Process Improvement Projects and the Research Credit, May 2021

What types of activities qualify, and how can taxpayers support their claim?

The Section 41 Research and Development Tax Credit allows for the qualification of process development/process improvement activities to be claimed as qualified, due to the following subsection:

  • 41(d) QUALIFIED RESEARCH DEFINED.–
  • 41(d)(2)(C) SPECIAL RULE FOR PRODUCTION PROCESSES.–Any plant process, machinery, or technique for commercial production of a business component shall be treated as a separate business component (and not as part of the business component being produced).

It is still incumbent upon the taxpayer to demonstrate how a process improvement activity/project meets the “Four Tests” – Technical Uncertainty, Process of Experimentation, Reliance Upon Hard Science, and with goal of improving or developing a new performance, function, quality or reliability to the process. Additionally, it is important from a defensive standpoint that taxpayers document or gather documentation to support the claim of qualified process improvement activities. This will not only help in final determination of whether process improvement activities are qualified but will also aid in demonstrating how the activities meet the four tests. Some of these documents may already be generated as part of the process improvement activity, especially if the taxpayer is employing programs such as Lean Manufacturing, Six Sigma, or conducting Kaizen events.

Technical in Nature/Technical Uncertainty

Improving upon a complex process, whether in the manufacturing industry or industries such as health care, can meet the test of being technical in nature. The technical nature of the activity can be enhanced when using such complicated industrial engineering techniques and hands on analyses as those found in programs/approaches like Lean Manufacturing or Six Sigma. However, technical uncertainty or complexity can also exist due to the nature of the process itself – how complex the process is, how difficult modifying or changing portions of the process may be, or how much engineering, design, testing, and iterations are required to implement the process improvement.

Technical uncertainty within a process is often the driving factor for using programs/approaches such as Lean Manufacturing or Six Sigma in process improvement. However, if a taxpayer is not using these programs specifically, the principles can still be applied in these instances. For example, in the initial phase of a Six Sigma project,  the process or system as a whole is defined (business component) and questions are raised as to where problems such as bottlenecks, design flaws, scheduling, and inventory management can be solved (uncertainty). This phase is where possible paths of improvement are suggested or evaluated and recording this portion of the process can help with supporting the taxpayer’s claim. The Define, Measure, Analyze, Improve, and Control (DMAIC) approach, the backbone of most Six Sigma improvements, can also be applied both when planning and executing a process improvement activity; and can also be utilized when documenting and/or describing how an activity is qualified.

Process of Experimentation

Figuring out what data to determine and conducting statistical analysis of this data is included in the process of experimentation within DMAIC approach. There is often extensive testing and studying of the effect of different components within a process. These components might include the inputs and outputs of the system or the mechanical workings of different parts of the process.

Modeling and simulation are also prevalent when studying process improvement possibilities. Modeling and simulation make it possible for the system to be analyzed without interrupting daily operations. By modeling and simulating a production floor or process flow, engineers/process designers can understand how certain factors affect inputs, outputs, and overall performance without interrupting the real-life process from functioning. Additionally, some of the modeling and analysis tools can provide a good example as to why a process improvement activity is technically challenging or uncertain. Some of these documents may include video analysis of a regular production day – following a product through the entire process to identify the possible bottlenecks, supply chain issues or production line hinderances. Other examples might be spaghetti diagrams, data analysis of waste from specific production lines, etc.

Consideration of Alternatives

Lean manufacturing, Six Sigma, or other process improvement approaches are rarely taken without considering multiple alternatives. The complexity of the process, how many parts or different processes there are within a system, determines the number of alternative process improvements that can be considered. In some cases, there are a significant number of changes that can be made, but only several alternatives can be prudently considered. These are the cases in which modeling and simulation can be an effective way of comparing these alternatives with each other. When documenting the consideration of alternatives, it is not necessary to document every single possible alternative. However, if the taxpayer can show that there were at least more than one alternative considered, modeled, tested, vetted or even tried, then the case is better made for the existence of technical uncertainty that was attempted to be resolved through a process of experimentation. This can include test runs, comparing initial waste percentages to the percentages after the production line is modified; meeting minutes/email discussions with production engineers or personnel discussing the possible impact of changing production lines in suggested ways, or can also include more formal documentation like test reports, product quality evaluations, etc.

What is Kaizen, and Where Does it Fit In?

When roughly translated from Japanese, Kaizen means “continuous improvement”. The purpose is to eliminate the seven kinds of waste in:

  • Overproduction
  • Unnecessary stock
  • Defects
  • Waiting
  • Transportation
  • Processing
  • Motion

Improving all these aspects through the elimination of waste is an on-going process that strives for perfection. Companies that utilize the Kaizen philosophy are continuously testing their processes, studying relationships and outcomes, and working with new technologies to improve their processes. These activities are completed within a framework of what are termed as “Kaizen Events” – usually short, focused, specific outcome driven events that can include personnel from varying areas of the company – sales, production, engineering, product design, etc.

While all these activities make it seem like a Kaizen event would be a slam dunk for meeting all the criteria of a qualified process improvement activity, that may not be the case. Not all Kaizen events are created the same, nor are all of them documented in a manner that would slow them to withstand scrutiny under a review. In fact, a Kaizen event may be performed in an area of a company completed unrelated to manufacturing – i.e., Human Resources, or Accounts Payable. When determining whether a Kaizen event is qualified, it still need to meet the four tests. One of the benefits of a Kaizen event in terms of the Research Credit is that most are well documented – there is a stated purpose given for the event, specific metrics or goals for determining success of the event, named “stakeholders” or participants in the event, and most importantly, good record keeping related to each person’s time spent on the event.

