Should Manufacturers Consider the Expired Research Tax Credit?
Seamus Donoghue, CPA, MST
Congress first approved the “temporary” research tax credit in 1981, and it has been renewed 17 times since, often retroactively to its prior expiration. On Dec. 31, 2014, the research credit expired yet again. The congressional track record of continually renewing this credit suggests that it will be available again in 2015. To be prepared, manufacturers engaged in research activities should understand when and how to claim these credits. Even if the credit is not extended, you might be able to save tax by filing amended returns to claim the credit for recent years.
To be eligible for the research credit (also commonly referred to as the “research and development” or “research and experimentation” credit), a business must have engaged in “qualified” research activities. To be considered “qualified,” activities must meet the following four-factor test:
- The purpose must be to create new (or improve existing) functionality, performance, reliability or quality of a product, process, technique, invention, formula or computer software that will be sold or used in your trade or business.
- There must be an intention to eliminate uncertainty.
- There must be a process of experimentation. In other words, there must be a trial and error process.
- The process of experimentation must fundamentally rely on principles of physical or biological science, engineering or computer science.
Among those activities specifically excluded from the credit are reverse engineering an existing product; research related to social sciences, arts or humanities; software developed for internal use; and research performed outside the United States and its territories and possessions. Research that’s funded or reimbursed by someone else via a contract, grant or other arrangement is also excluded.
Expenses that qualify for the credit include wages for time spent engaging in supporting, supervising or performing qualified research, supplies consumed in the process of experimentation and 65% of any contracted outside research expenses.
Methods to Compute Your Credit
There are three options for computing research credits:
Traditional method. Here you first compute qualified research expenses as a percentage of gross revenue for the period between 1984 through 1988. In turn, that historic fixed base percentage is multiplied by the average of the four prior years’ gross revenue to determine the current base amount. The credit equals 20% of the excess over that base amount. For example, if your current base amount is $100,000 and your qualified expenses are $150,000 for the current year, you’re eligible for a $10,000 credit (20% of $150,000 – $100,000).
Start-up calculation method. This technique can be used if a company was founded after 1983 or had less than three years of activities between 1984 and 1988. It uses a historical build-up computation to establish the fixed base percentage and then, similar to the traditional method, allows a credit for 20% of the excess qualified research expenses.
Alternative simplified credit method. A company uses this option when it either cannot establish its historic fixed base percentage or that percentage is so high that the credit would be limited significantly. Here the fixed base is 50% of the average research expenses incurred in the previous three years and the credit is 14% of the excess. For example, if a manufacturer averaged $100,000 per year of qualified expenses over the last three years, the credit would be $7,000 (14% of $50,000) even if its research activities didn’t increase.
Keep in mind that amended returns may be filed to claim research credits up to three years back, potentially allowing you to reap refunds from previous years.
Food For Thought
Claiming research credits can be tricky. Alternative minimum tax issues could undermine your plans to use these credits. On the other hand, if your state also offers credits for research activities, the research credit may be even more significant than you initially anticipated. So discuss with your tax advisor whether it’s worth pursuing—and for the latest on whether Congress extends it again for 2015.
Think Outside the Retirement Planning Box
Adam Guldan, CPA
The National Center for Employee Ownership (NCEO) currently estimates that there are about 7,000 Employee Stock Ownership Plans (ESOPs) covering about 13.5 million employees in the United States. Roughly two-thirds of companies offer ESOPs to provide a market for a departing owner’s interest in a closely held business. Others may serve as a supplemental employee benefit plan or a mechanism to borrow money under favorable tax rules. ESOPs are popular among manufacturers and distributors, because their employee— including plant managers, salespeople, machinists, assemblers, dispatchers, drivers and quality control workers—can directly affect profits and productivity.
How Do ESOPs Work?
An ESOP is a type of retirement plan that invests primarily in the company’s own stock. The employer makes tax-deductible contributions to the ESOP, which the plan uses to acquire stock from the company or its owners. Essentially, an ESOP provides a “buyer” for the company’s shares.
At the same time, an ESOP provides a powerful incentive for employees to share in the company’s growth on a tax-deferred basis. When employees retire or otherwise qualify for distributions from the plan, they can receive stock or cash.
What Administrative Guidelines Apply to ESOPs?
Like other qualified plans, ESOPs are strictly regulated. They must cover all full-time employees who meet certain age and service requirements, and they are subject to annual contribution limits (generally 25% of covered compensation), among other conditions.
ESOPs are subject to rules that do not apply to other types of qualified retirement plans. For example, an ESOP must obtain an independent appraisal of the company’s stock when the plan is established and at least annually thereafter. Also, participants who receive distributions in stock must be given the right to sell their shares back to the company for fair market value. This requirement creates a substantial repurchase liability that the company must prepare for.
What Financial Benefits Can ESOPs Provide?
An ESOP provides several tax benefits. If it acquires at least 30% of a company, its owners can defer the gain on the sale of their shares indefinitely by reinvesting the proceeds in qualified replacement property within one year after the sale. Qualified replacement property includes most securities issued by domestic operating companies.
ESOPs also permit a company to finance a buyout with borrowed funds. A “leveraged” ESOP essentially permits the company to deduct the interest and the principal on loans used to make ESOP contributions—a tax benefit that can do wonders for cash flow. The company can also deduct certain dividends paid on ESOP shares. Interest and dividend payments do not count against contribution limits.
Another advantage of ESOPs over other exit strategies is that they allow owners to cash out without giving up control over the business. Even if owners transfer a controlling interest to an ESOP, most day-to-day decisions will be made by the ESOP’s trustee, who can be a company officer. However, ESOP participants may have the right to vote on major decisions, such as a merger or sale of substantially all of the company’s assets.
Who Can Answer Questions About ESOPs?
ESOPs offer numerous financial upsides. But there are some significant differences in the rules for administering ESOPs, depending on whether the company is set up as a C corporation or an S corporation. Consult with your tax, legal and benefits advisors to decide whether an ESOP is a viable option for you and your employees.