By Michael Devereux II, CPA, CMP, partner
Mueller Prost

Enacted in 1981, the Credit for Increasing Research Activities [also known as the Research & Experimentation (R&E) or Research & Development (R&D) tax credit] rewards companies for the development or improvement of products, processes, techniques, formulas, inventions or software applications.

The R&D tax credit is a dollar-for-dollar credit against the taxpayer’s federal income tax liability. Taxpayers may benefit from both the deduction in the year the expenditure is paid or incurred and by claiming the research tax credit.

In addition, approximately 35 states also have incentives for research and development, typically based upon the federal definition of research. The various state R&D tax incentives range from one percent to 24 percent of the eligible research expenditures, with some states requiring taxable income as a prerequisite for utilizing the credit and others refunding any unused credit to the taxpayer, irrespective of the existence of taxable income. Each state has its own requirements, and state credits are only eligible for research conducted within each respective state.

We have found that AMBA members consistently perform qualified research and development activities. This may include the design and development of new molds, attempts to improve production processes, sampling new tools and investments in automation.

How do mold builders qualify?

The credit is activity-based, and there are four basic requirements for an activity to qualify for the research tax credit. The following overview discusses the four requirements and how these activities apply to tool builders.

1. Development or improvement of a business component
For an activity to qualify, taxpayers must be developing a new business component or improving an existing business component that is held for sale, lease or license, or used by the taxpayer in its trade or business. Business components are defined as products, processes, techniques, formulas, inventions or software applications.

For mold builders, custom, novel, one-of-a-kind tools – as well as related manufacturing processes and automation techniques – meet the requirements.

2. Activities must be technological in nature
For an activity to qualify, the research must be undertaken for the purpose of eliminating technological uncertainty concerning the development or improvement of a business component. That is, the activities must fundamentally rely upon the sciences or engineering disciplines. That is not to say that moldmakers must expand, exceed or refine the knowledge in their industry. Rather, moldmakers may rely upon existing engineering principles to eliminate the technological uncertainty.

Tool builders regularly rely upon the engineering disciplines to eliminate technological uncertainty related to the design of new tools.

3. Activities intend to eliminate uncertainty
Uncertainty exists if the moldmaker is unsure about the capability of developing the tool, the method of developing the tool or if the appropriate design of the tool is uncertain at the beginning of the research activity. We have found that many shops must eliminate uncertainty related to the appropriate design of the tool with respect to many new tool builds.

4. Process of experimentation
For an activity to qualify, a taxpayer must eliminate the technological uncertainty by engaging in a process of experimentation. A process of experimentation is an evaluative process and should be capable of evaluating more than one alternative.

Treasury regulations define a process of experimentation as modeling, simulation or systematic trial and error. This includes 3D modeling of new tools or parts, mold fill analysis, warpage/cooling experimentation and sampling new tools.

Activities that may qualify for tool builders include, but are not limited to, the following:

• Development of alternative part designs to improve manufacturability of the tool
• Development of alternative tool designs
• Experimentation with critical variables, such as wall thickness, rigidity and ejection methods
• Development of processing alternatives within the tool with an emphasis on gating and runner design, flow rates, pressure and cooling rate/time
• Improving processes with gas injection technology
• Developing new automation techniques
• Improving production processes through new technology

Qualifying expenditures

While there are numerous expenditures that meet the definition of research, only three types of expenditures are allowed in calculating the R&D tax credit. These include wages paid for qualified services, supplies used in the conduct of research and contract research.

Wages paid for qualified services include wages paid for three types of activities performed by employees of the tool builder. These include engaging in qualified research, directly supporting qualified research and directly supervising qualified research. Therefore, qualified services are not limited to those services performed by the engineering department, but also include the services performed by the production and quality departments prior to the elimination of design uncertainty, as well as management oversight of the research efforts.

Moreover, mold builders also may include supplies used in the conduct of research. Generally, taxpayers may include the costs of supplies and materials that are used in the conduct of research, regardless of whether the materials are part of the finished product. These expenditures are typically significant for tool builders, as many times the first (and perhaps only) prototype or production mold the tool builder is producing is unique, novel and involves numerous design alternatives. That is, the design uncertainty still is being eliminated at the time the tool is being built and trialed.

Finally, taxpayers may include 65 percent of the amounts paid for contract research, which includes any amounts paid to third parties for research performed on the tool shop’s behalf. Generally, these amounts may include expenditures related to mold fill analysis, heat treating, cooling analysis or outside testing.

Tax reform increases the value of the R&D tax credit

Beginning in 2018, tool shops’ R&D tax credit became more valuable, thanks to the Tax Cuts and Jobs Act of 2017.

For mold shops making the proper election on an originally filed return (including extensions), the value of the credit was increased significantly. The §280C election percentage is equal to 100 percent minus the top corporate tax rate. When tax reform lowered the top corporate tax rate from 35 percent to 21 percent, the applicable percentage found in §280C went from 65 percent to 79 percent. As a result, tool shops’ credits will be greater with the same level of research expenditures.

Conclusion

The R&D tax credit is one of the most beneficial tax incentives that US-based mold builders may utilize to reduce their income tax liabilities. Both quantitative and qualitative documentation is necessary to support these research credit claims, so tool shops are best served by creating and maintaining the proper documentation to support such claims.

Further, with recent legislation and changes to Treasury regulations, mold builders are able to monetize greater research credits, thus allowing shops to be more competitive in the global marketplace.

Michael Devereux II, CPA, CMP is a partner and director of manufacturing, distribution and plastics industry services at Mueller Prost CPAs + Business Advisors. To find out if a business activity qualifies for the R&D credit or any other available incentives, contact Devereux at [email protected].