R&D Tax Credit – Don’t Leave Money on the Table

Presented by

Raj Rajan, JD MBT Managing Director, CBIZ MHM, LLC

Michael Silvio, CPA Managing Director, CBIZ MHM, LLC

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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 Revenue Code.

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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

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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. Michael’s 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 CPA’s, the National Association of Manufacturers, the R&D Credit Coalition in Washington, D.C., and the American Bar Association.

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Raj Rajan, JD, MBT Raj Rajan is a Senior Manager at CBIZ MHM, LLC. and the national technical lead on the research 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 held companies 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 Bachelor’s 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.

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Technical Rules

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The Federal Research Credit : Technical Aspects Governed by IRC Sections 41 and 174 of Internal Revenue

Code • 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

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– 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 be less than 50% of current qualified research costs

– The base limitation is typically the ratio of a company’s prior years’ (which can include various years) qualified research costs to gross receipts multiplied by the company’s average annual gross receipts (net of returns and allowances) for the four years prior to the year of the credit

Base Limitation Issues

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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

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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 the component’s:

• Function • Performance • Reliability • Quality

Technological in Nature

The activity performed must fundamentally rely on principles of:

• Physical science • Biological science • Computer science • Engineering

Technical Uncertainty

There must be uncertainty concerning the capability to develop, method of developing, or appropriate design of a new 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. To document this process we must explain:

•The alternatives considered and attempted •Testing performed on the alternatives •Test results and analysis

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R & D Credit Scope Limitations

To take the credit, it must not be “funded;” This involves two concepts:

The business must be at risk on its investment in the

research and

The business must retain substantial rights in the results of the research

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Qualifying Activities, Processes and Costs

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The Research Process: Qualifying Activities

Foreign OutsourcingDesign

Fabrication/PrototypingManufacturing

Domestic OutsourcingDesign

Fabrication/PrototypingManufacturing

Finished Product or ProcessReleased to Production

Research and Development ActivitiesDesign/Engineering

Innovation/ExperimentationPrototyping and Testing

ConceptProduct or Process

Product New Product Development

Product Enhancements Product Improvements

Process New Manufactur ing Systems New Production Equipment

Production Changes

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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 be held 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 these changes do not change the functionality of the product.

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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 less energy. 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 Software must be used in the production process.

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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 another’s patent, model, production or

process Research in connection with literary, historical or similar

projects (social sciences), Management function or techniques developed for

internal use

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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 (reverse engineering)

Routine data collections Funded Research (I.e. by grant, contract or other) Research performed outside of the United States

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Costs Included

Wages, excluding any fringe benefits, of employees directly engaged in the research, or that provide direct supervision or support of the research. This amount can be found on line 1 of the form W-2.

Supplies, excluding land and depreciable property. These supplies must be consumed in the performance of the research activities. Certain overhead costs can be included such as rent and utilities and telephone expenses.

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

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

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Identifying Opportunities and Industries

• What to look for • Specific costs to include • Specific activities to include • Contemporaneous Documentation

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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?

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R&D Activities By Industry Industry 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 • Automotive High tolerance, design and prototyping, customer specifications, testing • Agriculture 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, process

engineering, 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

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

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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 to

FDA for approval

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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)

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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

drawings

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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.

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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

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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

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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

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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)

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Practical and Regulatory Aspects of Proper Record Keeping

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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

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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

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Tier I Internal Revenue Service Issue Potential 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&D

percentage qualifications used in determining the qualified research expenses • Break out time into appropriate categories—by 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 be your 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.

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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

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Proper Record Keeping

• The ideal methodology to support proper record keeping is:

Contemporaneous Documentation

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Current Case Law

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Research and Development Tax Credit- 2009 -2011

A number of important court decisions were handed down in the past 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

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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 close approximation 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 taxpayer’s evidence and oral testimony.

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U.S. v. McFerrin, 570 F. 3d 672 (5th Circ June 9, 2009)

IRS disallowed credits due to “lack of documentation” and “discovery test”

Lower court upheld IRS’ denial of research credits The Fifth Circuit Court of Appeals vacated the district court

ruling and remanded it back to lower court The Fifth Circuit noted and further confirmed that the 2004

final regulations should be applied retroactively to research credits and removed the “discovery test”.

The Fifth Circuit said that lower could should have accepted estimates and should have looked to oral testimony and institutional knowledge of the employees

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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 & D credit

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.

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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 to take 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.

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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 credit

permanent • 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 in

lieu 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

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Summary/Key Takeaways

– The R & D Credit has broad application to a number of industries. You should look at your company’s 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 qualifying activities 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, don’t let that stop you from reviewing 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

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YouTube Link

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

please click here.

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CBIZ MHM, LLC Contact Information

Raj Rajan Managing Director 949.727.1327 rrajan@cbiz.com Michael Silvio Managing Director 858.795.2071 msilvio@cbiz.com

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Thank You