In part 1 last week, we looked at the contract manufacturing and whether the activities of a contract manufacturing company could qualify for research tax credits (see How does contract manufacturing qualify for R&D tax credits (part 1)).
Today we will look at some of the R&D credit tax issues associated with companies in this industry that may be evaluated under an IRS audit.
What tax issues should I consider under the R&D tax credit if I am a contract manufacturer?
As we have discussed in several articles, the research tax credit is an area where the IRS has devoted specific resources to manage taxpayer compliance. Questions do arise for taxpayers whenever there is an R&D tax credit being audited. So, let’s look at a few of the issues that should be managed BEFORE you calculate and take your tax credit so that your result under audit has a better chance of being sustained:
Estimates versus timecards
For a small business that does not track an individual’s time directly to projects, using estimates for hours spent on qualified R&D activities has been allowed under audit and sustained in various court cases. However, this approach leaves room for an auditor to disallow or reduce those estimates if they feel they are not based in reasonable assumptions. A better answer is to have employees (including the owner) complete time cards or time sheets by project. The best answer; however, is to break time down both by project and task rather than simply by project (more on this under documentation in part 3).
Auditors may evaluate the various projects on the basis of how your company was compensated and who retains rights to the finished product following completion. In many cases, a contract manufacturer will commit contractually to convey all rights to the customer for the product their produce (usually from a customer’s specifications). The definition of Funded Research under the Internal Revenue Code includes disqualifying projects where the taxpayer does not retain substantial rights to the results.
For a contract manufacturer, it is important to remember that your projects may qualify as new or improved processes rather than new or improved products. Unless you convey rights to your manufacturing process, substantial rights should not be an issue. If however, you are providing your services on a time-and-materials basis where you have no risk in the project (meaning your customer is burdened by the risk), the associated research could be considered funded and would not qualify for R&D tax credits. (We will look at this issue again in part 4 of this series.)
Process versus Product
As I alluded to above, contract manufacturers bring process experience and know-how to the table when completing a project for their customers. Typically, a design specification is received by the contract manufacturer and is evaluated for manufacturability. In many cases, due to design attributes (difficult shapes, new materials, and strength or thickness tolerances) the approach to manufacturing the product requires a new process or new techniques to be developed. In virtually all cases, new tooling or molds must be designed. These activities should be evaluated in light of the R&D tax credit as they may qualify (see the above discussion for tax issues such as funded research that may disqualify certain projects).
After initial parts are approved by the customer, additional testing may be done to evaluate the manufacturing process on a larger scale (over 10,000 parts rather than a small test batch). Upon completion of the project, the final product may be transferred to the customer with all rights but the process to make the product is retained by the contract manufacturer.
Contract manufacturers would be wise to consider adding contractual language that states any processes developed are the property of the contract manufacturer (if their standard contracts are currently silent on the issue).
In part 3 of Contract Manufacturing
In part 3, we will discuss various types of documentation and approaches to developing a strong system to aid in a potential audit.
What say you, my friends?
Are you currently documenting your R&D process on a project basis?
Do you have a formalized R&D process that has specific tasks that can be measured?
Do you currently utilize a job cost system as part of your daily operations?
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Randy Eickhoff, CPA is President of Acena Consulting. With more than 20 years of tax and consulting experience, Randy focused on helping companies successfully document and secure tax incentives throughout the US. He has been a long-time speaker nationally as well as conducted numerous training sessions on R&D tax credits and other US tax incentives.