2017 promises to be a year of change for American business, including the AE industry. With the Trump administration in place, their campaign promise of sweeping changes to the federal tax system will be taking center stage.
The changes proposed during the Trump campaign, as well as the “Better Way for Tax Reform” blueprint introduced in June 2016 by the House Ways and Means Committee, call for significantly lower corporate and individual income tax rates. Offsetting these lower rates will be the elimination of many of the tax credits and deductions we have utilized over the years.
Meet 2017’s “Go To” Tax Credit
While the possibility of overall lower federal taxes is exciting, there is a level of uncertainty surrounding the tax planning tools that we count on today. One tried and true strategy that stands out from the confusion is the Research and Development Tax Credit (R&D Credit). Both the Trump administration and the House explicitly state that the R&D Credit will remain a key component of their tax plans.
Surprisingly, even though the powerful R&D tool has been a part of the federal tax landscape since 1981, we find that many design firms do not take advantage of the credit. The following is an overview of the credit and the benefits that your firm can experience.
As noted, the R&D Credit has been on the tax planning scene for some time, but in late 2015 the Credit became a bit more interesting. When The Protecting Americans From Tax Hikes (PATH) Act was enacted, it created two taxpayer-friendly changes that significantly enhanced the credit’s value to smaller firms and their owners. First, it made the credit a permanent part of the Tax Code. Companies that invest the time to set up systems and capture the costs associated with R&D no longer need to worry that their efforts will be short-lived.
More importantly, the PATH Act eliminated limitations caused by the Alternative Minimum Tax (AMT). An explanation of the AMT is well beyond the scope of this article, but in short, many companies who did invest time and resources to track and generate the R&D Credit found that their owner’s ability to utilize the credit was severely limited or even eliminated once the credit reached their personal tax returns. Effective January 1, 2016, the AMT no longer impacts the ability to use credits if the claiming company has annual gross receipts of $50 million or less. Additionally, for startup companies – defined as being in business five years or less and with annual average gross receipts of $5 million or less – the credit can be utilized to offset employer payroll taxes.
Credit Qualification and Maximization
So how does an AE firm qualify for the credit and what is it worth? The R&D Credit is based on costs known as qualified research expenses (QREs). Three types of expenses qualify as QREs – wages, supplies consumed and contracted research. QREs are the costs associated with a qualifying activity. The official definition of a qualifying activity sounds a bit intimidating: The development of a new or improved business component that is: technological in nature; involves the process of experimentation, where; uncertainty is eliminated, and; the ultimate purpose is a new or improved function, performance, reliability, or quality.
In the end, it’s all about solving problems and doing things better. Each project is unique and requires brainstorming, experimentation and trial and error, and it’s precisely these efforts that the credit is designed to reward. The key here is that the new process, technique, project, etc. does not have to be unique or revolutionary. Rather, it just has to be new to the firm in how it applies to the specific project. It is also important to note that the activity does not even need to be successful. You read that correctly – success is not a factor! It stands to reason that not all activities will be successful and the credit is designed to encourage risk-taking and innovation.
Central to maximizing the credit is capturing those qualifying expenses. For an AE firm, the wages associated with the project design are the most significant cost. This includes not only the direct labor of the design professional but also supervisory and support wages. Contracted research can also be a major factor if your firm makes extensive use of sub-contractors. For the design firm, supplies consumed are typically not as significant, but should also be considered.
On average, the credit will be approximately 5-6.5% of the QREs. Don’t forget; a credit is more valuable than a tax deduction since a credit eliminates your tax liability dollar for dollar while a deduction is only worth a fraction of its cost. As such, the credit will retain its value even if we see significantly reduced tax rates, while the value of deductions will decline.
Once you have generated your federal credit, don’t forget about state taxes. Approximately 40 states have some variation of the R&D credit program in place, although the mechanics of the program can vary widely from state to state.
Get Your Firm Moving on Next Steps
Projects carry a vast amount of challenges that your team successfully navigate on a daily basis, and you deserve to reap the benefits of that hard work. The Research and Development Tax Credit is one of the most overlooked sources of tax savings available, and we work with many firms to not only identify R&D costs but calculate the credit and develop documentation that supports our conclusions. The exciting part is that a company can capture these costs collectively as projects are performed.
To learn more about the R&D Tax Credit and other tax savings strategies, please watch our on-demand webinar titled “Turn Complexity Into Profitability for Your AE Firm“.