In today’s economy, businesses have become more cash-conscious. The focus on expenses has become increasingly important to the bottom line. Typically, the top three business expenses are wages, raw material costs and taxes. If jobs are cut, or raw material purchases are reduced, margins may be salvaged in the short term, but over a period of time, lack of inventory and production shutdowns can prove to be costly.
A truly benign way of cutting costs is reducing the tax burden. By taking full advantage of the R&D tax credit, many chemical process industries (CPI), with annual sales ranging from five million to more than one billion dollars, have achieved annual tax savings of anywhere between $50,000 and $1.5 million.
Those pursuing the R&D credit without the necessary background knowledge and experience, however, run into two main issues: excluding qualifying activities from the credit; or failing to identify and utilize records associated with qualifying expenses.
While most chemical manufacturers have capable and competent certified public accountants (CPAs) to get returns prepared correctly and financials audited, few CPA firms have the combination of CPI expertise and tax knowledge necessary to properly capture the federal and state credits and incentives for CPI firms. In fact, there are more than 7,000 credits and incentives available to assist companies.
Why all the confusion?
The misconception that a CPI firm or chemical equipment manufacturer must develop formulations or devices that are revolutionary to claim an R&D tax credit comes from the outdated notion of the discovery rule. However, numerous statutory and regulatory changes to the R&D tax credit over the past decade have drastically modified this and other key components of the R&D credit. The result in many cases is that companies either do not claim the costs associated with process development and product and process improvement or worse, they fail to claim a credit at all.
In fact, tax credit claims can be made for new product formulations and designs, as well as improved formulations and designs, new and improved processes, and new laboratory testing methodologies that require experimental testing to overcome any design or performance uncertainties. This broader definition of qualified costs allows the capture of additional material, wage and sub-consultant expenditures from a more comprehensive variety of activities.
The other major challenge typically encountered when filing for an R&D tax credit is a scarcity of costing records. This obstacle leads many to believe they are unable to pursue the credit. The truth is, there are substantial regulations for how to treat costs that are not tracked contemporaneously and a lack of job costing by no means eliminates the ability to claim the R&D credit. Our experience with surmounting these and other technical challenges associated with the credit can easily double or triple a company’s annual tax savings from that captured in the past.
What is considered R&D?
The typical definition of R&D brings to mind scientists in white lab coats; however, the recent changes noted above allow groups from a wider spectrum of specialties to receive tax benefits. While many companies believe that they do not qualify for the R&D credit, advisers with the right expertise and technical background can help identify and qualify activities they may have never considered. These include developing new or improved methods and equipment for the manufacturing process, terminal and plant design and petroleum-refinery processing design in addition to just formulation development.
Example 1. For example, one company was involved in the replacement and repair of flue-duct expansion joints, gas turbine exhaust parts and associated ductwork for chemical plants. The company believed that repair work did not qualify as a R&D activity and so was not pursuing the credit. In surveying sites, however, they often designed not only replacement parts, but new layouts and systems to tie-in with the existing work to improve the efficiency of the final product. Each site had to be evaluated and designed to achieve the provided requirements while working around existing site constrictions.
Once the engineers determined the final design, the employees involved in the installation process had to determine the best method for implementing the design. Again, since each site was unique in the existing obstructions, the field foreman had to devise alternate methods for executing the chosen design. Since the employees often had to design new installation processes and equipment, it was possible to claim additional wages as qualified for the R&D tax credit for those field employees associated with the process design. By delving into the details of the company’s procedures, process design activities were identified that qualified for the R&D tax credit and provided $100,000 in tax benefits for a single year.
Example 2. Another company was involved in developing chemical formulations for carpeting, automotive, dyeing and industrial manufacturing applications. This company was not taking advantage of the R&D tax credit because its prevailing mindset regarding the R&D credit was to focus only on new formulation development and improvements to existing formulations to advance product performance. This approach allowed them to claim only the wages from the R&D department and the raw materials used to produce prototypes toward the R&D credit to the tune of about $250,000 in tax savings. After additional review and conversation, however, two additional areas for capturing R&D costs were identified: manufacturing process improvements and testing methodologies.
Both of these activities were essential to this business’s survival in a competitive market with increasing regulatory pressure to ensure product quality. For many of the unique formulations, the company had to design new or improved manufacturing processes and equipment. Once the chemists created prototype samples for each of the chemical compounds, technicians had to develop methods for scaling up the batch sizes. This often resulted in equipment improvements to achieve the required properties for the formulations at a large scale.
Furthermore, new testing methodologies were required to ensure products adhered to enhanced quality standards to protect consumers. Even though both activities were conducted to keep the company competitive (and not specifically to bring something new to market), they still met the statutory definition of R&D. By finding these additional sources of qualified expenditures, the annual R&D tax credit more than doubled to approximately $500,000 in tax savings.
Example 3. In addition to manufacturing process improvements, another area that is often overlooked by taxpayers is terminal, petroleum-refinery process and petrochemical plant design.
A company with sales of $6 million developed asphalt, hot oil, polymer expansion, and biodiesel terminals. The company primarily designed the refining process for raw material facilities and had invested in a large project that year. While it was already convinced that its activities qualified as R&D, the company focused on claiming the wages paid in conjunction with the design of various refineries for the R&D tax credit. This initial approach identified $60,000 in tax benefits.
