The R&D Tax Credit - Who Qualifies and How to Claim It

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Heidi: This podcast is sponsored by Engineered Tax Services, a subsidiary of Engineered Advisory, whose goal is to support CPAs and their clients to achieve the highest and best use of time and resources. Ets offers specialty tax services and incentives which help expand your capabilities and ensure that your clients are paying only what is required in taxes and nothing more. To learn more about Engineered tax services, go to Engineered Tax and mention the healthy, Wealthy and Wise podcast to receive project discounts and a free CPA partnership book. Hi, everyone. This is Heidi Henderson and you are listening to the Healthy, Wealthy and Wise podcast for accountants. I am really passionate about people and the industry, and I truly believe that the accounting industry can do better for both our clients and it's professionals. So I'm going to share insights from people who have found professional success and who have managed to balance that with their physical, mental and personal health. So I hope you enjoy and I hope you get inspired. Accountants can earn free CPA From listening to this episode, just visit Earmark cpcomm. Download the app, take a short quiz and get your CPA certificate. And now on to the episode. Welcome to today's podcast. My guest today is George Matar, who, if you listen to the podcast, you'll realize that actually George was on a few weeks ago or maybe a month ago or so, and we had talked about 45 credits and 179 deductions as they relate to energy efficient buildings.

Heidi: George is back because he also is the head of our R&D department or research and development team. And so he is an expert on research and development tax credits and manages our team of project managers and experts in that space. And this particular tax credit has some very interesting nuances and applications across the spectrum of many different industries. We wanted to have the conversation today to first really give a high level overview of what the tax credit is all about, talk about what qualifies and what doesn't, kind of the four part test and give some examples there. And then we're going to end the conversation really highlighting this 174 issue, which is an amortization rule that has shifted just since 2022, that is requiring tax payers to amortize or depreciate their related research costs or development costs rather than expense them, and that includes wages. So there is really a huge impact, huge negative impact actually as it relates to 174. So we're going to talk about what that is, how it impacts R&D, how it impacts businesses. Maybe we'll do a couple of case studies or basic estimated calculations to give you a ballpark and circle around from there. So that's the agenda today. But George, thank you for being here and it's always a pleasure.

George: Yeah, Thanks, Heidi. Happy to be here. And talk about R&D.

Heidi: Perfect. So why don't you start and give us like the high level rundown. So talk a little bit about what is the R&D credit? Yeah.

George: So the R&D is an amazing tax credit started in the 1980s as kind of an incentive for companies pushing the envelope in their industry. It's meant to kind of look at companies payroll wages, supply costs, contractor costs, just kind of everything they're doing on a day to day basis to kind of push the envelope and try new things, whether it be new product, new production, new technique, new formula, and give some money back for them, kind of doing this trial and error process where we might succeed, we might not succeed. How can we kind of push our company and our firm forward? So it's an amazing tax credit that people can claim on their current tax year and the prior three open tax years.

Heidi: Awesome. And it's a federal income tax credit. And then there's quite a few states that that have kind of an equal or similar credit that kind of follows federal, is that right?

George: Yes, that's right. There's about 30 plus states that have some type of state tax incentive in addition to the federal tax credit for their research and development activities.

Heidi: Fantastic. As far as the amount of an R&D credit, what's kind of the ballpark range, what is the value of the credit for how we could monetize that?

George: Sure. So at its heart, being a tax credit, it's a dollar for dollar reduction of a client's tax liability. And what we see as a rule of thumb is whatever we're able to qualify as a research expense, say million, 500,000, whatever that kind of bucket of eligible research cost are. Our rule of thumb is 8% of that translates into the net tax credit value.

Heidi: Perfect. And that's on the federal side. So any state credits then would be in addition to that. So roughly 8% of qualifying costs, which would be wages or supplies or other related costs, right?

George: That's right.

Heidi: Perfect. What are some of the industries we work with? A number of industries and kind of full spectrum. What are some of the industries that are the obvious ones? And then tell me some of the ones that maybe aren't so obvious.

