Because manufacturing companies are heavily involved in innovation, many are eligible for a manufacturing R&D tax credit. How can these enterprises qualify for this tax benefit? We’ll discuss this further in this article.

What are Manufacturing R&D Tax Credits?

The R&D tax credit is a federal tax benefit supporting companies working on innovative science and technology projects. Because manufacturing companies are heavily involved in creating innovative solutions, plenty are eligible for this tax benefit.

Who qualifies for Manufacturing R&D Tax Credits?

Contrary to what some might think, research and development go beyond scientists in a laboratory. Many manufacturing processes can qualify under these tax incentives. Companies that are involved in the following may file for the R&D tax credit:

• Engaged in product design or process improvement activities as an original equipment manufacturer (OEM) or contract manufacturer
• Utilize computer-aided design (CAD), computer-aided manufacturing (CAM), or computerized numerical control tools (CNC) to improve or create prototypes, fixtures, and manufacturing processes.
• Product development and design relying on systematic trial and error
• Engineer new or improved products and manufacturing processes to create new revisions to part numbers and systems
• Work with new material specifications or enhance your capabilities by bringing outsourced processes into your facility

Four-Part Test for Qualifying Activities

Manufacturing firms that pass the following four-part test may file for R&D Tax Credit:

Permitted Purposes

The activity must relate to a new or improved business component’s function, performance, reliability, quality, or composition. It should intend to develop a new or improved product, process, or software. Moreover, it ensures that the research is not conducted for non-commercial purposes, such as social science or arts-related endeavors.

Technological in Nature

The activity should rely on biological sciences, physical sciences, computer sciences, scientific methods, or engineering principles to qualify for the credits. This requires using technology or engineering in a science field. Moreover, its goal is to improve or develop a software, product, or process’s performance, functionality, quality, or reliability.

Elimination of Uncertainty

The activities must discover information that may eliminate uncertainty about a particular capability or method for improving or developing a process or product.

Process of Experimentation

The activity must involve experimentation, evaluating alternatives, simulation, and hypothesis confirmation through trial and error, testing, and modeling. It should also involve a systematic process to assess at least one alternative, including modeling, prototyping, testing hypotheses, and iterative analysis. The activity should also identify alternatives and test potential solutions.

Qualifying Research Activities for Manufacturing Firms

Here are activities manufacturing firms can list as qualified research activities under this tax credit:

• Alternative material testing
• Design and development of cost-effective operational processes
• Design and evaluation of process alternatives
• Design of manufacturing equipment
• Development of second-generation or improved products
• Assessment and determination of the most efficient flow of material
• Improve product quality
• Integrate new materials to improve product performance and manufacturing processes.
• Optimization of manufacturing processes
• Product development utilizing computer-aided design tools
• Prototyping and three-dimensional modeling
• Tooling and equipment fixture design and development

Not all processes create tax credit opportunities. For example, maintaining research facilities doesn’t count as a manufacturing process.

Qualifying Research Expenditures for Manufacturing Firms

Only select expenditures are classified as qualified research expenses for the R&D tax credit. In particular, the following count:

• Wages paid to employees directly involved in Qualifying Research Activities, including bonuses and taxable commissions. The company must present supporting documents, including timesheets, project descriptions, and employee job descriptions.
• Supplies used for research and development. All tangible material bought for R&D activities counts as qualified research expenses. The company must present documentation like invoices, receipts, and so on.
• Contract research expenses are when a business performs qualified research on behalf of the taxpayer. In this case, 65% of the amount paid to the non-employee can be considered a qualified expense.

How to Claim Manufacturing R&D Tax Credits

Companies must file IRS Form 6765, Credit for Increasing Research Activities, for this tax benefit. This process includes determining qualifying research activities and providing documentation proving these costs meet the Internal Revenue Code Section 41 requirements. Companies may use business records, financial records, oral testimonies, and technical documents.

Before you complete this form, you should familiarize yourself with the instructions mandated by the IRS. The PDF version of this form can be downloaded from the IRS website.

In general, the IRS Form 6765 has four sections:

• Section A is utilized to claim the regular credit and has 11 lines of required information.
• Section B applies to the Alternative Simplified Credit or ASC.
• Section C identifies additional forms and schedules that require reporting based on one’s business structure.
• Section D only applies to qualified small businesses or QSBs making a payroll tax election.

The IRS recommends that companies calculate their credit using regular and simplified methods and then fill out sections (A or B), resulting in the most significant tax benefit. Getting assistance from companies specializing in tax credit services would be ideal to avoid possible mistakes.

