EXT2012!08!22 RD Tax Credit Don't Leave Money on the Table Presentation

8/13/2019 EXT2012!08!22 RD Tax Credit Don't Leave Money on the Table Presentation

1/52

R&D Tax Credit Dont Leave Money

on the Table

Presented by

Raj Rajan, JD MBT

Managing Director, CBIZ MHM, LLC

Michael Silvio, CPA

Managing Director, CBIZ MHM, LLC


2/52

Trouble Shooting

Troubleshooting Tips

No Audio?

This is an audio only event. Ensure that your computer speakers

are turned on and that the volume is appropriately set. Check to ensure that audio streaming is enabled on your computer

If the presentationsl ides stop advancing during the presentation

Close out of the presentation and re-launch the webcast

If you are still having audio or other technical difficulty Check with your IT personnel at your firm to ensure that this event is

not being blocked by a firewall.

Contact LearnLive support by clicking on the Support tab.

2


3/52

How to submit questions during the

presentation?

Click the Q&A button in the toolbar above and then Click

Then type your question in the boxand click send.

If possible, we will answer questions as we go. We have also built in some

time for additional questions at the end of the presentation. 3


4/52

Continuing Professional Education

There will be a total of 4 participation pop-up markers

during the event (i.e., about 1 every 15 minutes)

To obtain CPE, you must click I am present on 75% of

the participant pop-up markers

If you did not register to receive CPE for this event,

ignore the pop-up markers

4


5/52

Circular 230 Notice

Any tax advice contained in this program is not intended to

be used and cannot be used for the purposes of avoiding

any penalties that may be imposed by the Internal RevenueCode.

5


6/52

Agenda

Technical Rules

Qualifying Activities, Processes and Costs

Identifying Opportunities and Industries Practical and Regulatory Aspects of Proper

Recordkeeping

Current Case Law/Legislative Developments

Summary/Key Takeaways Questions

6


7/52

Michael Silvio, CPA

Michael Silvio is Managing Director with CBIZ MHM, LLC. He leads the San Diego and Orange

County offices Research & Development (R&D) and Energy Incentives Tax Credit Services Group.

Michael has more than 22 years of experience in public accounting and tax and has served a variety

of businesses in the manufacturing, construction, professional service and not-for-profit industries.

Michaels primary focus is in R&D tax credit and tax incentives areas. He has conducted over 350

research credit studies for numerous companies in various industries, and has served as a

representative before the IRS and state taxing authorities to support and defend numerous research

credit claims for taxpayers.

He also has experience in financial accounting, reporting and management, auditing, and individual

and business income tax. Michael has supervised compilations, audits and reviews for various

clients, including small and medium sized businesses, in addition to providing income tax planning,

consulting and compilation services.

Michael is a CPA certified in California. He is a member of the American Institute of Certified Public

Accountants and the California Society of Certified Public Accountants. He has a Bachelor of Arts in

business administration with an emphasis in accounting from California State Polytechnic University

in Pomona. Throughout his career he has authored several publications and conducted numerous

presentations on current tax legislation, R&D tax credit, energy incentive issues and other tax related

business incentives. He has also spoken to organizations such as the California Society of CPAs, the

National Association of Manufacturers, the R&D Credit Coalition in Washington, D.C., and the

American Bar Association.

7


8/52

Raj Rajan, JD, MBTRaj Rajan is a Senior Manager at CBIZ MHM, LLC. and the national technical lead on theresearch and development tax credit. He has over 11 years of professional experience

working exclusively with research and development tax credit studies.

He has conducted over 350 research credit studies for numerous companies in various

industries. In these engagements, he has been involved in analyzing and substantiating a

variety of issues emerging from the research and development tax credit. He has

performed such services for a wide range of clients including large publically heldcompanies to small privately owned businesses.

Prior to joining CBIZ MHM, Raj worked for two of the big 4 public accounting firms as well

as another large national firm, performing R&D credit analysis for companies ranging from

Fortune 500 companies to small and mid-sized companies. He has also taken the lead on

defending numerous research credit claims for taxpayers before the IRS and state taxing

authorities.

Raj has a Bachelors degree in Business Marketing from the University of Tennessee,

Knoxville. He also has a Juris Doctorate (JD) from University of San Diego School of Law,

and a Master of Business Taxation (MBT) from the University of Southern California.

8


9/52

Technical Rules

9


10/52

The Federal Research Credit : Technical

Aspects Governed by IRC Sections 41 and 174 of Internal RevenueCode

Federal credit is 20% of qualified costs in excess of base

limitation for activities performed with U.S.