Through additional conversations about the nature of the terminal design projects and various expenses associated with them, an additional source of expenses that qualified for the credit was identified: contractor costs.
Contractor costs can include outside testing to evaluate formulations or prototype products, surveying and assessment of existing site constraints, and formulation and engineering design. Anyone not employed by the business that is performing research and furthering the design process for the company should be appraised for potential R&D credit visibility.
While the client developed the overall refining process and performed the necessary design and drafting work, it also paid a substantial amount to outside contractors to complete the detailed design work. The company subcontracted surveying and testing, engineers for electrical wiring design, and engineers to design and construct equipment around the determined refining process. Since an outside company was performing part of the research and the contracting company was fiscally responsible for the ensuing fees regardless of design package acceptance, so the subcontracted costs were captured. The company’s R&D tax benefit for one year doubled to $120,000.
Example 4. Like many other companies, one chemical engineering firm pursued the R&D credit for the first time to help alleviate the tax burden associated with $50 million in sales. The company was an industrial-based engineering and construction firm that provides engineering services primarily for petroleum refineries and petrochemical plants. It provided complete engineering packages that covered everything from filtration processes to piping layout and structural design of the plants.
This particular taxpayer maintained sparse internal records, causing us to determine the most acceptable means of using extant data and non-standard documentation to build out the substantiation of the credits. The information the taxpayer did possess enabled us to determine the types of activities associated with each project and further qualify or disqualify them. When we began examining the projects in further detail, we discovered that nearly all employee activities on the largest jobs were system and process design. The company undertook activities such as evaluating equipment for the refinery process, performing calculations, drafting flow diagrams, designing piping layout and tie-ins, and structural engineering.
In addition to designing plants from the ground up, the company also performed repair work for facilities that were no longer functioning properly. When we examined the jobs that were designated as repair work, we found that the company was continuously trying to improve the design and the refinery process for economic, quality and safety upgrades. Not only was the company trying to improve the system as a whole, it also had to design around site constraints. During system repair, new or improved equipment often required piping and tie-in redesign for compatibility with the new equipment.
Because we were able to capture a large percentage of the wages associated with the electrical engineering, civil and structural engineering, piping design and process design work (from 350 employees), we calculated nearly $1 million of tax savings in a single tax year.
Solutions without sophisticated job costing
Many companies outside of the Fortune 500 do not keep detailed accounts of R&D costs. Moreover, for many of the U.S.’s smaller CPI firms, implementing such a system is cost prohibitive. For the time and energy it would take to bring such a system to maturity, many of these companies could find new and inventive ways to serve different markets. Without the R&D-cost accounting readily available, many firms are unsure of how to pursue expenditures for the credit. Such was the case for a company that specialized in developing products for the sporting goods industry.
Example 5. The main area of expertise for this company is formulations to reduce volatile organic compounds (VOCs) in cleaners for the sporting goods market and epoxy systems for equipment repairs. While the company did not have an employee time-tracking system, we were still able to capture wages associated with research activities. By talking to employees about qualifying projects, we identified documentation, including notes and pictures of tests conducted on prototypes. This additional information made it possible to establish a nexus between employee activity and the projects, thus strengthening the company’s claim to the tax savings to which it was entitled. Ultimately, the process saved close to $750,000 in overpaid taxes.
Example 6. Another small company, which develops and manufactures polyurethane and other foam products in addition to designing manufacturing process improvements, did not pursue the credit due to a lack of contemporaneous time tracking. It was hesitant to capture wages of anyone not directly involved in formulation and new-product development and testing. Through thorough investigation, documentation that was originally not considered was uncovered and used to estimate employee time on R&D projects. Those involved in research conducted monthly meetings (which were recorded) to discuss the status of projects and solutions to problems encountered during the research process. Employees often kept emails that discussed progress on projects or client requirements for the new products. There were even test results from trial runs on file that had the signatures of those involved for quality control purposes. Through this level of documentation, we were able to tie each employee to every project worked on. This allowed the company to capture additional salaries, including those for an employee who spent nearly all of his time supervising new product development. This detailed documentation earned an additional $50,000 in tax benefits for one year.
Edited by Dorothy Lozowski
Authors
Les Bryson is the director of implementation for alliantgroup (5400 Westheimer Court, Suite 700, Houston, TX 77056; Email: [email protected]; Phone: 713-877-9600; Website: www.alliantgroup.com) and heads alliantgroup’s Chemical Industry Specialization Program. Prior to alliantgroup, Bryson was a chemist whose work included setting up operations of an industrial laboratory, expertise in multiple disciplines of spectroscopy, and academic research in organic and organometallic synthesis, as well as industrial R&D in transition-metal catalyst recovery. Bryson has been a member of the American Chemical Society for five years. He received a B.S. in chemistry from Rice University.
Nichole Gaudette, is an associate at alliantgroup’s Houston national office (same address as above; Email: [email protected]) working with the Chemical Industry Specialization Program. Prior to joining the alliantgroup, Gaudette worked on research in the area of polymer physics with applications in nanotechnology, a topic on which she published an article. Additionally, Gaudette researched specialized areas of biophysics, including protein aggregation resulting in neurodegenerative diseases. At alliantgroup, she has participated in R&D tax credit studies for several chemical engineering companies. Gaudette received a B.S. with a major in physics and a B.A. with a major in classics from Union College.