The federal Research and Development (R&D) Tax Credit was originally enacted in 1981 as a temporary measure to boost innovation and the economy. Along the way, the R&D Tax Credit, which became a permanent part of the U.S. tax code in 2015, has been amended and expanded. With more changes on the horizon in 2024, it’s a good idea for manufacturing and distribution companies to take a fresh look at how to optimize the credit and reduce income tax liabilities.

The Opportunity for Manufacturing and Distribution Businesses

Manufacturers are constantly evaluating processes to find ways to increase efficiencies and improve production. However, the innovation involved can be expensive. The R&D Tax Credit is aimed at encouraging businesses to invest in research and development. The expenditures that qualify for the credit can range from product development through distribution processes. Examples include improvements in manufacturing operations, tooling and engineering processes for new products and packaging innovations.

Overall, the IRS requires qualifying R&D activities to meet a four-part test:

• Permitted Purpose: The purpose of the research must be to create or improve a product or process, resulting in increased performance, function, reliability or quality.
• Elimination of Uncertainty: You must demonstrate that you’ve attempted to eliminate uncertainty concerning the capability or method for developing or improving a product or process, or the appropriateness of the product design.
• Process of Experimentation: At least 80% of the activities must be elements of a process of experimentation designed to evaluate alternatives for achieving the desired results through confirmation of the hypotheses accomplished by trial and error, testing or modeling, and refining or discarding of the hypotheses.
• Technological in Nature: The activity performed must fundamentally rely on principles of physical science, biological science, computer science or engineering.

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Proposed Changes to the R&D Deduction Under Section 174 & Reporting Requirements on Form 6765

The Tax Relief for American Families and Workers Act of 2024 proposes a delay to the R&D capitalization and amortization requirement under Section 174. The pending legislation would allow qualifying domestic R&D expenses incurred between the end of 2021 and the start of 2026 to be immediately deducted. Currently, U.S.-based research expenses must be amortized over a five-year period.

If the Act is passed, companies that claimed the R&D Tax Credit in their 2022 tax filings would be able to accelerate their Section 174 capitalized balance over the next two years and will be able to immediately deduct their 2023 R&D expenses on their tax return but must file a change in accounting method. (For foreign research costs, the 15-year amortization requirement will stay in place.) The Act is pending Senate approval after being passed by the House of Representatives in early 2024.

Another proposed change impacting companies claiming the R&D Tax Credit comes from the Internal Revenue Service (IRS). The IRS is proposing revisions to Form 6765, the form used to calculate and claim the R&D Tax Credit. The intent behind the changes is to formalize the capture of detailed information listing each business component related to the company’s R&D projects.

Currently, businesses report their total qualified research expenses by category with their filing. However, the revised Form 6765 would require documentation for each business component, including:

• How many business components are included in generating the credit
• The category of the business component (product, process, computer software, technique, formula or invention)
• New categories of expenditures included in the current year
• Documentation of what the research sought to discover and one or more alternatives evaluated during the experimentation phase
• Officer wages included in the qualifying research expenses
• Wages by type of work (supervisory, direct research and support)
• Supplies, rental or lease costs of computers and qualified outside contractors

How to Prepare for the Possible Changes

To optimize the R&D Tax Credit and not leave money on the table, your company should begin to adjust how it tracks R&D expenses in anticipation of the proposed reporting changes. Manufacturing companies in particular may need to change to more detailed tracking processes, capturing the money spent and time investment at the project and person levels. Ultimately, you need the ability to track separate research initiatives and the expenses and people resources involved with each.

An expert research and development tax advisor can help you navigate all the pending changes and reporting complexities. They can provide guidance on the implications for past tax filings and any necessary adjustments to current tracking processes.

The manufacturing and distribution industry experts at CBIZ can keep you in the loop as changes to the R&D Tax Credit and Section 174 deductions are implemented. They can also help you identify qualifying R&D activities and optimize the credit for your business. Connect with a member of our team and gain access to more resources here.

This article includes input from Gary Fujita, Managing Director at CBIZ MHM, LLC and a leader in tax incentives. Gary is a strategic partner for clients, as he advises companies on best practices for tax credits and provides clients with a detailed action plan and control points for the R&D environment.

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