Various states have varying credit provisions relating to

qualified costs in excess of base limitation for activities

performed within the state

Methods of calculation:

Traditional Method

Alternative Simplified Credit (Fed only)

Reduced credit can be elected (IRC 280C)

Fed: Can be carried back 1 year and carried forward 20

years (except for 2010 when, under specific circumstances,

the carry back is 5 years)

States: Certain states have varying carry forward provisions

10


11/52

The base limitation is the threshold (floor) that a

company must exceed in current qualified research

costs in order to be eligible to take the research

credit

The base limitation is formula driven and cannot beless than 50% of current qualified research costs

The base limitation is typically the ratio of a

companys prior years (which can include various

years) qualified research costs to gross receipts

multiplied by the companys average annual grossreceipts (net of returns and allowances) for the four

years prior to the year of the credit

Base Limitation Issues

11


12/52

The Research and Development Tax Credit-

First Test

The Section 174 Test (IRC 174)

In Connection with a Trade or Business Discover information to Eliminate Uncertainty-Experimental in

Nature

12


13/52

The Research and Development Tax Credit-Second Test

New or Improved Business Component

The activity must relate to a new or

improved product or process that

improves thecomponents:

Function Performance Reliability Quality

Technological in Nature

The activity performed must fundamentally

relyon principles of:

Physical science Biological science Computer science Engineering

Technical Uncertainty

There must be uncertainty concerning the

capability to develop, method of

developing,orappropriate design of anew or improved product or process at the

outset of the project.

Process of Experimentation

Substantially all of the activities must be

elements of a process of experimentation

to resolve the technical uncertainty. Todocument this process we must explain:

The alternatives considered and attempted

Testing performed on the alternativesTest results and analysis

13


14/52

R & D Credit Scope Limitations

To take the credit, it must not be funded; This involves

two concepts:

The business must be at riskon its investment in the

research and

The business must retain substantial rightsin the

results of the research

14


15/52

Qualifying Activit ies, Processes and Costs

15


16/52

The Research Process: Qualifying Activities

Foreign OutsourcingDesign

Fabrication/PrototypingManufacturing

Domestic OutsourcingDesign

Fabrication/PrototypingManufacturing

Finished Product or Process

Released to Production

Research and Development Activi tiesDesign/Engineering

Innovation/Experimentation

Prototyping and Testing

Concept

Product or Process

ProductNew Product DevelopmentProduct EnhancementsProduct ImprovementsProcess

New Manufactur ing SystemsNew Production EquipmentProduction hanges

16


17/52

Qualifying Activities

New Product Development- expenses related to the

creation of new products that previously did not exist.

Includes any pilot model, process, formula, invention,

technique, patent or similar property.

The definition also includes products to be used by the

taxpayer in its trade or business as well as products to beheld for sale.

Product Improvements- expenses related to the significant

redesign of products, i.e. functionality. This does not

include product redesign and changes related to

appearance, individual market or customer tastes if thesechanges do not change the functionality of the product.

17


18/52

Qualifying Activities

Process improvements- expenses related to improving the

way that products are made. This includes efforts to

reduce production costs by using different materials,

increasing automation or making changes to use lessenergy. This also includes creating or designing R & D

and production equipment, tools and dies.

Software Development-Software must be developed and

sold, licensed, etc. to customers. In this case the software

is the product being sold. Software must be used in an

activity that constitutes qualified research, or Softwaremust be used in the production process.

18


19/52

Exceptions

Expenses That Do Not Qualify:

Ordinary testing or inspection for quality control

Efficiency surveys

Management studies or activities

Consumer surveys

Advertising or promotions

Acquisition of anothers patent, model, production or

process

Research in connection with literary, historical or similar

projects (social sciences),

Management function or techniques developed for

internal use

19


20/52

Exceptions

Activities that do not Qualify:

Activities not directed at functional aspects of a product

(typically, this includes expenses relating to style, taste,

cosmetics, etc.) The adaptation of existing business component to a

particular requirement or customer need where no

uncertainty element exists (Custom product

development does qualify, I.e. job shop, etc.)

Duplication of an existing business component (reverseengineering)

Routine data collections

Funded Research (I.e. by grant, contract or other)

Research performed outside of the United States

20


21/52

Costs Included

Wages, excluding any fringe benefits, of employeesdirectly engaged in the research, or that provide directsupervision or support of the research. This amount can befound on line 1 of the form W-2.

