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Minnesota Technology Magazine - February 2008

Getting Credit

By not taking advantage of the R&D Tax Credit, many manufacturers are leaving thousands of dollars on the table.

BY SARAH GILBERT

Over the past three years, Jan Meier has received almost $75,000 from the U.S. government. Meier, the CFO of Meier Tool & Engineering, Inc. in Anoka, had been waiting for the windfall. It was three years’ worth of tax credits for the research and development the metal stamping company had been doing, payback for all the time they had spent making prototypes and tinkering with their processes.

Scott Schmidt, principal of Black Line Group

Unlike many other manufacturers, Meier has long understood that all that experimentation qualifies for the federal research and development (R&D) Tax Credit, which was established in 1981 to encourage innovation among American companies. Meier Tool’s accountant had already been helping the company claim small amounts of salaries toward the credit. But, Meier says, it wasn’t making full use of the opportunity. “Our accountant told us the kinds of things that we could [claim], but they didn’t go far enough,” Meier says. “It wasn’t their area of expertise. They just didn’t go far enough.”

The sizable checks that arrived at Meier Tool illustrate just how much further they — and other manufacturers — can go. Some have been able to claim credits of more than $100,000. “It is often a lot,” says Scott Schmidt, principal of Black Line Group, which focuses exclusively on the R&D Tax Credit. “We see 100, 200, 300 grand. To a $30 million company, that’s a lot.”

The problem is it can seem like a lot of work, especially to companies that are unsure about the definition of R&D and that aren’t working with an accountant who understands the tax code in and out. But as Meier and others who have gone through the process have found out, the work is worth it. So is the cost of an outside expert who can facilitate the process. “It’s not difficult,” Meier says. “It is somewhat time consuming, because you do have to sit down and talk with people about what they’re working on and you have to create documentation for everything. But that’s the way it is if you want to save this much money.”

The truth is, it should be a no-brainer for most manufacturers. The vast majority would qualify for the credit, and many would recoup significant sums of money. Even with added administrative time and the costs associated with hiring an R&D Tax Credit expert, most would come out far ahead.

“We create money,” Schmidt says. “There are not a whole lot of ideas out there where you can actually create cash. We’re a business that can put money back in your pocket.”

Where Credit Is Due

The R&D Tax Credit was enacted in 1981, during the first year of the Reagan administration. As inflation and unemployment plagued the American economy, foreign businesses were becoming more and more competitive. The goal of the credit was to encourage innovation on American soil and to give companies an incentive to invest in new products and processes by giving a dollar-for-dollar credit — not a percentage-based deduction — on certain activities that qualified as research and development.

But because the tax code surrounding the R&D Tax Credit is so complicated, few manufacturers take advantage of it .According to the IRS, about 4,900 manufacturers claimed the credit in 2003, which means hundreds of thousands nationwide aren’t taking advantage of the credit. Some don’t know anything about it. Others don’t know enough about it. Many simply don’t understand that th ework they do would qualify.

“A lot of manufacturers, especially machine shops and job shops, don’t see what they’re doing as R&D,” says Brent Terhaar, a principal in the Larson Allen manufacturing and distribution group. “The design stages and all the process changes — which are just constant formostmanufacturers — are, in theirminds, just normal, just what they do. But from a tax standpoint, those things qualify for the credit.”

For example: A customer brings a drawing of a part to a job shop asking for it to be made. The manufacturer then has to figure out whether the part can be produced, put together the processes to make it and provide prototypes to the client. Until the piece goes into production, time and materials spent perfecting the part could qualify as research and development.

That’s exactly what happens at Dynamic Group, which includes both Dynamic Engineering and Dyno-plast. Customers present a challenge to them and they figure out how to solve it. “[Sometimes] before we even get an order from a customer, we do a mock-up of the product, just to validate that it can be made,” says Peter McGillivray, president of Dynamic Engineering. “Very often, we get into a lot of development to optimize either the product or the process.”

