How to Claim the R&D Tax Credit for Manufacturers

April 16, 2024

Manufacturers claim the lion’s share of R&D Tax Credits annually – over $7.5B in the most recent year for which data is available.  

This tremendous incentive is a dollar-for-dollar federal Credit that can be claimed yearly and used to offset tax liability. The Credit allows companies to hire new employees, expand their technologies, and finance other business objectives. Some states have their own versions of the Credit, further boosting the possible benefit.  

If you own a manufacturing facility, or you advise someone who does, you need to know how to tap into this Credit.  

Why is Manufacturing Such a Good Fit for R&D Tax Credits?  

The intention of the Credit is to incentivize companies to develop and improve products and processes, and it was actually created with manufacturers in mind.  

Problem-solving is at the heart of the manufacturing industry, and the activities undertaken to develop, refine, and improve products are exactly what the Credit is designed to reward.  

Beyond creating and improving products, manufacturers are increasingly focused on making production faster, more cost-effective, and more sustainable. Process innovation may also translate into qualifying R&D activity.  

Any type of manufacturing may qualify for the Credit, including:  

  • Aerospace, automotive, and machinery manufacturers 
  • Automated equipment manufacturers  
  • Chemical manufacturing  
  • Contract manufacturing  
  • Medical device and tooling manufacturers 
  • Metal fabricators  
  • Original equipment manufacturers 
  • Plastic manufacturers 
  • Precision machining  

Any type of manufacturer may qualify as well – from small ultra-custom prototype-only shops to huge mass-volume producers – if they are solving problems, they’re likely eligible for the R&D Credit.  

 

How Can Manufacturers Qualify for the R&D Tax Credit? 

Eligibility Criteria of R&D Credit

The R&D Tax Credit is an activities-based Credit, and most manufacturers qualify for the R&D Tax Credit just by performing their day-to-day activities. If you develop or improve a product or process, you likely perform Qualifying Research Activities (QRAs).  

To officially be considered a QRA, your activity must pass the IRS’ Four-Part Test. This is generally a very easy task for a manufacturer:   

PART I: New or Improved BusinessComponent: The activity must be related to developing or improving the functionality, quality, reliability, or performance of a business component.  

Manufacturers develop and improve products and processes all day long – CHECK.  

PART II: Elimination of Uncertainty: The activity must be undertaken for the purpose of eliminating some uncertainty — 

  • Can I make a brand-new product? 
  • What will the new product design look like? How can I make it? 
  • Can I improve an old product? Is this even feasible? 
  • Can I improve the process by which the product is made? 
  • How can I incorporate new features and functions into an existing product/process? 

Another easy CHECK – questions like these are at the heart of the manufacturing industry.  

PART III: Process of Experimentation: The activity must involve some kind of experimentation designed to resolve the uncertainty, which may include:  

  • Evaluation of Alternatives 
  • Hypothesis Testing 
  • Systematic Trial and Error 
  • 3D Modeling or Simulations 

 A third CHECK – it’s all about the iterative process.  

PART IV: Technological in Nature: The activity must be based on a hard science – engineering, physics, chemistry, etc.  

The final CHECK – that’s a 100% on this test.  

Which Manufacturing Activities Qualify for the R&D Tax Credit?  

Clearly, manufacturers are going to ace the four-part test. So which specific activities actually qualify? Let’s take a closer look.  

Remember that qualifying activity can be geared towards product or process design/improvement, so we’ll consider those separately:    

PRODUCT-RELATED QRAs 

Manufacturers commonly qualify for the R&D Tax Credit by developing a new custom product or improving the design of an existing product 

The following are likely to be considered Qualified Research Activities (QRAs):  

    • Designing, constructing, and testing prototypes and pilot models 
    • Utilizing computer-aided design (CAD), computer-aided manufacturing (CAM), or computerized numerical control (CNC) tools in design 
    • Designing and developing custom tooling for product manufacture (wire EDM, grinding, milling, assembly, quality check) 
    • Determining optimal placement of equipment 
    • 3D modeling  
    • Evaluation of flat blank layout possibilities  
    • Custom fabrication  
    • Testing alternative materials to improve product performance  
    • Trial production runs that allow team to check for and address production issues  
    • Creating and implementing specialized technologies, such as artificial intelligence or machine learning 
    • Meetings in which the three “F”s of design are discussed – form, fit, and function

       