 3 Benefits for Claiming Manufacturing R&D Tax Credits

The R&D tax credit can help qualified companies enjoy several benefits, including the following:

1. Reduced tax liability: This tax benefit can help a manufacturing firm lower its overall tax bill. This tax credit can also lower other tax-related expenses, like payroll taxes.
2. Increased cash flow: his tax benefit permits manufacturers to allocate more money for R&D expenses. The money they receive can offset current or future tax liabilities, freeing up cash for other business needs.
3. Encouragement of innovation: Companies that benefit from this tax claim are more motivated to engage in activities that foster innovation and count as future credits.

How to Calculate Manufacturing R&D Credits

There are two ways to calculate manufacturing R&D credits:

Regular Research Credit

For the traditional method of calculating this amount, you need to calculate the credit as 20% of the excess of current year Qualified Research Expenses (QRE) over a base amount. Most startups use this method, which yields the highest credit for most technology companies.

Alternative Simplified Credit

Companies using the alternative simplified credit (ASC) must provide a 14% credit for QRE exceeding 50% of their average QRE for the preceding tax years.

Apply for Manufacturing R&D Tax Credits Today

Eligible manufacturing companies should take advantage of tax credits, like the R&D tax credit—fortunately, plenty of manufacturing activities account for this tax benefit. However, companies should seek professional assistance to avoid miscalculating or missing required documentation.

FAQs

What documentation is necessary for the R&D tax credit? 

Companies must present documentation such as receipts, payroll registers, and invoices that support the expenses they claim.

How much can a company save with Manufacturing R&D tax credits?

The Manufacturing Tax Credits depend on the company’s size and activities. Companies can save up to $5 million through this tax benefit.

What is the 80% rule for R&D credit?

Businesses can claim 100% of W-2 wages paid to employees, spending at least 80% of their time on qualified R&D activities. This allows businesses to estimate the qualified R&D amount to be 80% or more for salaried employees and use the complete 100%.

What are the examples of R&D in manufacturing?

Improving product quality, processes, and systems is considered R&D in manufacturing.

What is the 25% limitation for R&D credit?

The “25/25 limitation” restricts C-corporations with over $25,000 in regular tax liability from offsetting more than 75% of their tax liability using the R&D tax credit.

New businesses with revenue under $5M founded in the last five years may qualify. Research activities don’t need to be groundbreaking or successful to be eligible.

How can small businesses qualify for this tax credit? We’ll discuss further in this article.

R&D Tax Credits for Small Businesses

The R&D tax credit is a dollar-for-dollar reduction that allows companies that engage in research and development activities to offset their business’s tax liability. Its goal is encouraging companies to innovate, create, and perform valuable research for society.

Before, startups could only apply for this tax claim once they became profitable. However, the PATH, or Protecting Americans from Tax Hikes, expanded the legislation and permanently renewed the number of tax credits for businesses, individuals, and families. The expansion permitted unprofitable startups to use their tax credits against their payroll tax liabilities by up to $250,000 annually.

Consequently, a small business can obtain up to $1.25 million in Research and Development tax credits to offset expenses. Let’s say a company doesn’t have gross receipts before the five years ending with the current tax year or less than $5 million of annual gross receipts in the tax credit claim year. In this instance, this company is qualified for tax credits against the payroll tax liability. Most startup companies aren’t profitable until after five to ten years.

The R&D tax credit differs from a tax deduction because the latter reduces taxable income. This credit directly minimizes a company’s tax liability.

Qualifying Research Activities for the R&D Tax Credit

Proper filing of R&D tax credits for small businesses entails distinguishing which activities count as federal income tax liability. Generally, a taxpayer can claim two broad categories of activities towards the R&D tax credit: QRAs — sometimes called qualified research expenses (QREs) — and basic research payments. Most small businesses can claim expenses under the QRE category.

Here are some examples of qualifying research and development activities that small businesses can declare for this tax credit:

• Design or development of new or improved products
• Enhancements to existing processes or products
• Development or improvement of existing prototypes and software
• Streamlining manufacturing processes to increase automation or to reduce cost or waste
• Refining techniques that are already in place
• Advancing software to bridge or interface between outside entities

While it’s vital to identify which activities count as research activities, companies should also take note of activities that shouldn’t be declared for this tax credit. Here are some examples to take note of:

• Duplication of a product or process that already exists
• Studies or surveys conducted, like market research
• Research conducted once commercial production has begun
• Research in the humanities or social science
• Research to adapt an existing product or process to an individual customer
• Research related to software intended for internal use
• The fixed costs for maintaining research facilities

Qualifying Four-Part Test

A small business must pass a standard four-part test to be able to declare activities and expenses related to research. This test applies to companies of all sizes, including small businesses.

