calculate a credit and be able to carry that credit forward to an open tax year to offset uh tax liability and we've included that on this on the slide there also just to revisit amt starting in 2016 eligible small businesses can now apply the r d credit against alternative minimum tax so we're going to talk a little bit about some irs audit considerations number one treasury has an audit technique guide that is publicly available it focuses on the areas that are commonly looked at under audit i will say that our kbkg's final client deliverable seeks to address the most common questions that the irs asks when conducting its audits number two the the irs continues to target the use of estimates uh even though the courts have ruled on more than a few occasions that credible estimates may be used to determine qualified expenses also oral testimony so long as it's credible may be relied upon to determine qualified activities surrounding its business components and then number three documentation supporting the r d activities as well as the expenses related to the development continue to be a major focus of the audits although there is no uh clear guidance as to what constitutes contemporaneous documentation other than permanent books and records sufficient to establish the amount of the credit i would say the more relevant the documentation is to the activities you performed and the expenses that you incurred the better and to that extent what i'd like to do is to share with you this last slide showing really the sample documentation or examples of some contemporaneous documentation that we would request during the course of an r d credit study and really this is just to get a head start on if there is ever if this is ever audited uh that we have good documentation that shows that the four-part test was met and and these were the the the people the supplies and the uh the outside services that were that were paid for and these activities incurred and these are the this is the evidence of that so really what the irs is looking for here is a nexus between the qualified projects and the activities as well as the nexus between qualified projects and qualified individuals so what i advise my clients is when it comes to contemporaneous documentation is look at where your qualified expenses are coming from if you if you have highly qualifying individuals software developers for instance let's say you've got you know 10 software engineers that's all they do is they create code and do programming for new video games let's say so they're going to be you know nearly 100 qualified uh and so you you if that's where your qualified expenses are coming from then you want to focus your documentation on those individuals that are performing that research and get good documentation from that on the on the flip side if you are a manufacturer and you're let's say an engineering consulting firm and you've got four engineers five engineers and you are developing you know these massive systems for customers and where the prototype supply costs are dwarfing the uh employee wages uh then that's where you're going to want your documentation focused you know the uh if the irs or taxing authorities at the state come in uh they're going to look at the low-hanging fruit and as to as to to target and reduce your your credit and those are going to be those expensive costs so make sure that you're you're tailoring your documentation uh and pulling that contemporaneous documentation to support the qualified expenses that you have another thing that i would say is highly paid individuals you should have you should be prepared to explain how that uh that additional expense wage expense relates to the r d work that was performed michael's and alisa's contact information can be found on this slide if you have any questions about the material that was covered or would like to discuss an opportunity please give us a call kbkg also offers other webinars that may be of interest to you i invite you to check them out at kbkg.com webinars