R&D Credit & Spending

Learning about available tax credits may increase R&D spending in the future.

By Douglas Kalman

A big topic of conversation among dietary supplement organizations of late is how much money and re­sources should be dedicated to R&D, an absolutely essential component to a company’s long-term success in the market. R&D not only applies to a clinical research trial or a bench study (hardcore lab study, not human interventional trial), it also includes computer work, library research, batch testing of new samples, reformulating a product for taste and so on. Understanding what R&D entails is very important because so many companies do not realize that they can obtain federal and state tax credits for in-house and outsourced research.

What Legally Defines Research & Development?

The Treasury Department rules are complex, but companies may be able to claim the credit if:
• The research is undertaken to discover technological information that is “intended to eliminate uncertainty concerning the development or improvement of a business component.” The process of experimentation “must be an evaluative process and generally...capable of evaluating more than one alternative.”
• The research experimentation relies fundamentally “on principles of the physical or biological sciences, engineering or computer science.”
• The research experimentation “relates to a new or improved function, performance, reliability or quality of the business component.” Research undertaken for “style, taste, cosmetic or seasonal design factors” does not count.

In short, in order to qualify for the credit, the research must be technological in nature (not research in the social sciences, arts or humanities) and must be intended to be useful in the development of a new or im­proved business component—in this case, a dietary supplement product would be considered a component of business. Further, it must relate to a new or improved function, performance, reliability, or quality, which are all facets of products sold to the tax-paying consumer.

Qualified Expenditures

The most common mistake companies make when claiming tax credit is not capturing all of the qualified expenditures. For example, the time a maintenance worker spends on tooling for a new process improvement could be a qualified expenditure, even though a maintenance worker is technically not associated with the actual research and development.

Among the costs that do qualify for the credit are:
• W-2 wages for employees engaged in the qualified research activity
• Non-capitalizable materials and supplies
• 65% of the costs of an outside consultant hired for research

This deserves much more attention (Internal Revenue Codes 41 and 174 to be more specific). For example, if you have a beverage and you plan on doing a study to demonstrate that the beverage offers a tangible benefit to the consumer-at-large, then the study would be tax credible because you are testing the “technology.” However, if you have created just a new label for a product, then the cost of the label production is not true R&D and thus not defendable as a credit. The R&D credit is claimed on IRC (IRS) Form 6765, Credit for Increasing Research Activities.

Who Reaps the benefits of R&D Credit?

R&D credit is designed to encourage businesses to increase the amount of money they spend on research and experimental activities. The R&D credit is generally 20% of the amount by which your research expenses for the year are higher than your “base period amount.” The aspect of “base period amount” is where you definitely need a qualified tax accountant familiar with R&D to help you craft the business model and framework of each department in your company (and at least to define just what this means). Qualified research expenses include in-house research, 65% of the cost of research carried out by a person other than an employee of the taxpayer, and 75% of the costs paid to a qualified scientific research consortium. Thus all in-house research would qualify for tax credit AND up to 75% of contracted research (with outside research firms like Miami Research Associates or a University) can be written off as a credit as well.

If you are unsure if your firm can qualify to reap the rewards of spending money on R&D (rewards being two-fold, tax credit and gain of intellectual property/market advantage), then you need to seek the advice of a good accounting firm. The educated guess here is that all firms in the natural products industry (supplement, functional foods) would qualify as long as they meet the letter and spirit of the law in terms of organization structure. Dairy farmers, computer companies, pharmaceutical firms and many others have qualified. If your firm spends internal or external R&D money on a new process to make the way you manufacture or produce a product more efficient, then your company can also receive a tax credit.

According to Tony Szczepaniak, a managing director with RSM Mc­Gladrey, a firm that specializes in federal tax issues, “The R&D credit is a great deal, and you’d be surprised how many different types of businesses qualify.”

Although the R&D tax credit has been part of the federal tax code for several years, many companies are either unaware of it or don’t claim as much of the credit that is available because they lack full understanding of the complex rules and reporting requirements. Suffice it to say, you don’t need a bunch of people in “white coats” to be able to get R&D tax credit—just the right department setup and the appropriate policies and procedures in place.

Bringing in an accounting firm to conduct your initial review is imperative. The bottom line is that the cost of a rigorous analysis of R&D expenditures is typically just a fraction of what is gained in tax savings. And once these bookkeeping processes are in place to identify future research expenses, even more savings can be accrued. Think of this as a gift that can keep on giving to your company on the federal and state level (yes, each state gives additional tax credits for R&D conducted by companies like yours so you can claim both on your corporate returns). In addition, if you have a tax credit assessment conducted, you can also have it conducted for retroactive taxes—meaning you may be able to get an adjustment on past paid taxes and receive a new refund.

R&D Spending

New federal rules make it clearer—and ease the reporting requirements—for how businesses can qualify for R&D tax savings of up to 6.5% on “qualified research expenses.” In short, companies can claim credits for as much as 75% of their R&D expenditures and perhaps more, so why not allocate more money to this area? To me, it would seem that the base amount any company in the dietary supplement or natural products industry should budget for R&D should be 6.5% of the total budget, with a high ceiling of 11%. The R&D spend should be on par with that of your marketing spend since science can also drive sales. Think about it this way, the lack of scientific substantiation, no matter how great sales are, will most certainly invite FDA and FTC to knock hard on your door!NW


*References furnished upon request.*