Conclusion

While it may seem at first glance that qualifying and supporting process improvement costs is a nebulous process and not likely to withstand review; given that there is a specific subsection of Section 41 specific to processes should provide some assurance that it is possible to qualify these types of activities. However, as with all qualified activities for the Research Credit, it is important to not only demonstrate how and why an activity qualifies, but also supporting that claim with documentation as much as possible. Thankfully, many of the companies undertaking these activities may already be generating the necessary documentation; if not, then it may not be too much of a burden to implement some methods for doing so.

CFO Services Can Help With Your Research Credit & Tax Incentive Needs

The Research Credit provides an opportunity to reduce tax liability. In order to maximize the Research Credit impact to don’t forget to capture all the expenses that should qualified, especially wages that are direct support.  To learn if you’re eligible for the Research Credit or have more questions related to qualified direct support, please contact CFO Services.

Through knowledge and perspectives gained working with virtually every industry and type of client (Fortune 500, medium-size and small companies), CFO Services has committed to a strategy of providing a depth of knowledge in a narrow field of focus: business incentives and credits. Providing tried and tested methodologies, our professionals can help almost any business research, identify and comply:

  • Research and Development Credits
  • Multi-State Tax Incentives and Credits
  • State Sales and Use Tax
  • Strategic Alliances
  • Workforce Training Programs

Our company was founded on the principal that we’d deliver results – cash results. Our focus, is not about persuading companies they need something; it’s about sharing ideas and then ensuring that our niche will benefit the company.

A narrow field of focus. As much or more knowledge than anybody else in our niche. Actual profits to our client companies. That’s our objective.

Research Expenses Change for 2022, April 2021

Economics of “Specified” Research Expenses Change for 2022

With 2021 off and running, it is important to highlight the upcoming change for the Research Credit and deduction starting at the beginning of 2022.  The Research Credit (Section 41) and R&D deduction (Section 174) have been utilized by companies for many decades to help build research, improve processes, and launch new products.

Tax reform from 2017 has put a little wrinkle into capturing this benefit, and many of our clients have asked about the economics and effects of the change.  Previously, if a company wanted to claim the Research credit (41), they were not required to claim the corresponding R&D deduction (174).  Companies would still receive the deduction for wages, supplies, and contract research claimed under the credit but typically deduct them under section 162 as ordinary and necessary business expenses, treat them as cost of goods sold, or capitalize them.  Either way a company could gain the immediate deduction of the full amount of the expense.

With the tax law change, and starting in 2022, companies will only be able to claim the research credit for expenditures that “may be treated as specified research or experimental expenditures” under section 174.  Additionally, under 174 a company is required to capitalize and amortize the deduction over five years.  Under these news changes, in order to claim the Research Credit, a company will be required to capitalize and amortize the deduction, instead of immediate expensing. 

Economics & Impact of the Change

The next question in the tax law change, is evaluating the two choices companies have with regards to research expenses. 

  • Immediately expense the cost under another section, BUT lose out on claiming the Research Credit; or
  • Amortize the cost under section 174 and claim the Research Credit

At first it might seem that immediate expensing is the most desirable, but the amortization is an overall timing issue that is only impacted by inflation or the time value of money.  Since inflation has been historically low, and within the next five years looks to stay historically low, that difference is very small.  Second, a taxpayer loses the credit fully if they choose immediate expensing which can’t be recovered.

Below is a comparative example for a company to demonstrate the economics of this change.  Here are a few assumptions within the example.

  • Utilizing a 1.5% discount rate
  • Research Credit is calculated using the simplified method
  • Using 21% as the corotate tax rate
EXAMPLE of “specified” research economics   
 Immediate ExpensingNew 174 “specified expense”Difference
    
Amount of Expenses$100,000$100,000 
    
Current Year Deduction$100,000$20,000 
Remaining NPV of Deduction  $0$75,653 
    
Total Deduction$100,000$95,653 
Tax effective Benefit$21,000$20,087($913)
    
R&D Credit (Year 1)$-$5,530$5,530
    
Total Benefit$21,000$25,617$4,617

From the above example, even with the new tax law change, a taxpayer who has R&D costs should be deducting these as a “specified expense” and claiming them as a Research Credit.  If the company chooses the other method, they will lose any ability to claim the Research Credit, which is shown above to be approximately 22% of additional tax benefit. 

In 2021, companies should start looking at their current accounting system to start isolating the expenses for research that will need to be “specified” and captured for the Research Credit.  This will allow these companies to make an easy transition to the new method and not miss out on the additional benefit for claiming the Research Credit.

CFO Services Can Help With Your Research Credit & Tax Incentive Needs

The R&D Credit provides an opportunity to reduce tax liability. In order to maximize the R&D Credit impact to don’t forget to capture all the expenses that should qualified, especially wages that are direct support.  To learn if you’re eligible for the R&D Credit or have more questions related to qualified direct support, please contact CFO Services.

Through knowledge and perspectives gained working with virtually every industry and type of client (Fortune 500, medium-size and small companies), CFO Services has committed to a strategy of providing a depth of knowledge in a narrow field of focus: business incentives and credits. Providing tried and tested methodologies, our professionals can help almost any business research, identify and comply:

  • Research and Development Credits
  • Multi-State Tax Incentives and Credits
  • State Sales and Use Tax
  • Strategic Alliances
  • Workforce Training Programs

CFO Services

Our company was founded on the principal that we’d deliver results – cash results. Our focus, is not about persuading companies they need something; it’s about sharing ideas and then ensuring that our niche will benefit the company.

A narrow field of focus. As much or more knowledge than anybody else in our niche. Actual profits to our client companies. That’s our objective.

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