George: Sure. Yeah. We found a lot of research development success with software development companies, manufacturing companies, architects, engineers, the construction world, basically how you're kind of building and constructing these buildings. Also, pharmaceutical, chemical manufacturers, oil and gas industry, kind of you name it, Any company is kind of pushing the envelope, trying to create a new product or process or new development. Anyone that's kind of there's a lot of technical uncertainty and trying to overcome that in your field. There's probably some research and development there.

Heidi: Okay. And does does someone have to have a patent or do they have to have created some brand new product that they've developed in order to qualify?

George: And that's a great question because while a patent is an excellent fact pattern, we still have to measure it against the four part test you mentioned. So, yes, a patent is a great indicator of R&D going on. It's not the only indicator. And the activity doesn't have to be new to the world. You don't have to be doing something groundbreaking that's going to change our industry. It's kind of new to your firm, some type of new technological knowhow, maybe new process or new design that you might be implementing for a client. That's very challenging in the field. That may. Your staff haven't faced before that you need to kind of do some trial and error to figure out how to maybe make that best design or that best approach to deliver that end product.

Heidi: Okay. So let's talk about the four part test. And to preface this, one thing I think is interesting is prior to I don't you remember the you might remember the year, but prior to a certain year it was something different. And then they changed it to the four part test. And it was at that time that that shift to the four part test definition is what really started to open the window up for other industries that previous to that really didn't have as much qualifying or application for R&D because of how they redefined it. Do you remember the year by chance that they did that four part test?

George: I want to say maybe 2010, but you're right. You're talking about the discovery rule. Used to be this implication on had to be something groundbreaking. And now moving to the four part test, which the four part test is permitted purpose. You're talking about like a new product, new technique, new formula. Yeah. There is some technical uncertainty going on. You have a defined process orientation and then it has to be technological in nature. Now, this like much simplified four part test compared to this discovery test has allowed the doors to open to a number of industries that previously probably only thought, you know, someone in a lab wearing a coat using test beakers was probably the fit of R&D.

Heidi: Yeah, absolutely. Yeah. I mean, people think of it as well. It's got to be some test tube or I've got a petri dish or something where I'm, you know, creating a cure for this or cure for that something directly then patented a medical device, you know, that's brand new on the market. But that, I think, is what's interesting. I mean, let's talk, for example, in the architectural space, we work with so many architects as a partner with the AIA nationally, the conversation is always very similar where a lot of architects say, Well, this is what I do every single day. This mean I'm working on an iterative process where I have a concept and then I have to essentially determine the end result and how I'm going to accomplish that original concept. And it's a little unclear at the onset that is the exact definition of R&D. But in the architectural space it's confusing because they say, well, first off, it sounds too good to be true. And second, I do this every single day. This is just what I do. And and so it's interesting because it's hard sometimes in that particular industry to wrap your head around or for for a taxpayer to wrap their head around how that applies and how that correlates. So let's talk a little bit, say, in that particular space, because it does get a little more complex how we define those activities in a in a, say, a design firm.

George: Sure. And I think going back to the four part test, the easiest way to filter your company's activities is kind of to of that, that part's one. We have to make sure it's technical in nature. So it needs to be related to engineering, computer science, chemistry, biology. So for architects and engineers, that engineering principle is kind of at the heart. Maybe some computer science with Revit and BIM modeling to help test that energy analysis. And then when we talk about perimeter purpose for most architects and engineers in construction industry, we're looking to qualify their design product, which is going to be their technique, right? Their knowhow to a client comes to them with a problem. I have this site. How can I create something from nothing? And that knowhow is really what we're trying to focus on. And then the heart of our study is going to be okay, now that a client's come to you with a plot of land and a concept to build this 12 story building, what are all the challenges? What are all the hurdles? So yes, you do this on a day to day basis, but, you know, you've got to do conceptual analysis on how the site's going to be accessed, how much parking, what are the what's the foundation going to look like? Are you going to use piling you use like footings, What type of building systems you can use you're going to use like, is it large enough for a chiller boiler, geothermal plants? What type of lighting, electrical systems, plumbing.

George: I mean, the list goes on and on and we see a lot of the R&D for that space really happens in that conceptual schema design, design development, construction documents phase. And then it kind of tapers off because at the end of heart is the technical uncertainty is what is the best and most appropriate design for that concept. So using architects, having this project accounting to tie into okay, John Smith worked on Project A for five hours doing design development, that type of documentation, that type of activity, while it's day to day, is a great indicator of uncertainty in the design effort and how your team is kind of uncovering it each day through this process. Experimentation. That's an industry standardized.

