By bringing in specialty tax consulting firm Tri-Merit to assist with taking advantage of the Research and Development (R&D) Tax Credit, a midwestern remanufacturer of automotive parts has saved nearly $350,000 each year in federal and state taxes and has substantially reduced its audit risk.
Overview
A $120 million automotive component remanufacturer was seeking ways to improve its tax savings from the R&D credit it had been claiming. While remanufacturing is not always thought of as a viable business sector for the R&D tax credit, this example provides evidence that the ability to take the specialty tax credit is pervasive across industries; and experts who are trained in the nuances of engineering-based credits can often find additional savings that companies and their CPAs may have overlooked. This particular remanufacturer had identified and developed innovative processes to determine—on a high-volume production scale—specific components needed for various types of used transmissions intended to be returned to high functioning order. The processes also included development of equipment and tests to validate the build processes of those transmissions prior to resale.
While the company knew it was entitled to R&D tax credits for its manufacturing process development work, it was not following all the rules correctly that are laid out in the Internal Revenue Code. As a result, the company was leaving qualified expenses and credit on the table and putting itself in a vulnerable position if the IRS ever challenged its methodology.
At the suggestion of the company’s CPA, Tri-Merit was invited to do an initial consult. After reviewing tax returns, Form 6765’s and workpapers including the qualified employee allocations, Tri-Merit discovered a number of additional expenses the company could be claiming, which would increase its credit.
Challenges
- The company’s CPA and finance team suspected they weren’t claiming all the credits to which they were entitled. Also, they weren’t entirely confident about their methodology and calculations for the credit they were taking.
- Tri-Merit discovered the remanufacturer was incorrectly using the regular calculation method and claiming less than $75,000 in total federal and state tax credits—a fraction of what an innovative company of its size would be expected to take.
- The company was attempting to take a very strict approach to tracking qualified worker hours, but the method was not being followed well by employees. As a result, the company wasn’t claiming as much R&D credit as it could have been based on this tracked time.
To qualify for the R&D Credit, activities for all taxpayers, including manufacturers must meet a four-part test below:
- Permitted purpose. Must intend to create a new or improved product, process, or software.
- Seek to eliminate uncertainty regarding the activity’s capability, cost, design, or process.
- Engage in a process of experimentation—including testing, modeling, or trial and error—designed to resolve the uncertainties.
- Technological in nature. Must rely on engineering, physics, biology, or computer science in completing the process of experimentation.
Solution
Tri-Merit’s initial study determined that the ASC credit method was more beneficial for the company than the regular calculation method—and it was a more defensible calculation. Within a year of Tri-Merit’s study, the company had more than quadrupled its credit to nearly $350,000. By improving the study processes and expense tracking each year, the company is now claiming nearly $500,000 in federal and state tax credits annually. And Tri-Merit continues to work with the company to continually review the rules and relevant court cases to identify additional credit opportunities for the company.
Tri-Merit brings alternative solutions to the table that help clients maximize credits for employee hours worked on processes and products related to innovation. Rarely do companies track hours well enough for the purposes of calculating R&D credits. There are Tax Court precedents that allow us to estimate qualified employee hours—rather than tallying up tracked hours—as long as the estimate is coming from a direct manager or employee, and as long as there is documentation to support worker activity on qualifying projects. Companies may be very diligent about tracking overall hours by project, but they often forget to break down those hours by qualifying activity. Without providing that breakout, they may not be able to include those hours in their credit calculations—another lost opportunity, perhaps, but useful information in supporting the estimation process that Tri-Merit employs.
Tri-Merit’s study also revealed that the company wasn’t including a great deal of its managers’ time. It turns out that some of the managers functioned as launch employees. They spent a significant amount of time each year in the development stages and their labor should have been factored into the credit calculations.
Machine shop excluded. Tri-Merit also found that the company’s machine shop was being excluded from credit calculations. This was another missed opportunity, since several employees were engaged in developing fixtures, CNC programming, tooling, and in various processes for machining new or improved components.
Tri-Merit also detected a very important error. Before Tri-Merit arrived, the company was including a good chunk of supply costs that should NOT have been included in its R&D calculations. Without correcting this error, the company’s audit risk would have been much higher.
Retroactive adjustments. As part of its analysis process, Tri-Merit was able to reevaluate the prior year credits that the company had calculated on their own and was able to recalculate the corrected credit amounts based on adjustments to the qualified wage and supply expenses. As a result, Tri-Merit was able to assist the company in amending its prior year tax returns to make up for and recapture the missed credits from the earlier years.
Result
Tri-Merit was able to use much of the client’s existing information and data to avoid disruption of day-to-day operations, but took additional action when they saw a need to drill down into qualified wage expenses for potential credits that could have been previously overlooked.
Over the past five years, Tri-Merit significantly strengthened the defensibility of the manufacturer’s qualified credit calculations and tripled the amount of federal and state credits the company was able to claim.
Conclusion
Do you and your CPA ever wonder if your company may be eligible for the R&D Tax Credit, but aren’t sure how to proceed? Have you been taking the credit in the past, but aren’t sure whether it is supportable due to the methods used? Contact Tri-Merit to schedule a complimentary appointment with Andy Lane.
ANDY LANE | Managing Partner | andy.lane@tri-merit.com | 847 627 5677 x 125