Supplies,excluding land and depreciable property. These

supplies must be consumed in the performance of theresearch activities. Certain overhead costs can be includedsuch as rent and utilities and telephone expenses.

Outside services incurred during the research process.Only 65% of these costs are eligible for the credit. Thesecosts include outside consultants, software programmersand engineers, outside tool and die makers, etc.

Only costs related to activities performed in the UnitedStates and U.S. possessions qualify for the credit.

21


22/52

Identifying Opportunities and Industries

What to look for

Specific costs to include Specific activities to include

Contemporaneous Documentation

22


23/52

How to Identify and Qualify Opportunities Have you spent significant dollars in developing new products or processes or

machinery in order remain competitive or an industry leader?

Do you anticipate an increase in research activities in future years?

Do you hold any patents for new products, processes or technologies?

Have you paid tax in recent years? Do you employ engineers, chemists or programmers?

Are you coming off NOLs or NOL carryovers that have been fully utilized and needs a

way to reduce current and future taxes?

Have you completed a recent sales transaction and has a taxable gain on the sale of

the company or division? Have you developed a unique and novel website?

Have you made any of the following changes to the production process related to

cost efficiencies, including: new ingredients, materials, increased automation,

reduced energy consumption, new ways to manufacture products that incorporated

the use of new materials?

23


24/52

R&D Activit ies By IndustryIndustry R&D Activity

Adhesives Formulation development, V.O.C. requirements, prototypes, testing

Aerospace High tolerance, design and prototyping, testing

Apparel Process engineering, design, fade resistance after washing, fabric strength and durability

Automot ive High tolerance, design and prototyping, customer specifications, testing

Agr icul ture Seed coating/development, equipment development, organics and organic pesticides

Biomedical/medical devices Design, development, bioengineering, clinical engineering, prototyping, testing, process

improvements

Biotech/Pharmaceuticals Listed and generic drugs, clinical trials, FDA requirements, testing, prototyping, processengineering, inactive and , active ingredient determination

Defense High tolerance, software development, engineering, design, development, prototyping, testing

Energy/alternate fuels Resource processing/extraction technologies, formulations, development, testing, prototype

Engineering: environmental, Structural design, abatement, remediation, waste disposal, infrastructure design and

Civil, architectural development

Equipment Design, development, prototyping, testing, engineering

Financial services Software development activities

Food mfg/processors Formulations, process improvements, ingredients, shelf life, pH, packaging

Furniture Engineering, materials development, process improvements, Healthcare products Formulations, pH, process improvements, prototyping, testing

High tech Engineering, process improvements, design, prototyping, testing

Life science Development, genetics, testing, biological testing, cell theory, process engineering

Lubricants Formulations, V.O.C., viscosity, pH, prototyping, testing, process improvements, Milspec

Paper products Materials development, process improvements, design, development, prototyping, testing,

packaging

Software Developers Concept/idea generation, programming, alpha and beta testing, functional enhancements/development,

version changes, not debugging

24


25/52

Historical R&D Credit Capturing Industries

Biotech/Pharmaceutical

Biomedical/Medical Devices

Software development (for sale, lease or license) Automotive Industry

High Tech

Aerospace

Oil and Gas

25


26/52

R & D Credit: Industry Opportunities-Biotech

Drug development issues

Generic drugs can be included

Phased and Clinical trials are involved

FDA approval issues

Drug delivery methods (proprietary)

Supplies are involved

Chemical and molecular make up needs to be analyzed

Inactive vs. Active Ingredient issues

Results of trials, ingredients lists, documents provided toFDA for approval

26


27/52

R & D Credit: Industry Opportunities-Software

Software concept design

Software programming

Alpha and Beta Testing Supplies are virtually non-existent

Will involve software programmers either as employees

or outside consultants

Rights and risk issues; Flowcharts, revision notes ,functional specification

documents, computer code

Not all software development activities quality (including

coding)27


28/52

R & D Credit: Industry Opportunities-High Tech

Component and product development

Process/manufacturing improvements

Supplies are usually involved First run or prototype costs involved

Usually involves engineers and specialized

expertise Usually complex products being developed

Schematic drawings, test results, component

drawings28


29/52

R & D Credit: Industry Opportunities-Job

Shops [Build to print]; Mold Makers (Injection Molders);

Precision Products; etc

Clients can include medical device product companies

and aerospace product companies

DFM (Design for Manufacturability)

