Understanding the R&D Tax Credit for Manufacturing

Innovation is at the heart of every successful manufacturing company. Businesses must find ways to improve, create more efficient processes, and develop new and valuable products. That innovation can be expensive. R&D tax credits for manufacturing can be helpful. Still, too many companies don’t know how to take advantage of them. Learn about the options that your business could be missing out on.

How To Qualify for the R&D Tax Credit for Manufacturing

The R&D tax offset is meant to support businesses coming up with new solutions and products, but there are specific requirements to qualify. In general, you must show that your company invested heavily in manufacturing R&D or other research and development to create a new process or product. Here are a few critical aspects that are required to see if a company can claim this credit:

  • Technical Uncertainty: Companies must show they are using manufacturing R&D to experiment and create a new process. They need to demonstrate that they have not had a technical solution.
  • Technological Advancement: Your process must be new and innovative to qualify for a tax credit. It should also create a solution or product that was not available before.
  • Experimentation: You must show that you tested a hypothesis multiple times in multiple ways with controlled and documented experiments.

Remember that you must prove these elements exist in your project no matter what your industry is, not just manufacturing. Biotech R&D, pharma R&D, farming R&D, and even aerospace R&D have the same requirements to claim the tax credit.

What Is R&D in Manufacturing?

You will want to familiarize yourself with research and development to ensure you have the best chance at claiming the R&D tax credit for manufacturing. R&D in manufacturing are the activities companies use to discover, develop, and implement new technologies, products, or processes. It involves scientific and technological research and enables manufacturers to stay ahead in the market.

What Counts Toward the R&D Tax Credit for Manufacturing?

Getting the most out of the credit means understanding what you can claim. Work with a KBKG R&D tax incentive consultant to review your company’s activities for the most straightforward path forward. In most cases, new expenses for the research and development process count toward the credit. This includes supply costs for prototypes and experiments, machine tooling used to develop a new process, R&D chemicals, and employee wages.

Note that you cannot claim supplies and items that were capital investments for the business rather than specific expenditures for the R&D process. Existing machinery or products cannot be used to increase your tax credit claim.

Does the R&D Tax Credit Incentivize Research Investment?

Like most tax programs, the Research and Development (R&D) tax credit for manufacturing and other industries is meant to encourage businesses to create new and valuable products and solutions. Established in the 1980s and recently made permanent, this tax credit is the government’s way of recognizing that research is expensive for companies. A corporation can risk hundreds of thousands of dollars on development, only for a product or process to fail.

By offering a tax credit, businesses are incentivized to take that risk. They know they can minimize a bit of the loss if they can show their qualified research activities and recoup some of the investment in a tax credit.

Tax Incentives for Pharmaceutical Companies

Pharmaceutical companies have made headway in pushing for more tax incentives in recent years and are enjoying the benefits. As R&D tax legislation grows, pharmaceutical companies are getting more ways to use tax offsets to help their operations. They can claim research and development credits to work on more new medicines.

Pharmaceutical businesses and their R&D departments also have the chance to claim the Orphan Drug Credit. An “orphan drug” is one developed to treat rare but serious diseases that impact fewer than 200,000 people. These medicines aren’t as profitable, so companies aren’t motivated to make them. The Orphan Drug Credit promotes innovation but differs from other R&D tax credits

What About Section 174?

Many small and large businesses rely on research and development to improve their offerings, compete with international markets, and increase profits. The implications of recent changes to section 174 and no movement from Congress have left many business owners trying to figure out how to move forward with R&E expenses for the 2022 tax year and beyond and how to qualify for the credit and manage their qualified research expenses.

However, the Tax Cuts and Jobs Act of 2017 changed Section 174, which went into effect for tax years beginning after December 31, 2021. Under the TCJA, businesses must capitalize and amortize R&D costs over a five-year period for domestic costs and a 15-year period for foreign costs. For instance, software development expenses are now included under the umbrella of Section 174 and must be capitalized and amortized, further impacting the qualification for the credit and management of qualified research expenses.

What Is the Interaction Between Section 174 and the R&D Tax Credit Under Section 41?

The IRS section 41 research credit is a permanent tax incentive for qualified research activities, which can be determined using the four-part test for R&D qualification:

  • Permitted Process: The research activity must be directly tied to developing a new or improved business component for a permitted purpose (functionality, quality, performance, and/or reliability). Notably, the business does not have to improve the component to earn the credit successfully.
  • Technological in Nature: The activities performed must fundamentally rely on hard sciences. For example, the activities should be grounded in biology, computer science, physics, engineering, chemistry, geology, or a similar field.
  • Eliminate Uncertainty: At the outset, the taxpayer should be uncertain about the appropriate design, method, or capability to achieve the intended results. For example, the taxpayer could not know whether a product is feasible, if the design is technically sound, or how the result can be achieved.
  • Process of Experimentation: Businesses must experiment and evaluate alternatives through a process of modeling, testing, simulating, and systematic trial and error.  

While both IRS section 174 and section 41 deal with incentives to encourage research and development, section 174 covers a wider range of expenses. However, the costs claimed under section 41 must also meet section 174 requirements. Additionally, section 41 qualified research does not include activities that involve:

  • Surveys, advertising, or market research
  • Duplication or adaptation of an existing business component
  • Research conducted outside of the U.S.
  • Research in the arts, humanities, or soft sciences
  • Funded research from a grant, government, or other outside entities

The changes listed in TJCA did not have a material impact on the section 41 credit. However, the proposed American Innovation and Jobs Act would expand this section regarding qualified small businesses. As section 41(h) noted, qualified small businesses can use the R&D credit to offset payroll tax. Some suggested amendments include:

  • Doubling the cap from $250,000 to $500,000.
  • Allowing startups to claim the refundable credit for up to eight years instead of five.
  • Expanding the startup credit rate to 20%.
  • Increasing the gross receipts threshold to $15M.

Take Advantage of R&D Tax Credits

Every successful business needs to find ways to add more money to its bottom line, and tax credits can help. Contact KBKG today to see how to use the R&D tax credit to improve your company.