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BNA Tax Management | Weekly State Tax Report
December 23, 2011
By Dean Zerbe and Jeremy Fingeret, alliantgroup
The federal research and development tax credit expires at the end of 2011, but state R&D credits, offered in 35 states, are not dependent on the fate of the federal tax break. Nevertheless, many small businesses are unaware that they qualify for R&D credits. In this article, authors Dean Zerbe and Jeremy Fingeret of alliantgroup discuss some of the errors that businesses make in applying for the credits and suggest strategies they can use to defend claims of credits in a state tax audit.
The Often Overlooked Research and Development Tax Credit: A Federal and State Tax Savings Many Businesses Are Missing
The Research and Development (R&D) tax credit is the largest federal tax credit for business and is often one of the most generous state tax credits for business. While the Fortune 500 sharpen their pencils and take good advantage of the R&D tax credit, the reality is that at both the federal and state level far too many companies – especially small and medium companies – fail to realize they are eligible for this tax benefit. This failure to consider whether a company is eligible for the R&D tax credit is unfortunate given that several states have enacted a refundable tax credit in recent years that benefits small business.
Relationship Between the Federal Credit and State Credits
While the roughly 35 states that have an R&D tax credit vary considerably state-by-state in the generosity of the credit, almost all of the states basically follow the definition of R&D provided in the federal statute (although not a surprise the states require that the R&D be done in the state). Qualified research expenditures for the federal credit will qualify for the state credit as a general rule.
The federal R&D credit is subject to a continual stop-go-stop from Washington, D.C. – thanks to the credit only being extended for one/two years at a time (and often retroactively) and not being made permanent law. Happily, the state R&D credits have separate and often much less frequent termination dates, are in many cases permanent law, and are generally unaffected by the fortunes of the federal credit. Currently, the Federal R&D tax credit has been enacted through the 2011 calendar year. That said, we strongly expect Washington, D.C. to extend the federal R&D tax credit – although it may be late next year (post-election) when it happens. However, accountants and business owners should be taking advantage now of the state credits as well the open years for the federal credit in addition to preparing for the federal credit's inevitable extension.
State R&D Tax Credits
Given the difficult economy, a number of states have sought to encourage economic development with a more robust R&D tax credit. Balancing this good trend has been the reality that states are facing tight budgets – with the result that in some states the R&D tax credit is all sparkling champagne at the bill signing ceremony but goes flat in actual practice.
As mentioned earlier, a number of states have recently enacted a refundable state R&D credit. Refundabilty is hugely beneficial to the thousands of start-up companies, new companies and struggling companies that aren't making a profit. After all – a non-refundable tax credit does little good for companies not paying tax.
The top state credit would certainly be Minnesota. The credit is 10% of the first $2 million dollars in qualified research above the base amount (and 2.5% after that). Businesses claim the credit on their state tax return.
Louisiana has on paper a generous credit – but the very generous credit for small businesses is still is going through some birthing pains. The base amount in Louisiana for companies with 50 or more employees is similar to the federal Alternative Simplified Credit (ASC) with a base amount of 70% of the average of the prior 3 years' state QREs. Companies with less than 50 employees receive a flat 40% credit.
New York has a robust program – the Qualifying Emerging Technology Tax Credit -- but unfortunately this is the rare example of a state R&D program that is being discontinued. The program ends in 2011 without intervention from the legislature. Action by the legislature may be on the horizon in the near future, but we won't count our chickens before they're hatched.
Iowa, West Virginia and Hawaii also have refundable credits. Arizona and Virginia have refundable credits as well – but these credits are hamstrung by limitations on overall caps and dollar amounts.
A strong number of states have an R&D tax credit that – while not refundable – provides a significant benefit to businesses. States that stand out include: Arizona which has a credit of 24% for the first $2.5 million in Qualified Research Expenditures (QREs) over the base amount, and 15% for all additional QREs, and California with a credit of 15% of QREs over the base amount.
The Two Biggest Mistakes
Business owners and tax advisors make two classic mistakes when it comes to the R&D tax credit: 1) not recognizing they are eligible for the credit; and, 2) undercounting their expenditures that count for the credit.
Self-Censoring
Time and again we still encounter the view that the R&D tax credit is for companies that have labs, white coats, and a lot of rocketry. Nonsense. The R&D tax credit is intended to benefit a vast range of endeavors and activities – and especially the application of technology and knowhow to solving the problem at hand. Yes, the shopfloor, the men and women with dirty hands – they can be doing R&D.
Unless your business has been making the exact same widget the exact same way for the last ten years (really? are you still in business?) – you are doing research and development. The key turning point was when the old proposed Treasury regulations were pulled down in 2001 – ending the “discovery test.” No longer were businesses saddled with the impossible burden of showing that their work was new to the world. Now the R&D only has to be new to the business. There is no requirement for patents for the R&D tax credit.
Common mistakes we see are that it isn't R&D if you are: a) applying known scientific principles; b) you know you can solve the problem you just don't know how; c) it is being done for a client; and, d) it is just a modification of an earlier product. Wrong. All these activities are eligible for state and federal R&D tax credits. In addition, it is not just the product itself – but if you are improving how you make a product – the manufacturing process – that also can count for the R&D tax credit.
Big picture – these credits are for real companies operating in the real world. You don't need theoretical physicists on staff to qualify (although they don't hurt).