Permitted Purposes

The activity must relate to a new or improved business component’s function, performance, reliability, quality, or composition. It should intend to develop a new or improved product, process, or software. Moreover, it ensures that the research is not conducted for non-commercial purposes, such as social science or arts-related endeavors.

Technological in Nature

To qualify for the research credit, the activity should rely on principles of computer science, engineering, physical sciences, biological sciences, and scientific methods. This requires using technology or engineering in a science field.

In addition, its goal is to improve or develop software, processes, or products’ performance, quality, reliability, or functionality.

Elimination of Uncertainty

The activity must aim to discover information to eliminate uncertainty about a specific capability or method for improving or developing a process or product. There is uncertainty if the software, product, or process’s design method or capability isn’t readily known.

Process of Experimentation

The activity must involve the experimentation process involving alternative evaluation, simulation, hypothesis confirmation via trial and error, refining or discarding hypotheses, or testing and modeling. A systematic process evaluating at least one alternative should be involved, including modeling, prototyping, hypothesis testing, and iterative analysis. It also requires determining uncertainties and testing possible solutions.

Qualifying Research Expenditures for Small Businesses

Companies should note expenditures they can declare for this tax claim in addition to which activities qualify for this tax credit. The credit covers two types of qualified research expenses: in-house and contract. In-house research expenses comprise salaries paid to staff for any qualified activities performed, supplies bought for the qualified research, and contract research expenses paid for the research.

Only salaries, including taxable wages reported on a staff member’s W-2 form, can be considered qualifying research expenses. Only employees involved in qualified research activities or directly supporting these activities count.

Any tangible property purchased to conduct qualified research is considered a supply for the tax credits. Contract research expenses are when a third-party business performs qualified research on behalf of the taxpayer.

How to Claim R&D Tax Credits for Small Businesses

Qualified companies must file IRS Form 6765, Credit for Increasing Research Activities, for this tax benefit. This process includes determining qualifying research activities and providing documentation proving these costs meet the Internal Revenue Code Section 41 requirements. Companies may use business and financial records, oral testimonies, and technical documents.

Before you complete this form, you should carefully read the instructions mandated by the IRS. The PDF version of this form can be easily downloaded from the IRS website.

In general, the IRS Form 6765 has four sections:

• Section A is used to claim the regular credit and contains 11 lines of required information.
• Section B applies to the Alternative Simplified Credit or ASC.
• Section C identifies additional forms and schedules that require reporting based on one’s business structure.
• Section D only applies to qualified small businesses or QSBs making a payroll tax election.

The IRS recommends that companies calculate their credit using both regular and simplified credit methods, and then they fill out the section (A or B) that would result in the greatest tax benefit.

3 Benefits for Claiming R&D Tax Credits

Companies that claim R&D tax credits can enjoy the following benefits:

1. Reduced Tax Liability

Tax liabilities, like payroll taxes, can be very costly for startups. This tax credit empowers companies by directly decreasing their tax obligations. It can even offset payroll taxes.

2. Increased Cash Flow

The R&D tax credit provides immediate cash flow benefits, allowing reinvestment in business growth. The money qualified small businesses to receive from this benefit can be allotted to other vital research-related activities.

3. Growth Opportunities

Increased funding for research activities can lead to new market opportunities and revenue streams for small businesses.

R&D Payroll Tax Offset

The federal R&D payroll tax offset provision of the R&D Tax Credit allows a startup company to claim credit against their payroll taxes. Under IRC Section 41(h), a qualified small business can use its federal R&D credit to offset its employer-paid payroll taxes starting in tax years after December 31, 2015.

To be eligible for this, the business must have less than $5 million in gross receipts in the credit year and has no “gross receipts” for any taxable year preceding the 5-taxable-year period ending with the credit year.

How to Calculate R&D Credits for Small Businesses

Calculating one’s R&D credits entails five crucial steps:

1. Calculate qualified research expenses for the preceding three years.
2. Average these amounts.
3. Multiply that average by 50%. This number is your credit base.
4. Subtract the amount of your credit base from your total R&D expenses for the year.
5. Multiply by 14% to find your R&D tax credit.