Heidi: Okay, so in that scenario, you have a company that's working on projects like that. They're going through that process or the typical phases of development and design in an architectural or engineering type company. What are the costs then that correlate to the R&D? What fall into the. Calculation itself.

George: Sure. So there's kind of four buckets of cost that can kind of generate the R&D tax credit. The biggest by far that we see is wages. So your employees W-2 Box one wages make up the biggest bucket and then from there we have any supplies or raw materials that are consumed during the research and testing process for R&D firms. That's typically on the low end. Maybe they're building a prototype or building some type of physical case study model that we might be able to qualify. And then contract research costs. Is any consultants that are aiding and supporting the design effort, which in the architectural engineering space, usually that's going to be consulting designs, right? An architect might hire engineers, structural designers, and that kind of leads toward a topic. We'll talk later about funded research. But the fourth bucket is computer rental costs. And these are mainly for cloud services, cloud computers that are not owned by the taxpayer, but are kind of rented and hosted. So like Microsoft Azure, Amazon Web Services. And while that's not in the R&D space, sometimes that can be an eligible cost for software development or even manufacturers.

Heidi: Yeah, absolutely. Well, that's interesting. I mean, so there's there's quite a few different costs that can factor into the calculation. You kind of hit on funded research. Yeah. So with that, then let's then highlight the things that don't qualify. And I'll tell you, I ask this question because there are so many times I have conversations. One of the first things is we bought all this amazing equipment this year. We bought this 3D printer and we bought this laser cutter. And, you know, we spent, you know, $2.5 million on this equipment to set up our processes. And a lot of people are thinking, Hey, this is great because I can get an R&D credit for the value of of acquiring all this new equipment. So let's talk about what doesn't qualify for the credit, because I think that's a really big discussion as well.

George: Absolutely. So what we talked about the four part test for qualifying research activities and kind of the four buckets of qualifying research costs. One of the biggest issues or qualifying issues is this two part funded research test. Who owns the rights to the work being done and who holds the economic risk in these engagements? So focusing on architects and engineers, one of the best indicators of economic risk is when the client engages or sorry, I should say, the taxpayer engages its clients on a fixed fee lump sum basis. Right? You're basically paid X dollars to figure it out. If you spend 100 hours, 1000 hours, 10,000 hours, the risk is on you to fit it and make it efficient within that bucket of cost that defined cost. And that's kind of the economic risk model we're looking at. And then for substantial rights, who just owns the knowhow, the rights of the design? And we look at the contract that you're engaging on, whether it be the third party contract or who the taxpayer is engaging with their clients on how the terms are defined, on who holds that. And that's something that we do on a day to day basis, that contract analysis, some other non qualifying activities. I mean, we talked about equipment costs, so anything that's depreciable, those assets can't be claimed. It needs to fall into one of the buckets.

George: So equipment costs that have more than one year lifespan machinery, 3D printers, manufacturing space is kind of notorious for this, right? They buy big equipments are huge dollar amounts. So they're like, okay, we can claim this toward the credit, but those are depreciable assets and we can't claim them. But in the manufacturing space we can claim like the raw materials going into the prototype. So like the steel, the electric boards, the raw materials to make their prototypes, some other non qualified activities would be international expenses. I mean, this is a federal US based domestic tax credit, so we can only look at domestic research expenses, any in the software development space. That's kind of a big indicator that a lot of people outsource their software activities, whether it be to Romania, India, wherever, and we have to carve those out. And then some of the low hanging fruit is any kind of like routine data gathering, management surveys, marketing, sales, clerical. This is a technical tax credit. So we want to kind of always pull back to that technological in nature component of the four part test. This is an engineering and computer science, a biology or chemistry based activity at its heart. And that's what we're going to be kind of qualifying on the activity side.

Heidi: Perfect. Interesting. How is the the credit? You know, you were saying it's roughly an estimated 8%. Is that something that people usually are doing every single year? Are they recurring from the sense that they're claiming R&D every year and they have activity? Or how is that impacted on an ongoing basis?