Although Dynamic Group has been in business even longer than the tax credit has been available, the company didn’t realize that its activities qualified until just a few years ago. “It hadn’t occurred to us to claim the credit,” McGillivray says. “We had this image that R&D took place at large companies in labs with lab coats and rats. We weren’t using either of those.”

“People still have this mentality that you have to wear white lab coats to do R&D,” Terhaar confirms. “But typically, most manufacturers do have qualifying activities.”

To qualify for the credit, activities have to pass a fourpart test that was set out by the government. First, they have to be connected to a specific goal, such as creating a new product or process. The goal could also be to improve an existing product or process for better function or performance, better quality or reliability, or to reduce costs. Next, there has to be technical uncertainty, which means that the process or methodology is not readily known: There has to be a question as to whether the goal can be achieved, as well as how it will be achieved. The third part is that the project must include some degree of experimentation. “If you do any modeling, testing or prototyping, that counts,” says Schmidt. And finally, the activity must rely on one of the “hard sciences”— engineering, physical science, computer science or biological science, for example.

“There’s no stipulation that the project come to a successful completion,” adds Joe Mayer, a tax manager for the Little Canada-based accounting firm Olsen Thielen and Co. “Things that don’t work qualify too. If you spend a lot of time and resources on something and it doesn’t work out, that still qualifies as R&D.”

Understanding the four-part test made a big difference in determining R&D activities at Meier Tool. “We can look at the four-part test and say, ‘Does this project meet all of these?’” Meier says. “We were able to pull in a lot more jobs when we did that, which meant that we had a lot more salaries to claim for the credit.”

Salaries make up the bulk of the costs claimed for the credit. Supplies also count, as do any contract expenses, including hiring an outside engineer or using another vendor for skills or technology not available in-house. Although keeping track of all of that may sound daunting, Terhaar says it’s not as onerous as it seems. “We can come in and do interviews with people involved, and that is valid as support. The more documentation you have, especially job schedules, the better, but the IRS hasn’t defined specific documents that you must have to claim the credit.”

Extra Credit

Another reason many small and mid-sized manufacturing companies aren’t taking advantage of the R&D Tax Credit is because they’re working with small and mid-sized accounting firms. And often, those accounting firms don’t have the expertise and experience required to understand the tax code. “It’s a specialty area,” Schmidt says. “It’s totally subjective, and the rules can seem very gray. Unless you work with it a lot, it’s hard to be confident and clear about how you can apply the rules.”

Although most accountants have at least heard of the tax credit, few consider themselves experts on the subject. “They may not be comfortable applying it to their clients’ businesses because of the subjective nature of the R&D Tax Credit,” Schmidt says.

That’s where firms that specialize exclusively in R&D, like Black Line Group, can be especially helpful. Most aren’t looking to steal clients; instead, they’re willing to partner with a company’s accountant to provide a roadmap that will make filing for the credit easier in the future. Dynamic Group, for example, contracted with Black Line Group to handle the initial credit claim. Subsequent claims have gone directly through their longtime accountants. “Black Line worked directly with us internally, and also with our external accounting firm,” McGillivary explains. “Their philosophy is to come in and teach both the internal and the external team how to handle it. For us, this was a one-time occurrence.”

Terhaar and Mayer have often been called upon as consultants as well. And that is just fine, they both say. “I’ve consulted with companies so that they could go back to their accountants and use them in the future,” Mayer says. “People can be very loyal, and that’s a good thing. We can work out the calculations with them so that they have something to follow in the future.”

Meier says they understand the process well enough now that her company can handle it in-house then pass the numbers to their accountant to include with the annual return. Already, they’ve been trying to streamline the process so that R&D can be tracked year round, not just at tax time. And looking to the future, they are pleased to know that they’ll be able to enjoy a substantial, dollar-for-dollar credit on their taxes every year.

“Any manufacturing company that isn’t doing this should look into it,” Meier says. “At least make the effort to see if it applies. There may be dollars there that they didn’t know about.”