With Republicans in control of Congress and President Trump’s broad outline to overhaul the tax code, businesses await legislation that could have significant impact on their tax burden. The fate of many tax credits and incentives remains up in the air, but manufacturing-friendly tax breaks such as the domestic production deduction (better known as the manufacturers’ deduction) and the research and development (R&D) credit are unlikely to be eliminated by new tax reforms. Here are a few basics on how to qualify for these two tax incentives that can be highly beneficial for manufacturers.
The manufacturers’ deduction
Also known as the Section 199 deduction, the manufacturers’ deduction went into effect with The American Jobs Creation Act of 2004 to encourage domestic manufacturing. Though the guidelines for qualifying may seem complicated, claiming this deduction can greatly reward businesses engaging in domestic manufacturing activities (including many activities that would not fall under the umbrella of traditional manufacturing).
How it works
The manufacturers’ deduction permits eligible taxpayers to deduct a specified percentage of the lesser of: 1) their income from “qualified production activities,” or 2) their taxable income for the year (adjusted gross income in the case of an individual). The deduction may not exceed 50 percent of the W-2 wages a taxpayer pays during the year. Wages not allocable to domestic production gross receipts are excluded from W-2 wages for the purposes of the deduction.
Qualified production activities income (or QPAI) is calculated by taking gross receipts from domestic production and subtracting the cost of goods sold and other allocable costs, deductions, expenses and losses. Domestic production gross receipts (or DPGR) are those derived from any lease, rental, license, sale, exchange or other disposition of:
- qualifying production property (including tangible personal property, computer software and certain sound recordings) manufactured, produced, grown or extracted by the taxpayer in whole or in significant part in the United States,
- qualified films produced by the taxpayer, or
- electricity, natural gas or potable water produced by the taxpayer in the United States.
Receipts from construction and engineering or architectural services performed in the United States also qualify as DPGR under the manufacturers’ deduction.
The R&D credit
The research and development (R&D) credit was established as an economic stimulus measure in 1981, providing financial incentives for companies that perform research and development activities domestically. This credit is more relevant than ever for businesses, as the PATH Act of 2015 made it permanent and even expanded its reach. This credit largely enjoys bipartisan support, so any upcoming changes to the tax code are unlikely to affect the R&D credit, unless it is further expanded. With the R&D credit now a fixture, businesses have the ability to make long-range plans with more confidence, seeing as the credit will likely be available to them in the future.
Not just for big businesses
The improvements and expansions to the credit that went into effect in 2016 are particularly beneficial for small and mid-size businesses, as well as startups. Now, businesses with less than $50 million in average gross receipts in the past three years are eligible to use the R&D credit to offset their alternative minimum tax (AMT) liability. So even if you have gross receipts greater than $50 million this year, you can still benefit from the credit so long as your three-year average is below this mark. The other recent expansion is a boon for startup companies. As of 2016, businesses with less than $5 million in gross receipts, and having gross receipts for no more than five years, are eligible to use up to $250,000 of the credit against the Social Security portion of the employer’s FICA payroll tax.
Determining what qualifies: the four-part test
For taxpayers claiming the credit, there are certain requirements that must be met for expenditures to be considered “qualified research” and therefore included in the calculation of the credit.
Generally, qualified research is an activity or project undertaken that includes all four separate and distinct elements (the four-part test):
- Permitted purpose: The activity must relate to a new or improved business component’s function, performance, reliability or quality. A business component is defined as any product, process, technique, invention, formula or computer software.
- Elimination of uncertainty: The activity must be intended to discover information to eliminate uncertainty concerning the capability or method for developing or improving a product or process, or the appropriateness of the product design.
- Technological in nature: The activity performed must fundamentally rely on principles of physical or biological sciences, engineering or computer sciences. Taxpayers can use existing technologies and rely on existing principles to satisfy this requirement.
- Process of experimentation: Substantially, all of the activities must be elements of a process of experimentation involving evaluating alternatives, confirming of hypotheses through trial and error, testing and/or modeling, and refining or discarding of the hypotheses.
If you are wondering how your business might take advantage of the manufacturers’ deduction or the R&D credit, please contact Mark Patterson.