The Hidden Tax Savings of R&D for Engineering Firms

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By Paul L. Peterson, CPA, MBA

The Research & Development Tax Credit is one of the best kept secrets of the Internal Revenue Service. Many engineering executives have never even heard of it. If you're like most other principals and managers of engineering firms, you are likely underestimating – or ignoring entirely – the amount of research and development your firm does, which means your company is missing a potentially tremendous cost savings in the form of R&D tax credits.

The Credits for Increasing Research Activities, as the R&D Tax Credit is more formally known, is, without doubt, one of the most complex and least understood corporate tax credits available. The IRS has a battalion of auditors solely dedicated to it, as do many states. Some accounting firms have entire divisions focused on generating these credits for their clients. American companies amassed over $5 billion dollars in R&D Tax Credits last year. So why haven’t you heard of it? Probably because you might not think that what your company does is R&D in the traditional sense.

When most engineering executives think of R&D, they imagine people in white lab coats hovering over Bunsen burners or computer programmers slaving away into all hours of the night. They don’t recognize many of their own firm’s R&D efforts, such as improvements in spec designs, modeling, and infrastructure investments. Managers frequently view these activities simply as normal and ordinary business operations. In doing so you are missing the opportunity to recoup up to 10% of your related expenditures as R&D Tax Credits—a dollar for dollar credit against your tax liability in addition to your normal tax deductions for R&D expenses.

What is the R&D Tax Credit?

The R&D Tax Credit was created by Congress in 1981 as an incentive for greater private industry research investments. Recognizing that technological innovation drives economic growth, productivity, and competitiveness, the purpose of the credit was to reverse a decline in U.S. research and development and encourage U.S. companies to expand their research activities.

The credit is known as a tax recovery or reimbursement amount, intended to offer substantial financial incentives to profitable companies engaged in certain types of product development and process engineering activities. It was meant to be used by businesses of all sizes in a variety of commercial activities, including engineering, manufacturing, processing, food production, and other commercial endeavors.

Unfortunately, the scope and complexity of documentation requirements have historically made many small and mid-size businesses believe pursuing the R&D Tax Credits was not worth their while. The companies that took advantage of the credits were generally large manufacturing and high-tech concerns that did “traditional” R&D and could afford to hire the Big 4 accounting firms. Smaller companies who were less familiar with the credit lacked the expertise to determine how they could benefit, especially within the engineering industry.

However, recently issued IRS Regulations have made it easier to qualify for the R&D credit by broadening the array of activities and industries that qualify and providing greater flexibility in certain record-keeping requirements.

Having a technical understanding of your company’s potentially qualifying R&D expenditures is the first step toward maximizing your savings. Whether or not you qualify is determined by the nature of the activities performed, not by their outcome or the job titles of the personnel performing the activities.

If you qualify, your company could see a substantial tax savings from qualified R&D expenditures. Companies can apply for credit for the current year as well as up to three prior calendar years. The actual amount of R&D Tax Credits is calculated using a somewhat complex formula, but for most companies the credit amounts to 10% of total qualified research and development expenditures in a given tax year. Governments from 27 states also offer some form of additional R&D Tax Credit.

Qualified R&D expenditures consist of salaries and wages for employees that work on or supervise the development projects (nearly 70% of the R&D tax credit dollars claimed by business are investments in the salaries of researchers), support staff, contract labor, materials, and supplies.

The R&D Tax Credit will likely become a permanent fixture in the American tax code eventually. In the 25 years since its inception, the tax credit has been extended nearly a dozen times, and Congress is likely to heed the call of the American Society of Civil Engineers to make the credit permanent and eliminate uncertainty over its future, thus motivating the various industries affected to adopt longer-term views of research projects and the returns on investment they can generate.

What Qualifies as R&D for Engineering Firms?

R&D is a documented systematic, step-by-step process of experimentation that is technological in nature. At its most basic level:

Research is a planned effort to gain new knowledge that will hopefully be useful in developing a new product, service, process or technique, or in bringing about a significant improvement to an existing product or process.
Development is the translation of your research findings from theory to practice.
A process may be intended to achieve either cost reductions or generate revenue. Also, the need for R&D does not necessarily need to be internally generated; rather, it can come about through having to solve technical problems related to new customer orders or changes in product application.

Engineering activities that typically qualify as R&D include:

• Experimenting with new material and integrating the material to improve products or processes
• Analyzing functional requirements
• Performing engineering to evaluate new or improved specifications/modifications in terms of performance, reliability, quality and durability
• Conceptual design, testing, and modification of possible product or process alternatives
• Design, construction, and testing of prototypes and models
• Design of tools, jigs, molds, etc. involving new technology
• Engineering activity required to advance the design of a product to the point that it meets specific functional and economic requirements and is ready to be constructed
• Experimenting with new technologies
• Searching for applications of new research findings or other knowledge

For example, the in-house development of modeling software used to estimate the friction capacity for new steel high-speed train wheels would count as R&D expense.

