Editor: Alan Wong, CPA
Credits Against Tax
Food and beverage companies constantly face increasing costs of raw materials and fuel and regulatory changes while trying to keep their pricing competitive and gain market share. Some of these rising costs stem from research and development (R&D) strategies to develop new products related to food safety, cost reduction, organic/natural products, dietary guidelines, and sustainable resources.
According to Food Processing magazine’s annual R&D survey, 48% of respondents selected new product development as their top priority for 2013, up eight percentage points from last year. Further, the magazine reported food manufacturers are extending product lines, improving existing products, “cleaning up” current products, and controlling costs. And, although 51% of R&D budgets were about the same as last year, the survey found 22% of R&D budgets increased.
Fortunately, federal and state governments offer R&D tax credits that can help food and beverage companies of all sizes offset these expenses. The federal R&D tax credit allows companies that perform technological research (which is broadly defined) to receive tax breaks on certain costs associated with research as long as it was performed in the United States.
Food manufacturers should look closely at this incentive even if, in the past, they did not believe their activities in developing new products or processes qualified as technological research.
Often, credits mistakenly are assumed to apply only to the creation of a new product or package, but food companies can qualify for research tax credits in a number of ways—including for activities they already perform. Consider the following examples of activities that may qualify as research.
- Improving the taste, texture, or nutritional content of food product formulations;
- Incorporating new or sustainable ingredients in a formula; or
- Producing sample batches in a test kitchen or a pilot run.
- Developing techniques that will reduce costs and/or improve product consistency;
- Redesigning processes to comply with new federal or state regulations; or
- Improving machinery and equipment to ensure safe handling of food.
- Creating new packaging to improve shelf life, durability, and/or product integrity;
- Reducing materials or using more environmentally friendly materials in packaging; or
- Introducing new or alternative materials to improve packaging.
- Creating new methods for minimizing contamination, scrap, waste, and spoilage;
- Increasing energy efficiency of water, fuel, and utilities through introduction of new technologies; or
- Developing processes to convert waste to energy.
How the Credit Works
To determine whether food manufacturing clients are eligible to claim the credit, first review their activities and expenditures. Generally, if they employ engineers or technical personnel who are developing or improving products or manufacturing processes, they should be able to take advantage of the R&D credit.
Regs. Sec. 1.41-4(a) provides four criteria (the four-part test) for determining whether activities qualify for the R&D credit. The activities must meet each of the criteria to include the associated taxable salaries and wages, supplies, and/or contract research in the calculation of the tax credit. These activities need only be evolutionary to the company, not revolutionary to the industry, to qualify for the credit.
1. The activity must be technological in nature (Regs. Sec. 1.41-4(a)(4)): The activity must be based on principles of the following hard sciences:
- Computer science;
- Physical sciences; or
- Biological sciences.
2. The activity must be for a permitted purpose (Regs. Sec. 1.41-4(a)(5)(ii)): The activity must involve the creation of a new or improved level of:
- Reliability; or
3. The activity must involve the elimination of uncertainty (Regs. Sec. 1.41-4(a)(3)(i)): The activity must explore what was not known at the start of the project:
- Capability uncertainty—Can we develop it?
- Methodology uncertainty—How will we develop it?
- Design uncertainty—What is the appropriate design?
4. The activity must involve a process of experimentation (Regs. Sec. 1.41-4(a)(5)(i)): Substantially all of the activities must include elements of experimentation:
- Evaluating one or more alternatives;
- Performing testing or modeling;
- Examining and analyzing hypotheses; or
- Refining or abandoning hypotheses.
Identify and Document Qualifying Activities
Once the tax adviser has determined that the company is engaged in qualifying activities, the next step is to develop a methodology for identifying, quantifying, and documenting project costs that may be eligible for the R&D credit. Costs that qualify for the credit include wages of employees involved in developing new or improved products or processes, supplies used or consumed during the research process, and 65% of fees paid to outside contractors who provide qualifying R&D services on behalf of the taxpayer (Secs. 41(b)(2) and 41(b)(3)).