George: Yeah. And. That's one of the great things about the R&D tax credit is it is an annual tax credit. As long as your research activities are ongoing, you can claim it every year. So architects and engineers doing new designs every year, manufacturers kind of testing new prototypes, building new components, improving their their workflow software designers, building new apps, building new platforms, kind of creating new things. As long as that kind of new product, new technique, new formula is ongoing, you can claim it each year. And that's kind of why we see it. The credit is primarily a wage driven tax credit because it's your firm overall, how are your people doing? What are your people doing? Are they kind of overcoming this uncertainty? And let's look at it every year.

Heidi: Yeah, absolutely. Well, it's interesting because I'll have people sometimes will have an initial scoping call and they'll go out and they'll start doing some research or they'll ask me for links to the the IRS code sections that correlate to this particular credit. And the interesting thing is the IRS actually calls this research and experimentation credit. So industry wide, we tend to refer to it as R&D, and most businesses are familiar with R&D. The terms typically used by the IRS are actually R&D as and experimentation. And then the other portion of the code is called the increasing research credit. So if you were to go out and Google the IRS code regs and start reading all the regulations, you would find that it's called the increasing research credit. And that portion of the credit is really incentivizing businesses that are continually investing in innovation, growing their businesses, adding new employees or increasing wages and growing that activity. So how does how is that rolled into the the the metric of this credit?

George: Yeah, and that's a layered question. So yeah, so you're absolutely right. I mean, this is a credit for increasing research expenditures. So if you're doing kind of a one off initiative that maybe started in 2022 and it's winding down in 2023, there are other variables, but most likely your credit is going to start to wind down. Usually you want to see research cost of equal or greater value than the prior year to show your credit kind of ongoing. Once the expenses drop below half of a prior year, your credit pretty much disappears. There's some rare scenarios where we can kind of evaluate other approaches. And that kind of brings to the point there are multiple ways to calculate the research credit. There is the regular method, which has kind of the research expenses based on a proportion of your gross receipts. So a lot of times startup companies who are kind of in their first five years of generating gross receipts, that kind of net rule of thumb, I mentioned that 8% of expenses, we can then increase that to about 10% of your research expenses for startup companies using the regular methodology. And then there's this alternative simplified methodology where we compare a single year of R&D to to the prior three years, R&D to kind of see how the the metrics kind of play out and how they increase how you're increasing research activities are ongoing. Yeah. Yeah. Different interplay.

Heidi: Yeah. The complexity of it. So interesting. And as background for listeners, the R&D credit is very often reviewed or analyzed by people with subject matter expertise or people with very in-depth background, particularly in this code section, a lot of small to mid sized CPA firms will not do it or will utilize an outside source to provide that, which of course our firm Engineered Tax Services is a provider of R&D credits. It's interesting because we have had clients. I think there's a couple of red flags. And let's let's talk about some of the ones that I know. I've seen one in particular. We had a client that came to us and they had had a study performed years prior, and then after that, they they they were a little bothered by the fees associated with doing the credit. Granted, the credit still just a percentage is a small portion of the actual credit. But they said, look, we're going to save some money. We think we understand this really well, so we're just going to do the credit ourselves. And so they had a study done, another firm, I think it was five years prior, and then they started to do the credit themselves for the subsequent years. Well, then in the I think the fourth year they got audited and one of the biggest audit flags that was in there was that one of their C level executives had claimed that 90% of his wages were all attributed to R&D activity. And as we know, that's probably a pretty big red flag. And and so that ended up resulting in a negative change. For that particular company and also the realization of how complex the tax credit analysis is and how in-depth it gets into wages and activities and hours and time and and the correlation also calculating into prior years when when we're working with firms. If you are in that situation and you have a C level executive who says, Oh yeah, all of my time, you know, he's he's the CEO of this successful business and he's saying, oh, I would say 90% of my time is all R&D. What is our process for evaluating that?

