Author: David Shereda
Key Takeaways
- Adapting or improving a product can be a form of innovation worthy of R&D tax credits.
- However, your activities must make significant improvements to either the functionality, performance, reliability or quality of the existing product.
- The cost of retooling or modifying a product isn’t relevant if a substantial improvement is not made.
- Don’t overlook unsuccessful product improvement and qualified research activities as they may allow you to receive the R&D tax credit.
More companies in more industries than ever are earning tax credits for their research and development (R&D) activities.
Will Adapting an Existing Product Qualify for R&D Credits?
You don’t need to invent entirely new products or have an army of white coated lab technicians on staff to qualify. In fact, you can qualify for generous R&D tax credits simply by making improvements to your existing product.
The credit may also be applied to products that you improved after purchasing them, provided that the improvement you made resulted in something better than what previously existed.
In some cases, even your failed product improvement can qualify for credit.
While credit opportunities are numerous, you still have to be diligent to avoid penalties and/or hours of recalculation. As is the case with many federally legislated programs, the rules can be murky, so let’s try to bring a little clarification here.
The R&D Tax Credit, established in 1981, is a tax incentive that encourages companies to invest in research and development activities within the United States.
As mentioned earlier, improving existing products can be a form of innovation that qualifies for R&D tax credits.
You don’t always have to start from scratch. However, your activities must significantly improve the functionality, performance, reliability or quality of the existing product—they can’t be minor tweaks.
It is important to note that if you make only slight modifications to the original design of a product, then the activities generally don’t qualify.
The reasoning is that you’re not likely to face enough “technical uncertainty” to consider your activities qualified when only minor adaptations are made to existing products.
The examples below illustrate the distinction:
Example 1: Non-qualifying R&D Tax Credit Activity
Bob’s Tool and Die manufactures tabletop vises and sells them nationwide. In response to customer demand, Bob’s released a new line of vises featuring removable jaws and a variety of new colors and handle lengths.
Bob’s spent over $300,000 to retool its manufacturing lines. Sales got a nice boost, but unfortunately, the improvement activities were not considered qualified expenses.
Why? Because the new improvements to the vise did not add functionality to the product or improve its performance, quality or reliability.
Example 2: R&D Tax Credit Qualified Expense
Stan’s Tool and Die, a competitor to Bob’s, also released a new line of tabletop vises.
Stan’s latest vises feature a new type of high-strength steel construction, a large anvil work surface and a double lock-down swivel.
Stan’s spent $200,000 to adapt its existing vise and to evaluate prototypes. However, Stans’ development activities DID qualify for the R&D tax credit because the substantial changes Stan’s made to its existing vise added functionality to the product and improved its quality.
As mentioned earlier, the distinction between qualifying and non-qualifying activities can get murky when it comes to product enhancement.
Always consult a specialty tax professional before attempting to apply for R&D credits.
If your business claims product adaptation expenses as part of your R&D tax credit, or if you are considering claiming other credits, here are some important Do’s and Don’ts to keep in mind:
Understand the Do’s and Don’ts
Do
- Include expenses for purchased product adaptations. The same rules governing the adaptation of products you manufacture in-house apply to an adaptation of products you purchase.
- Include adaptations of existing products that SIGNIFICANTLY improve your product’s reliability. For an improvement activity to qualify for R&D credits, significant improvement must be made to the functionality, performance, reliability OR quality of the existing product.
Don’t
- Assume all product improvement expenses will qualify. For instance, simply adapting or customizing a product to meet a client’s particular needs may not qualify. See Treasury regulation 1.41-4(c) for more details.
- Overlook unsuccessful product improvements. Even if an adaptation of an existing product ultimately failed, it may still qualify for the R&D tax credit and often involves significant sunk costs.
- Get fooled by high costs. The amount of money spent on a product improvement doesn’t necessarily mean a substantial improvement was made. Cost alone does not qualify an improvement activity of products or processes for R&D credit.
Conclusion
If you or your clients have questions about qualifying for R&D tax credits or about ways to adapt existing products tax-advantageously, don’t hesitate to contact Tri-Merit for assistance.
David Shereda is a Director at Tri-Merit, a specialty tax provider that partners with CPAs and their clients to optimize R&D tax credits such as engineering-based incentives. For more than a decade, Tri-Merit has specialized in tax credits and incentives. The firm’s partners speak often at accounting industry trade shows and conferences to help educate the profession. Contact David at Dave.Shereda@tri-merit.com | 847.637.5677 x145.