The credit is calculated as 10% of QREs more than the base period up to $2M and 2.5% for expenses above $2M. The base period is greater than either a) the average annual gross for the four preceding tax years multiplied by a fixed-base percentage or b) 50% of current year QREs.

Other Tax Credits for Small Businesses

Small companies are eligible for other tax credits that can improve their overall business operations in addition to the R&D tax credit.

Work Opportunity Tax Credit 

This is a federal tax credit available to employers who invest in American job seekers who have consistently faced barriers to employment. Employers may meet their business needs and claim a tax credit if they hire an individual in a WOTC-targeted group.

SECURE 2.0 Act

This act contains 92 new provisions to promote savings, boost incentives for businesses, and offer more flexibility to those saving for retirement.

Natural Disaster Tax Relief

This bill sets forth tax relief provisions for individual taxpayers for losses resulting from a major disaster occurring in 2023.

Claim R&D Tax Credits for Small Businesses

Startups can benefit tremendously from the R&D tax credit. However, when dealing with taxes, it’s best to leave things to the professionals. Companies should seek help from experts in payroll tax credit matters and more if they intend to maximize these benefits.

FAQs

Can LLC claim R&D credit?

Yes, an LLC can claim R&D tax credit.

Can a sole proprietor claim an R&D tax credit? 

If your business is a sole proprietorship, you can qualify for the federal R&D tax credit.

How much can you Write Off for R&D?

This depends on the qualified expenses, but companies can generally claim up to $500,000.

What are Engineering R&D Tax Credits?

The R&D Tax Credit (26 U.S. Code §41) is a federal benefit that provides qualified companies with dollar-for-dollar cash savings for performing activities related to developing, designing, or improving products, processes, formulas, or software. This benefit includes engineering firms with much-needed funds for additional employees, increasing R&D, the means to expand facilities, and much more.

Who qualifies for Engineering R&D Tax Credits?

Pioneering solutions are vital in the engineering industry. That’s why plenty of firms in the industry qualify for this tax savings. The R&D tax credit is available to several sectors, including the following:

• Aerospace Engineering
• Agricultural Engineering
• Biomedical Engineering
• Chemical Engineering
• Civil Engineering
• Computer Engineering
• Construction
• Data Engineering
• Electrical Engineering
• Geological Engineering
• Industrial Engineering
• Manufacturing
• Marine Engineering
• Mechanical Engineering

In general, an engineering firm that engages in the following activities can apply for a Research and Development tax credit:

• Control system design: Firms that create unique computer control programs and produce innovative programmable logic controllers.
• Operation improvement: Companies that create improvements in techniques and methods reduce faults, achieve complex material forms, and develop next-generation capabilities.
• Development of formulations: Companies that overcome problems with material compatibilities, reduce costs, meet regulatory changes, or create new finishes.
• Copy with modifications: Firms replicating a product, device, or process without infringing patents.

Four-Part Test for Qualifying Activities

An engineering firm must pass a four-part test to qualify for the R&D tax credit program. This test determines whether the firm’s activities qualify for the credit. This applies to all kinds of companies, not just engineering firms.

Permitted Purposes

The activity must relate to a new or improved business component’s function, performance, reliability, quality, or composition. It should intend to develop a new or improved product, process, or software. Moreover, it ensures that the research is not conducted for non-commercial purposes, such as social science research or arts-related endeavors.

Technological in Nature

To qualify for research credits, the activity should fundamentally rely on principles of physical sciences, biological sciences, computer science, or engineering and on scientific methods. This entails that the activity requires the use of technology or engineering in a field of science.

Moreover, it aims to develop or improve a product, process, or software’s functionality, performance, reliability, or quality. Examples include developing new materials, improving manufacturing processes, or enhancing software functionality.

Elimination of Uncertainty

The activity must be intended to discover information to eliminate uncertainty concerning a particular method or capability for developing or improving a product or process. Uncertainty exists if the capability, method, or design of the product, process, or software is uncertain or not readily known.

Process of Experimentation

The activity must constitute the process of experimentation involving simulation, evaluation of alternatives, confirmation of hypotheses through trial and error, testing and modeling, or refining or discarding of hypotheses. It should involve a systematic process designed to evaluate one or more alternatives and include testing hypotheses, modeling, prototyping, and iterative analysis. It also needs to identify uncertainties and test potential solutions to resolve them.