George: Yeah. And that comes up a lot. So we mentioned like wages are definitely the biggest driver of the tax credit. So I guess just take a step back when we talk about like what type of wages are are applicable and what activities tied to those wages, it's going to be the people who are directly performing the research activity or one step above directly supervising those employees or one step below directly supervising those employees. So it's kind of you got to put a pin on who's actually doing in the R&D field, who's actually doing the design work and software development, who's actually doing the coding and manufacture, who's like building the prototype or building the schematics and then kind of draw your spider web out from that one level up. So when it comes to a C level executive, I mean, does he have software developers that are reporting to like a manager and the manager reports to the CEO? That's usually a red flag because that's two steps above. There's also like reasonable effort, like how much of that CEO's time or C level suite executives involved in vendor meetings, client meetings, you know business development compared to actually like hands on project work or giving direct technical feedback to the people doing the work. So all those things go into play and, and documentation is definitely a big hurdle. Construction space is an excellent example where project accounting, where labor hours are tracked to activity to project, and it's a great fact pattern that helps the. The case. Software development has other labor development tools where they can track, okay, this guy has spent X amount of hours doing bug fixes or this effort on enhancing the platform or a new function. Manufacturers have things like ISO 9000 is a great certification that a lot of manufacturers pursue or have for their own products, and that documentation is excellent for R&D tax credit. So at its core, kind of bringing this level of nexus on, okay, what employee is actually doing what and that type of documentation to create some some type of substantiation this is going on other than like word of mouth?

Heidi: Yeah, absolutely. Documenting all of that and the analysis of all of that time and wages can be time consuming, but certainly huge in defending something against IRS scrutiny and making sure that the documentation is there to to support that.

George: Yeah, I think one of the you mentioned a client kind of bringing the services in-house. I think one of the stories we see often is I mentioned the two different ways to calculate the credit, the alternative simplified method ASC or the regular method where you're doing a percentage of the gross receipts. Some of the things I see often are this fixed base percentage for startup companies. You can use a 3% fixed base for the first five years, but a lot of times if you're doing it internally or your CPA trying to do this, study yourself, that 3%, you might carry it on not realizing there's a limitation to the number of years you can claim that. And that's a big red flag. We see we're taking over the study or during audit that can jeopardize the tax credit.

Heidi: Yeah, absolutely. Yeah. We recently had a case, you know, another case where a client wanted to save some money on fees, which is understandable. They did the credit themselves for a few years and then realized that this was an interesting scenario. They they're doing a lot of software development. They have a contractor they're using for that software development. And this might have been the first time I've come across this. That particular company had both a US based entity as well as an entity based in India, and they were paying both of them essentially the same company name, but they hadn't divided what was US based versus what was foreign. They kind of lumped all of it together into the one sort of contract for software development and then calculated all of that into the credit and didn't realize actually until about three years down the line that they had erroneously claimed R&D credits against a substantial amount of costs that actually did not qualify for the credit because they were foreign costs that that should have been pulled out of the qualifying expenses. So there are some of those scenarios and situations where, you know, at the onset it may look like it's it's straightforward.

Heidi: In actuality, the credit is very complex. And, you know, people ask us oftentimes what is a specialty tax firm and why is it that we have to have some complex study? Why can't my CPA just do this for me? And it's just the nuances. It's just understanding how complex the calculations are. And not only that, it's also because it's so technical in nature. The activity that qualifies, the technical nature of it is really diving into to your point in software, the actual coding aspect of what they're building and if that qualifies or that doesn't, because there are some aspects of that. Let's say they're building a website and some of it is all about marketing and the esthetics of how something's looking for that outside appearance. But yet on the back end they have another team that's actually coding and adding functionality. That's not something typically a CPA has the knowledge to, to dig into with a technical team and identify how does how do we know what aspect does qualify and doesn't 100%.

George: Yeah. And that breakdown of kind of the graphical user interface user experience compared to the actual technical coding software effort that would be qualified. I mean we into that a lot and breaking down that percentage of okay, John Smith is a coder but like how much of his time is divided between those or how much is bug fixes versus actual like a B testing. That's a big part of it. Usually we find that like R&D is everything up to production. And then once you start doing commercialized production or that's when R&D stops. So trying to define that line and find like, okay, what is actually a post commercialization commercialization like bug fix, hot patch kind of thing, and what's actually like a version two or a new patch that's going to improve the functionality or enhance the product?