Developing tooling and fixtures, CNC programming, CAD

design and simulations, integrating new equipment, lean

manufacturing, process improvements, etc

Manufacturing process development work

Supplies can include bought/sold mold costs (TG

Missouri case) and samples for clients validation.29


30/52

R & D Credit: Industry Opportunities-Food

Food processing (including manufacturing for others)

and product development

Formulations and ingredients should be analyzed

Cost of ingredients

First batch run costs

Usually involves food chemists

Recipe lists Test result documents including: Ph, shelf life, taste

30


31/52

R & D Credit: Industry Opportunities- Apparel

New or improved leather and dye formulation treatments

Design activities related to construction and structural

integrity

Functional improvements to weaving techniques

Testing of colorfastness issues and tensile strength of

garments

Testing for dimensional stability New or improved material usage and manufacturing

process

31


32/52

R & D Credit: Industry Opportunities-

Architectural and Engineering Design and Build or Engineering Procure and Construct

contracts

Design issues

Unique project requirements

Site issues

Environmental issues

Codes associated with structure and energy Integration of all subcomponents (HVAC systems,

materials, designs)

Trinity case

32


33/52

R & D Credit: Industry Opportunities-

Architectural and Engineering Development of unique energy efficient features

Unique characteristics of the project site

Implementing alternative energy technologies

Designing for environmental issues

Designing for sustainability and space utilization

Harsh environment design and testing

Incorporating new materials and new technology Look for industry design awards (or even applications for

industry awards by the client)

33


34/52

Practical and Regulatory Aspects of ProperRecord Keeping

34


35/52

Best Practices: Documentation and

Substantiation

Four Primary Areas of Concern in this Area

(according to the IRS)

High-level estimates

Biased judgment samples

Lack of nexus between the business component

and qualified research expenses (QREs)

Inadequate contemporaneous documentation

35


36/52

Tier I Internal Revenue Service Issue R&D Credits have become a Tier I issue with the Large

and Mid-Sized Business Division of the IRS

There will be more audits with a higher level of scrutiny

Agents must adhere to following guidelines now:

IRS Industry Directives and Guidelines

R&D Audit Technique Guide (Released May 30, 2008)

Notice 2002-44

Use of R&D Technical Advisors

Four Primary Areas of IRS Concern

High-level estimates

Biased judgment samples

Lack of nexus between the business component and

qualified research expenses (QREs)

Inadequate contemporaneous documentation

36


37/52

Tier I Internal Revenue Service IssuePotential remedies to combat the Tier I issue and to document and substantiate

credits taken:

Establish Procedures and Tools for Capturing and Maximizing Future Credits

Revisit Fixed Base Percentage determination

Have researchers/client personnel spend time documenting how they arrived at the R&Dpercentage qualifications used in determining the qualified research expenses

Break out time into appropriate categoriesby person.

Attempt to identify the largest projects that individual cost centers

work on. Try to support this determination with work plans, payroll

records, etc.

Reliance on the recollection of a department head should beyour last resort.

For documentation, use material originally prepared for non-tax

reasons, if you can. Engineers are often pack rats. You might be

surprised at the type of details that they retain.

37


38/52

Prequalify Your R&D Costs and Employees

Need to identify which employees are part of the R&D

process.

Start with the employees performing R&D services

Identify the Not-so-Obvious employees (CEO, Sales

persons, Production)

Supplies

Outside Contractors

38


39/52

Proper Record Keeping

The ideal methodology to support proper record keeping

is:

Contemporaneous

Documentation

39


40/52

Current Case Law

40


41/52

Research and Development Tax Credit- 2009 -2011

A number of important court decisions were handed down in thepast 50 months.

The majority of these decisions were victories for the taxpayer

Some of the areas that these cases provided guidance included:

Level of documentation

Internal Use Software Tests

Supplies expense and depreciable items

Discovery Test

41


42/52

Union Carbide v. Commissioner, TC

Memo 2009-50 (March 10, 2009) 1994-1995: IRS allowed majority of projects but disallowed 106 new

research projects not included in original claim

Court agreed to look at 5 of the106 projects and analyze the taxpayers fixed

base percentage. Court found 2 of 5 projects to qualify

The IRS has regularly opposed the use of extrapolation and employee

recollections as a methodology to determine qualified research

expenditures, however the Tax Court in Union Carbide accepted the validity

of such methods.

The Tax Court confirmed that taxpayers are entitled to determine a closeapproximation of qualified research activities and expenditures by oral

testimony and interviews supported by documentary evidence.