Perhaps the best way to appreciate how breadth of the R&D tax credit is to consider the businesses that have received the credit: software; heavy and light manufacturing; pharmaceutical; petroleum; architecture; engineering; food production; and agriculture just to name a few.
Undercounting -- Leaving Dollars on the Floor
While some companies and tax advisors recognize that they may be eligible for the R&D tax credit, too often they fall into the second mistake of undercounting significantly the dollars that will count as QREs for the credit.
It is understandable that both companies and financial advisors will simply ask for the “R&D expenses” file and begin and end their review with that file. One of our strengths is having not only CPAs and lawyers involved in reviewing an R&D claim but also bringing in our technical experts – chemists, engineers, etc. to talk on an expert level with their counterparts at the business. These discussions consistently lead to a much more complete understanding of the R&D that is being conducted by a business. That better understanding translates into a significant increase in the tax credit and dollars in the pocket of the business.
Further, the tax code definition of what counts for R&D (example, supply, supervisory and support costs) are often at a variance with the company's own recordkeeping – again, leading to undervaluing the credit for a business.
Knowing the law and knowing the facts will go a long way to ensuring that businesses take full advantage of the R&D tax credit. One best practice note: businesses – particularly businesses that have historically done their R&D tax credit calculations in-house – would be well-advised to have an independent review to ensure that they are current with the morass of federal and state law and regulations (including recent caselaw that has been very favorable to the taxpayer). We have conducted a number of such reviews for major companies and it has been eye-blinking the dollar amounts that some companies have been able to recover (and it is nice to know CFOs can smile).
The Tax Man Comes Knocking
The general rule has been that the states' examination and audit of the R&D tax credit has followed (or piggybacked) the IRS examinations. The IRS has historically had a strong focus on the R&D tax credit but there is change in the wind.
The IRS is changing its primary focus to international tax transactions (especially 482 transfer pricing issues) as well as offshore banking. The IRS recently announced it is ending its traditional “tier” issues (of which the R&D tax credit was a tier one issue) and is replacing this with a new “knowledge management” process – issue management groups. A graceful way for the IRS to exit from the tier program -- which had become somewhat ossified.
Part of the reason for the IRS's actions vis-à-vis the R&D tax credit is due to ongoing discussions between the IRS and practitioners, including the authors, about best practices in R&D credit studies performed by consultants. The ongoing dialogue we have with the IRS has been fruitful in improving our R&D studies and ensuring that they continue to be responsive to IRS priorities and concerns. We have seen this continual effort for improvement of R&D studies reap benefits in working with the IRS and with state tax officials as well – who often look to the IRS for guidance.
However, states are facing hard times and the Department of Taxation is looked to by Governors to bring in the money. We have seen in our audit defense work a hard press across the board on businesses – and that certainly includes the R&D tax credit.
We have found that it is vital to approach a state examination with the utmost seriousness – as if preparing for trial (and at a minimum preparing for administrative appeals). A key part of this is from the beginning framing the examination and the scope of the audit. With the R&D tax credit, it is hard to emphasize the benefit (at both federal and state level) of having a technical expert (engineer, chemist, etc.) to defend and challenge the claims made by the examiner. We can assure that it is the happiest of moments when we can say, “let me have my software engineer explain this . . .
This bringing in of the experts underscores that a good deal of your time in an examination may be spent educating and providing comfort to a state examiner. It is far better to educate an examiner than face the costs of trying to convince a judge. We have had good success in a number of states at the exam and administrative appeals level just by patiently going through the facts and the law. Given that the state R&D tax credits leans so heavily on the federal R&D tax credit we have seen it especially helpful to highlight how the IRS has treated an issue. Many times when a state examiner is breaking a pick on an issue (often whether a certain activity by a business is R&D) the clouds part and sunshine comes in when we can show him examples of the IRS conducting an examination of same/similar issue and the credit being upheld.
The procedural approach to an audit is also particularly important. The IRS and State Agencies have various ways in which they can track and attack audits. Ensuring that the right people from the taxing authority are involved and have access to all of the right information is important. For example, we encourage practitioners to bate-stamp all documents provided so that there is no question of information provided and clear records. This avoids the “he-said”, “she-said” of what was provided – and greatly raises your credibility with appeals. Audits and exams are the reality of tax. Good planning at the beginning – a solid study based on a command of facts and law supported by experts in the field – can go a long way to short-circuiting an examination or ensuring a successful outcome.
Conclusion
The State R&D tax credit is a key consideration for any business seeking to trim its tax bill. As with the federal R&D tax credit, businesses and their tax advisors need to look again at whether they are eligible for the R&D tax credit at both the state and federal level – and especially for businesses located in states with a refundable credit. Good planning will do much to maximize the benefit of the state and federal R&D tax credit for your business and keep the tax man from knocking on your door.
Dean Zerbe is alliantgroup's National Managing Director based in alliantgroup's Washington D.C. office. Prior to joining alliantgroup, Dean was Senior Counsel and Tax Counsel to the U.S. Senate Committee on Finance.
Jeremy Fingeret is Managing Director of Operations and Tax Controversy Services for alliantgroup in Houston, TX. He is an experienced litigation attorney, having handled cases in multiple state and federal courts.
Reproduced with permission from Tax Management Weekly State Tax Report, null, 12/23/2011. Copyright 2011 by The Bureau of National Affairs, Inc. (800-372-1033) http://www.bna.com
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