Heidi: Okay. Yeah. When that makes a lot of sense. So with that now, now the fun conversation.

George: Yeah.

Heidi: As. Around the R&D credit for years When when George and I both started this years ago, the R&D credit kept coming and going. It would expire and then it would be gone for a year and then it would get extended or it would get extended retroactively. And there was just a lot of limbo with companies being unsure if it was even going to be there, if it was going to be gone or what the status was of the credit itself. Thankfully, there was a I don't know what was the year 2015, I think is when they made it permanent.

George: Yes. Yeah, it sounds right. Yep.

Heidi: Yep. And they made the R&D credit permanent at that point, which just first off, fantastic, because now the limbo is kind of taken out of it. So the companies aren't wondering every year if this is something that they're going to be eligible to claim. So the permanent nature of it was fantastic. Then in the Tax Cuts and Jobs Act in 2017, there was a provision put into that tax bill that was essentially a payback for allowing the bill to be passed. The question was, well, this is a tax cuts bill. That's the actual name of it. This is a tax cuts bill. This is going to cost us a tremendous amount of money. So how are we going to pay for it? And one of the provisions for how to pay for that Tax Cuts Act was to put in this amortization rule or this one, Section 174 rule to amortize the costs that relate to R&D activity and previously that those activities have all been eligible expenses. So all these things that George has been describing, our supply costs, our consumables, our wages, our contractors that we're paying to do software development or working on these innovative projects, those have been expenses that are reducing income and reducing the bottom line from what's being taxed. And then the credit calculation is claimed and you're being able to take a credit that's providing some benefit or payback for your investment in those activities. And then now this Tax Cuts and Jobs Act provision, which was passed in 2017 but did not take place until January 2022, which is right in the heat of it right now because we're in the 2022 tax filing season on extension at the moment.

Heidi: This provision now says those items can no longer be expensed and US based costs or domestic costs have to be amortized over five years. An international costs for R&D have to be amortized over 15 years. And this provision has a incredibly impactful, negative, impactful impact on businesses, particularly small businesses that are doing some type of R&D work because of the increase of income tax that they will be realizing. Some common misconceptions are that the R&D credit itself is changed, which interestingly enough, it has not changed at all. The R&D credit is exactly the same as it has been. You can still claim the credit. You get the credit. In fact, it's probably more important than it ever has been because at least you're getting a credit, you know, a dollar for dollar offset of your taxes owed. However, the impact of this amortization has no regard to whether you're claiming R&D or not. You have to amortize those costs regardless of whether you are applying the R&D credit to those or not. So, George, what do you have to add? I know I'm rambling on this and you and I have had many conversations with clients about it.

George: I think that's a great summary. And you're right, Tax Cuts and Jobs Act pulled this in as kind of like a revenue raiser program. And over the years, everyone in the industry kind of felt that this was going to go away. It was just kind of there as a revenue raiser to help the bill get passed. And we thought it was going to get repealed or amended or pushed back or something. Yet here we are, and a lot of our clients are facing like six figure seven figure tax bills that are tough to swallow, especially for small businesses. You mentioned this is an amortization of the deductions on those expenses that people would claim for their research activities. So what normally they were claiming as like a 100% tax deduction on those expenses. Now you're only claiming 10% in the current year and the remaining 90% is being amortized over the next five years, which then itself creates this almost like, okay, over six years, you're probably going to break even, might get some payback. But for that first year, for the people that are kind of the movers and shakers, really the people pushing the envelope in the industry, the people that we want to incentivize to do this type of activity in America. They're being. It's a stiff tax bill to swallow. So I think with a lot of that riding and to kind of help with definition. So the research development tax credit is Section 41 and then this is Section 174, which is just kind of the bigger bucket of just research expenses. So when you're doing an R&D tax credit, any cost you classify towards Section 41 for the research credit, those are automatically applied as section 174.