Documentation is essential for receiving and supporting the credits. It is vital to be able to clearly, completely demonstrate to the IRS that the project work was indeed R&D activities. Documentation needed to present to the IRS includes:

• Difficulties your company faced trying to achieve your objectives
• Issues you encountered during the course of the development work
• The processes your company undertook to resolve any uncertainties
• Support that the activity is technological in nature by relying on the principals of the physical or biological sciences, engineering, or computer science

Providing the IRS with formal project reports will be most effective, though dated notes, drawings, photos, letters/memos, earnings documentation, invoices, and other records will suffice in many cases. A qualified tax advisor will be able to guide you through the regulatory requirements to ensure that you have the documentation needed to present to the IRS.

An Example: Anytown Bridge

Anytown puts a contract out for bid for a new bridge, and XYZ Engineering is in the running. Every bridge has its own unique issues which need to be analyzed. First you need to determine what kind of bridge (suspension, cantilever, etc.) is best suited for the city. From there your team needs to evaluate everything from weather patterns and wind effects to how entry and exit will potentially affect traffic patterns to the flexibility and durability of materials to be used. XYZ Engineering pulls its team together to brainstorm how to solve the problems, put together a plan, and estimate what the cost would be. This is the beginnings of the R&D process. And many of the costs associated with this work apply to the potential costs savings from an R&D Tax Credit.

Now let’s say XYZ wins the contract to build the bridge. The engineers now need to determine how to best protect the bridge. How can we ensure that the bridge will survive a sudden, extreme stress, like an earthquake or plane crash? To fully develop the bridge spec the engineers will need to test different scenarios. They might develop a three-dimensional computer model of the bridge design. This model will inevitably reveal problems with the initial design and lead to necessary modifications. Creating this model is no different than producing a prototype for a new ethanol-powered engine, an MP3 player, or a cancer treatment. It answers questions about uncertainties. It is R&D.

Getting Your R&D Tax Credit

The process a qualified advisor will use to help your company determine and apply for R&D tax credits involves the following steps:

1. Performing an initial analysis to estimate the approximate amount of credit your firm may be eligible for
2. Scrutinizing your employees and their job functions to estimate how much of a given employee’s time was dedicated to R&D
3. Evaluating similar resource expenses and allocating percentages to R&D as appropriate
4. Reviewing external expenses to identify additional costs you incurred to further your R&D efforts
5. Determining your exact tax credit eligibility
6. Compiling supporting data and documentation
7. Amending and re-filing up to three prior years of tax returns

It is a complex process, but one that can be extremely lucrative. A recent engagement WISS & Company completed in conjunction with CCR Cost Recovery Services gives a real-world perspective on what the R&D Tax Credit can mean to engineering firms. We helped a large New Jersey-based engineering, design, planning and construction management firm apply for the R&D Tax credit for three previous tax years. Like many engineering firms, they had never before pursued an R&D Tax Credit because they didn’t realize that what they did was R&D related. Two months after taking the firm through a similar process to one outlined above, it received a tax credit of over $1,000,000.

Implications for the Engineering Industry

Any firm with cutting edge technology in its field is likely to have eligible R&D costs. Engineering and construction firms, from civil engineering and nanotechnology to supercomputing and alternative energy, spend a significant amount of time developing new processes that qualify as R&D. There is a constant effort underway to improve existing products, plans, and processes. Uncertainty about a particular issue or design is resolved through a discovery process based on trial and error and experimentation. The costs associated with the time and effort that goes into that discovery process amount to R&D expense.

So why haven’t engineering firms seen the millions of dollars in R&D Tax Credits they could potentially benefit from? In part it is due to the aforementioned misunderstanding of their eligibility. However it is also endemic to the highly fragmented nature of the engineering industry, which is made up of mostly small, privately held firms in their first generation of ownership. Many companies that fit this description fall prey to the fallacy that the cost and administrative burden of applying for these credits is impractical.

The reality is that the application process has become streamlined enough for smaller and mid-sized firms to receive sizeable benefits from pursuing R&D Tax Credits. Most advisory firms will charge a fee equivalent to a percentage of your overall credit in addition to hourly or project fees to collect the relevant documentation and amend your prior tax returns. When you consider it’s not uncommon for an engineering firm to initially receive credits of $200,000-$500,000 for three previous years of applicable expenses the first time they apply, the potential overall cost savings is staggering.

Paul L. Peterson, CPA, MBA, is a Partner at WISS & Company, LLP, which provides accounting and tax advisory services. He can be reached at 973-994-9400 or ppeterson@wiss.com.

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