Qualifying Research Activities for Engineering Firms

Most engineering firms qualify for this research credit, but it’s vital to determine which activities qualify for government incentives like the R&D tax credit. Here are some excellent examples engineering firms can refer to:

• Achieve Leadership in Energy and Environmental Design (LEED) certification
• Build information modeling
• Consider and evaluate different design alternatives
• Create prototypes, blueprints, and diagrams
• Design foundation and earthwork for site conditions
• Develop new or improved designs for structures
• Develop new software applications to use internally to interact with customers/vendors
• Develop preliminary design, development plan
• Develop preliminary computer-aided design (CAD) modeling and testing
• Develop schematic designs
• Develop sustainable designs
• Develop unique functional and energy-efficient designs
• Environmental design
• Improve alternative heating or cooling systems
• New materials
• Space utilization
• Toxic waste and other waste disposal processes

Qualifying Research Expenditures for Engineering Firms

Generally, the R&D tax credit covers two categories of qualified research expenses: in-house research expenses and contract research expenses. In-house research expenses include wages paid to employees for any qualifying activities performed, supplies purchased to conduct qualified research, and contract research expenses paid to conduct qualified research.

To clarify, only wages that include all taxable wages reported on an employee’s W-2 form can be declared as qualifying research expenditures. In addition, it should be highlighted that only employees involved in qualified research activities or directly supporting these initiatives are qualified.

Any tangible property bought to conduct qualified research can be considered a supply for this tax credit. An engineering firm working to improve the quality of a product may declare the materials used for that project as supply expenses.

Contract research expenses are when a business performs qualified research on behalf of the taxpayer. In this case, 65% of the amount paid to the non-employee can be considered a qualified expense.

How to Claim Engineering R&D Tax Credits

For these tax savings, companies must seek the assistance of tax credit experts. Miscalculations and wrongful declarations may result in penalties.

For this tax benefit, companies must file IRS Form 6765, Credit for Increasing Research Activities. This process includes identifying qualifying research activities and providing documentation proving these costs meet the Internal Revenue Code Section 41 requirements. Companies may use business records, financial records, oral testimonies, and technical documents.

Before you complete this form, you should familiarize yourself with the instructions mandated by the IRS. The PDF version of this form can be easily downloaded from the IRS website.

In general, the IRS Form 6765 has four sections:

• Section A is used to claim the regular credit and contains 11 lines of required information.
• Section B applies to the Alternative Simplified Credit or ASC.
• Section C identifies additional forms and schedules that require reporting based on one’s business structure.
• Section D only applies to qualified small businesses or QSBs making a payroll tax election.

The IRS recommends that companies calculate their credit using both regular and simplified credit methods, and then they fill out the section (A or B) that would result in the greatest tax benefit.

Benefits of Claiming Engineering R&D Tax Credits

What can engineering companies gain from filing R&D tax credits? Here are some of the benefits of filing research credits:

1. Lowered tax liability: Upon receipt of the tax credit, companies can lower their overall tax expenditures.
2. Improved cash flow: Companies that receive tax credit services can profit more in the long run because of this credit.
3. More budget for R&D activities: Engineering companies can focus on improving their businesses because they have more funding.
4. Means for more qualified staff: This tax benefit empowers companies to hire more skilled professionals to contribute to the company’s R&D activities.

How Much Tax Can You Save with an Engineering R&D Credit Offset?

This varies from business to business. Generally, companies can obtain up to $500,000 through the R&D tax credit.

Regular Research Credit

For the traditional method of calculating this amount, you need to calculate the credit as 20% of the excess of current year Qualified Research Expenses (QRE) over a base amount. Most startups use this method, which yields the highest credit for most technology companies.

Alternative Simplified Credit

Companies using the alternative simplified credit (ASC) must provide a 14% credit for QRE exceeding 50% of their average QRE for the preceding tax years.

Claim Engineering R&D Tax Credits Now

Most engineering firms qualify for the R&D tax credit. Every engineering firm involved in R&D should claim tax credits and reduce tax liability. But, claiming them won’t be an easy process. Declaring the correct amount matters, and documentation is vital to avoid issues with the IRS. Contact our team and get in touch with professionals to help you out with claiming these tax credits.

FAQs

What qualifies for R&D tax credits?

Companies that pass the four-part test can apply for Engineering R&D Tax Credits.

Is engineering considered R&D?

Every project among engineers involves some research, especially in the preliminary stages. Yes, engineering qualifies for R&D.

What expenses qualify for the R&D tax credit?

Wages of employees, supply costs, and contract research expenses qualify for the R&D tax credit.