George: So anything you claim for the research credit are amortized under section 174, but 174 is a much bigger bubble. That doesn't take into consideration a lot of the nuances that we do during the R&D tax credit. Things I mentioned, like the four part test, like the funded research kind of checks and balances, Section 174 doesn't really care about those, which creates a lot of kind of complications on is this R&D, do I need to amortize this? Where do you kind of put the border lines on your company's activities? And I think that's the biggest challenge is there's not a lot of guidance out there. Section 174 itself only kind of negates anything related to like land improvements, any depreciable assets, any those things are kind of carved out of 174, but like it specifically targets software development. Anything related to software development is supposed to be 174. So you get these, these oddities on, you know, I'm doing research activities. I hired a consultant to help me. Are we both being taxed on the same expense with R&D tax credit? You take a look at funded research to say, okay, who has retained the rights, who's retained the economic risk? And that's how the credit gets allocated between those two entities. But without that kind of consideration, it's like multiple entities are getting taxed twice on the same expenses. Like where do you put the line? And when we're talking this kind of dollar amount, I mean, you're talking about like 90% of a cost that was a deduction. That's now being applied as a tax as taxable income is substantial.

Heidi: Yeah. Yeah, absolutely. We we published an article. It's on our website actually on the blog which we can share a link to in the podcast notes. But we did a quick case study just to kind of calculate the impact of what this looks like. And with a company gross revenue of about $10 Million, they have payroll costs towards R&D of 500,000. So it's relatively low percentage in the big scheme of things, but $500,000 of qualified wages towards R&D that previously have been expensed was calculating out if they claimed an R&D credit. With the credit, it was calculating out a tax liability of about $485,000 is what they were paying in comparison. Under these new rules, if they now amortize those wages, the $500,000 in wages versus claiming that expense that they have in the past same metrics, $10 Million in revenue, $500,000 in wages attributed towards R&D, specifically their tax bill. If again, they still claim the R&D credit is going to be 642,500, it's a difference of $157,000 in taxes with, you know, that's $500,000 in costs for R&D, equating to a tax increase of 157,000 in the first year. Now, you know, to to lighten it a little bit over the years, it will build because it's a five year amortization.

Heidi: So the 500,000 wages in that example get carried over five years. So after year two, year three, year four, you're tacking it on, tacking it, on tacking it on, and essentially you're going to be kind of sixes because you're, you're, you're right off six or similar to the same level. But at least in these next couple of years, the impact is really dramatic, especially for small businesses. I had a conversation with an architect yesterday who was really, really alarmed because she has a small business. She has about ten employees and she says, You understand, I don't even make enough margin to pay that much tax on the wages for staff that I have to do projects. Our margins as our margins are, you know, slim. We have like a 10% margin ratio. And if I have to pay tax on all of this and I can't claim those expenses as business expenses because it's research activity, it very well may likely put some of these small businesses out of out of business altogether.

George: Yeah, we've had that uncomfortable conversation many times this year with I mean, you mentioned architects. I've had it with, you know, manufacturers, software companies, tool and Die shops. It's really handicapping these small and mid-sized businesses.

Heidi: Yeah, absolutely. On a on a positive note, there was a bill that was sponsored on June 8th. It's called H.R. 3936. Build it. In America Act is what it's called. We are asking for people. Depending on your industry, you can reach out to industry heads. If you're parts of a certain organization, like, for example, AIA, reach out to the the legal department in AIA and ask them to lobby on behalf of your industry to really help push this bill through. You should also reach out to your local legislators. Again, it's H.R. 3009 36, Build It in America Act. This would push back the amortization bill. It doesn't completely repeal it, but for right now, it's slated to push it back to 2027. It also has a provision in there to increase bonus depreciation back to 100%, and it has a provision to make the R&D credit refundable. That's actually something that's been within debate for many years because the R&D credit for some businesses creates AMT limitations and they can't actually use the credits at times. If it becomes refundable, it truly would be funding for these companies to continue to work on their innovative projects. So there are some really fantastic aspects to this bill. The biggest question that we're getting is this Right now it's the summer of 2023. If you're listening to this podcast sometime in the future, maybe you'll see where we're at in our projections. We have hoped throughout the whole year that a provision to repeal the Amortization Act would be passed prior to the extended tax filing deadline, which would be September 15th or October 15th of 2023, which is the extension deadline for 2022.