The court indicated that it will apply the Cohan rule to accept a taxpayers

evidence and oral testimony.

42


43/52

U.S. v. McFerrin, 570 F. 3d 672 (5thCirc

June 9, 2009)

IRS disallowed credits due to lack of documentation anddiscovery test

Lower court upheld IRS denial of research credits

The Fifth Circuit Court of Appeals vacated the district courtruling and remanded it back to lower court

The Fifth Circuit noted and further confirmed that the 2004final regulations should be applied retroactively to researchcredits and removed the discovery test.

The Fifth Circuit said that lower could should have acceptedestimates and should have looked to oral testimony andinstitutional knowledge of the employees

43


44/52

TG Missouri v. Commissioner, 133 T.C. No. 13

(November 12, 2009) Manufacturer of Injection molded products paid third parties to developed

production molds for them. They modified these molds and then sold them

to their customers as part of the contract to manufacture the products

Taxpayer took entire mold costs as R & D supplies-IRS denied the

treatment saying molds were depreciable property and reduced the R & Dcredit

The court held that production molds purchased from third parties, and later

sold to customers, were not assets subject to depreciation and that the

taxpayer properly included costs of the molds as supply expenses in

determining its research credit.

The tax court rejected the IRS position on depreciable property and supply

expenses by holding that the molds were not property of a depreciable

nature in the hands of the taxpayer.

Need to provide substantiation as to which molds are ultimately sold.44


45/52

Shami v. Commissioner, T.C. Memo 2012-78

(March 21, 2012) FSI, which manufacturers hair, skin and nail products, was successfully able to

claim that R&D was performed at the company and employees in the following

departments were involved in the development effort:

Lab

Production Quality Control

Executive/Management

Under Audit, the IRS agreed that 456 out of 460 designated employees

performed qualifying research activities

However, the owner and a high ranking executive were excluded by the IRS due

to lack of documentation. The company, relying on the Cohan rule, decided totake this issue to tax court.

The argument that the tax court rely on the Cohan Rule to estimate time for

these high ranking employees failed. The tax court determined that there was

no reasonable basis to make an estimate given a lack of sufficient testimony

and documentation. 45


46/52

Current Development-Legislative Update-R&D

Credits

Research and Development Credit expired on 12/31/2011

Senate Finance Committee current bill markup

President Obama and Governor Romney want to make the creditpermanent

Credit can only be used to offset regular tax, not Alternative Minimum Tax(AMT) except for 2010

Loss companies can elect to refund accumulated AMT or R&D credits inlieu of electing bonus depreciation on equipment purchases

Contingent Fees cannot be charged for R & D Studies (IRC Circ. 230)

Imposition of 20% Erroneous Claim Penalty by IRS- IRC Section 6676

46


47/52

Summary/Key Takeaways

The R & D Credit has broad application to a number of industries. You should

look at your companys activities to determine whether you may qualify

Remember, the 2010 tax year is a good year to take credits because they can

offset AMT

Seek to implement a system of controls and procedures to capture qualifyingactivities and costs contemporaneously throughout the year

Remember, a great deal of eligible companies are still not taking advantage of

the research credit

Many favorable court decisions have been handed down recently cementing

further that this credit is available and valuable to taxpayers

Just because there is no current credit for 2012, dont let that stop you fromreviewing this benefit. There are three (and sometimes four) years open by tax

statute that companies can likely go back and take advantage of

Watch for current extender legislation in the post election, lame duck session

of Congress during 2012

47


48/52

YouTube Link

To view our CBIZ BizTips Youtube Video on R & D credits,

please click here.

48
http://www.youtube.com/watch?v=DMoYcLEbQ_s&feature=g-all-uhttp://www.youtube.com/watch?v=DMoYcLEbQ_s&feature=g-all-u


49/52

QUESTIONS?

49


50/52

Upcoming Webinars

To view other upcoming CBIZ MHM webinars, please click

here.

50
http://www.cbiz.com/page.asp?pid=8580http://www.cbiz.com/page.asp?pid=8580


51/52

CBIZ MHM, LLC Contact Information

Raj RajanManaging Director

949.727.1327 [email protected]

Michael SilvioManaging Director

858.795.2071 [email protected]

51
mailto:[email protected]:[email protected]:[email protected]:[email protected]


52/52

Thank You

Documents

EXT2012!08!22 RD Tax Credit Don't Leave Money on the Table Presentation