Appropriate documentation may require changes to the company’s recordkeeping processes because the burden of proof regarding all R&D expenses claimed is on the taxpayer. If the company uses project-based rather than cost center accounting, it may be easier to match qualifying activities to costs. In preparation for claiming the credit, look at how the company records expenses and develop a methodology for associating costs to projects that is aligned with the company’s internal reporting structure. Also, consider whether expenses associated with eligible activities performed in the company outside of the R&D department may have been missed.
How to Compute the Credit
There are two methods for calculating the credit: a traditional incremental research credit and the alternative simplified credit (ASC) (Sec. 41(c)(5)). Under the traditional method, the credit is 20% of the current-year qualified research expenses in excess of a base amount. One of the factors used in the calculation of the base amount is historical qualified research expenses. Using the traditional method, some taxpayers are required to determine their qualified research expenses for years as far back as 1984.
The ASC credit is 14% of the current-year qualified research expenses in excess of 50% of the average qualified research expenses for the three tax years preceding the tax year for which the credit is being determined. Companies that have not claimed the research credit in the past or that may have difficulty determining their historical qualified research expenses may find the ASC to be more beneficial.
While claiming the credit requires time, resources, and expertise, it can provide significant monetary and operational benefits to businesses. Even companies currently operating at a loss may benefit because federal R&D credits generated but not used can be carried back one year and forward up to 20 years to when the company is profitable. And, if the company is acquired, the credits can be considered a valuable future asset in negotiating a selling price for the business. When credits are claimed correctly, companies can reap benefits such as increased cash flow, optimization of engineering investments, and a dollar-for-dollar reduction in tax liability.
The following demonstrates how companies can identify and take advantage of R&D credit opportunities in the food and beverage industry.
Company: A privately held manufacturer of processed beef and pork products for the food service and retail industries that operates several facilities throughout the United States.
Business challenge: Initially, the company was reluctant to pursue the R&D credit because, like many food manufacturers, it did not believe it was carrying out R&D activities. A common misperception is that the R&D credit applies only to companies operating in high-tech industries that are developing cutting-edge products or technologies. However, once the company was educated on the IRS’s broad definition of what qualifies, the company realized it could secure R&D tax credits.
Approach: Specialized and experienced R&D credit professionals can assist clients in identifying and uncovering R&D tax credit opportunities. A critical component of any approach is developing an R&D credit methodology aligned with the company’s operations and internal project reporting processes and procedures. The latter was accomplished in this case primarily through facility tours, interviews with key technical and financial personnel at the company, and a review of project documentation to support the R&D projects and activities.
It was determined that the company engaged in numerous R&D projects, many of which were undertaken within the company’s normal operations. The following are examples of qualifying projects:
- Development of new or improved product formulations to meet changing consumer flavor preferences;
- Development of manufacturing processes to accommodate new products or optimize processing;
- Modifications to existing manufacturing processes to comply with new regulations;
- Continuous improvement projects aimed at reducing scrap, waste, and spoilage and/or conserving water and utilities;
- Automation of manufacturing functions to minimize product contamination;
- Development of new packaging to extend the shelf life of products; and
- Plant layout design changes to reduce manufacturing time and increase throughput.
The company secured—and sustained under IRS exam—more than $150,000 in federal R&D tax credits. A sustainable methodology was also developed for the company to use on an annual and ongoing basis to identify, document, and substantiate eligible R&D projects and costs.
A version of this item originally appeared in Baker Tilly’s Food & Beverage Digest.
Alan Wong is a senior manager–tax with Baker Tilly Virchow Krause LLP, in New York City.
For additional information about these items, contact Mr. Wong at 212-792-4986, ext. 986, or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with Baker Tilly Virchow Krause LLP.