Heidi: Many of our clients and CPAs have their tax returns on hold while they are on extension, hoping that this repeal is implemented retroactively before they file so that they don't have to worry about a change or amending or anything like that. That has certainly been the hope. We did expect that it would be passed prior to summer, which obviously it has not as we sit here right now at the end of June. We are very hopeful at this point that it will get passed and repealed by the end of the year. So the end of 2023, which doesn't help folks that are on extension again and still have to file their 2022 tax returns and pay the additional tax that's going to be due because of needing to amortize those those costs. So just be aware of those changes. We are keeping our ear to the pavement closely and really watching how things are going. We actively are involved with local legislators across the country asking for their support of this bill. And we would implore you as a taxpayer or a CPAs to reach out to your clients and have them reach out to those local governing bodies and ask them to support the bill to help support businesses in this effort because of this amortization bill really being so, so impactful. Really difficult situation. Georgia, anything to add on the amortization?

George: I'll add on the proposed bill, it will be retroactive. So going back to January 1st, 2022, and then pushing all the entire amortization issue over to 2027. So if you have already filed your 2020 to 2022 tax return and this bill does pass, there is an option to kind of amend your tax return to help correct that situation.

Heidi: Yeah. Thanks for clarifying. Yes, absolutely. That's that's the big that's the big hope is that they'll do that and be able to retroactively get that back so that those additional monies are then received back into the company as operating capital instead of taxes due. So we're certainly hopeful that that will be the case. Um, aside from that, as I'd mentioned, the R&D credit is unchanged and we still have recommended declines to continue to claim the credit. It's just simply more tax that you pay if you don't and at least it does provide some offset to that. As I mentioned, George and I did a podcast earlier about a month ago on the 45 or the 179 deductions. That is another aspect of this is that the 179 D, although we still await some additional guidance on that, if we're talking about architects specifically or business owners who own real estate and have done improvements, the 179 D deduction, particularly for architects, has been expanded and the dollar amount is increased if prevailing wage is met. It has been expanded from public buildings to nonprofits and tribal properties. So there is certainly an option to also, if you have qualifying projects, make sure that you're claiming any of those eligible deductions, which can certainly help offset some of the impact that you're going to be faced by by this amortization bill. So that is one thing that as that's been increased, hopefully that's a little bit of an ease towards the change of. R&d and something to consider.

George: Yeah, absolutely. I mean, it's a nice repertoire on the table of just tax saving strategies, where you mentioned architects and engineers taking the R&D tax credit for their day to day design work and either design work for public entities, tax exempt entities claiming the 179 D and then building owners. Anyone that actually owns real estate can claim potentially 179 D cost segregation if you're doing any improvements. A lot of things on the table to help reduce that tax bill.

Heidi: Yeah, absolutely. Well, George, I am so appreciative of you joining. Like I said on our previous podcast, we've worked together for a long time. It's been an absolute joy. You are a fantastic knowledge, just a, you know, a wealth of knowledge in terms of the energy credits and the R&D and, and it's always been a pleasure. So if anyone has questions, you can reach out to George, you can reach out to myself. We both evaluate businesses to identify potential tax credits and benefits that may apply and certainly help work on the calculations to make sure that you're getting everything that you're eligible for and that those are well supported in the case of audit. So that's always the biggest thing. So again, George, thanks so much for joining and hope you all enjoyed today's episode. Thank you.

Creators and Guests

Heidi Henderson
Heidi Henderson
I am a Tax Consultant and Real Estate Investor, and podcast host of Healthy, Wealthy & Wise. I advise clients on the application of Tax Efficiencies relating to their investments both directly and indirectly. My education is in Accounting but my entrepreneurial spirit has led me through many business ventures. But I love finding money for people who didn't know it was there! Cost Segregation, 179D deduction, 45L credits, R&D tax credits, Historical Tax Credits, Conservation Easements, Opportunity Zones, Alternative Investments, and Captive Insurance are a few tools we can help you with. As the Executive Vice President and Board Member of Engineered Tax Services I help plan for growth and operational improvements internally, while working externally with investment minded individuals to optimize their investment. I also teach over 30+ Continuing Education courses annually to CPA's, Design Build Professionals and Real Estate Professionals across the U.S. If synergies are apparent, please send me a connection request and let's see how we can work together.
George Matar
George Matar
Director at Engineered Tax Services
The R&D Tax Credit - Who Qualifies and How to Claim It
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