Manufacturing tax credit studies—how to choose the right consulting firm

Rubber World, Sept, 2008 by Karim Solanji, Mark Lamber

The Research and Development (R&D) tax credit was created by congress as part of the Economic Recovery Tax Act of 1981 to encourage American industry to invest in research and development activities. The purpose of the credit was to stimulate R&D activities among businesses through tax incentives. However, due to the stringent requirements that existed under the provisions of the credit, a vast majority of the small to midsize companies was unable to reap the substantial benefits of the R&D credit.

The following industries have benefited from taking the R&D tax credit:

* Manufacturing;

* fabrication;

* engineering;

* software development:

* architecture;

* tool and die machine shops;

* electronics;

* biotechnology;

* pharmaceutical: and

* food sciences and agro-business

Here are a few examples of companies and their net R&D tax credit:

* Tool and die shop

--average four year payroll of $3.5 million,

--net credit benefit for 2004 through 2007 tax years: $200,000;

* Foam products manufacturer

--average four year payroll of $19.5 million;

--net credit benefit for 2004 through 2007 tax years: $1,200,000

* Software company

--average four year payroll of $6.5 million

--net credit benefit for 2004 through 2007 tax years: $500,000

* Custom plastics products manufacturer

--average four year payroll of $11.5 million

--net credit benefit for 2004 thru 2007 tax years: $700,000

As you can see, the R&D tax credit can be substantial for small and mid-sized companies especially if you consider what revenue might be required to generate an equivalent profit.

Changes enable small and mid-sized companies to benefit from R&D tax credit

Realizing that a majority of innovation in the U.S. was in fact transpiring from these small to mid-size firms, congress in 2001 liberalized the statutory requirements to enable small and mid-sized companies (SMBs) across the country to take advantage of the R&D benefits.

Specifically, the new regulations provided that companies were no longer required to maintain precise timesheets documenting every hour an employee spent conducting qualified R&D activities. Furthermore, the research no longer had to result in a product that was new to the industry; instead, the resulting product or process simply had to be new to the company that developed it.

Be wary of "boutique firms"

In selecting a true engineering firm to perform this very valuable, but extremely technical study, be wary of boutique firms that over-promise and under-deliver. There are only two or three true engineering firms in the country that are made up almost entirely of engineers and IP attorneys, and that use the IRS approved Comprehensive Project by Project approach, followed by a detailed "nexus" of qualifying research expenditures (QREs) to qualifying research activities (QRAs).

Because the IRS broadened the rules in 2001 to enable smaller to mid-sized companies to rightfully take their credits, there has been a flood of claims into the IRS. Naturally, and given the large size of the credit, the IRS has discovered that numerous claims filed by companies themselves or through the help of "engineering" firms have been wholly deficient in their documentation and substantiation of the claims they are making.

These "engineering" firms have been found to use deficient approaches, and many are not properly staffed with engineers and intellectual property attorneys with engineering backgrounds, both of which are needed to perform a proper study that can withstand any potential IRS audit. As a result, the credits were "shrunk back" significantly, or disallowed completely.

An unfortunate example of this can be found in a recently released case involving a firm called Alliantgroup, and one of their clients. The case can be accessed for your review using this link: (RW ) (http://www.paradigmlp.com/Case)

This example and many others have caused the IRS to elevate R&D studies to a Tier One Issue, so it is even more critical that you choose the right firm to perform your study.

How to select a consulting firm

In your due diligence in selecting a consulting firm to perform your R&D study, make sure the firm has the following attributes:

True engineering firm

Ask for the biographies of the individuals on their production staff and determine if each individual involved with your study is either an intellectual property attorney with an engineering background, or an engineer.

Comprehensive project-by-project approach

Determine whether the company will utilize a comprehensive project-by-project approach as well as establish a detailed "nexus" of QREs to QRAs. One of the IRS's biggest concerns is that some companies' "engineering" reports are in fact written by individuals with no engineering or scientific background, and that "no nexus" is established between a company's qualifying expenditures and qualifying activities. Their documentation should directly connect the project to the employee, and the estimated time spent on that project to each of the years under engagement. It is the most thorough methodology accepted by the IRS today.