      • In order to qualify for the Credit, each “F” must be discussed
      • Form: the shape, size, dimensions, weight of the part/product
      • Fit: The ability of the part to connect to or interact with another part
      • Function: The action that the part is intended to perform
PROCESS-RELATED QRAs  

Activities intended to improve the production process in some way – speed, efficiency, cost – are also generally considered QRAs. Many manufacturers qualify for the R&D Credit by evaluating process improvements, including:  

    • Designing and developing cost-effective operational processes 
    • Designing and evaluating process alternatives 
    • Evaluating and determining the most efficient flow of material 
    • Increasing manufacturing capabilities and production capacities through new technologies  
    • Improving procedures to advance assembly line speed 
    • Developing/updating processes to meet evolving regulatory requirements  
    • Redesigning a manual process into an automated one 
    • Experimenting with new or improved packaging techniques – to optimize size, reduce cost, design reusable boxes or custom dividers, etc.  
    • Experimenting with methodologies to minimize environmental impact  

Important caveat – what if your research activity didn’t succeed? What if you met the aforementioned criteria and conducted quality research, but at the end of the day you were unable to make your process more cost-effective?  That’s okay. Research doesn’t have to be successful to qualify for the Credit.  

What Can Manufacturers Claim Towards the R&D Tax Credit?  

Qualified Research Expenses (QREs) are expenses related to QRAs. QREs are the expenses that can qualify for the Credit, and they fall into 4 categories:  

  1. Supplies and materials (the largest QRE for manufacturers) 
  2. Employee Wages 
  3. Third-Party Contractor Payments 
  4. Cloud Hosting Expenses  

Let’s look at the most common QREs more closely.  

Supplies and Materials  

This is where the bulk of the expenses lie for most manufacturers, and the bigger and heavier the item you manufacture, the higher the costs will be.  

Qualified supplies/materials may include:  

    • Custom and unique equipment or tooling 
    • Mold costs 
    • Small-or large-scale test batches 
    • Materials used to develop and test prototypes and pilot models 
    • Materials consumed or scrapped during process development 

Please note that machinery/equipment purchased as a capital investment for the business is depreciable and may not be claimed as qualified supplies under the R&D Credit.  

Wages 

Employee wages may qualify for the Credit as well. Those who are actively engaged in the research are included of course, but the wages of those involved in supervising or supporting the research may also be claimed. The following job titles are illustrative of the types of positions eligible: 

R&D Tax Credit - Employee Wages

The “80% Rule” or the “Substantially All” Rule, is a taxpayer-friendly provision. If 80% of the work performed by an employee is related to QRAs, 100% of the wages paid to the employee may be captured as QREs and included in the Credit calculation.  

Third-Party Contractor Wages  

Payments made to third-parties for services like modeling, laser-cutting, testing, etc. may be claimed towards the Credit, as long as the third-party is based in the US.  

One important note – only 65% of these payments may be claimed towards the Credit.  

How Can Manufacturers Claim the R&D Tax Credit?  

Manufacturers can claim the R&D Credit by filing IRS Form 6765, Credit for Increasing Research Activities. Taxpayers must provide “sufficient documentation” to support the amount of QREs they are claiming.  

The IRS does not specify what constitutes “sufficient documentation,” and indeed the nature of the documentation will vary by type of manufacturing. In general, the more documentation you can retain and provide as needed, the better. Here are some examples of helpful documentation:  

    • Payroll information for employees directly involved in R&D and for employees or managers supervising them 
    • General ledger reports indicating which costs and supplies were related to R&D activities 
    • Copies of contracts and invoices paid to third-party contractors 
    • General documents that demonstrate the research process and progress: design revisions, test results, blueprints, drawings, emails, presentations, meeting minutes, etc. 

Credible employee testimony is also helpful in substantiating the R&D Tax Credit claim, especially in conjunction with documentation. 

There is an additional documentation requirement established by Memorandum Number 20214101F, “Minimum Requirements for an R&D Claim.” This 2021 Memorandum states that for each product or process, the claimant must:  

  1. Identify all research activities performed;  
  2. Identify all individuals who performed each research activity; and  
  3. Identify all the information each individual sought to discover.  

In short, you need to be able to demonstrate who worked on what, when, why, and how. There are different ways of gathering this information – at Capstan we create flow charts for each activity according to employee or department.  

It’s crucial to select an R&D Provider who understands the documentation requirements for a claim to be successful.  

How Large Can the R&D Tax Credit Be for Manufacturers? 

The amount of the Credit depends on the value of the QREs, not on company size or overall revenue. The more a company spends to innovate, the more they can potentially save, regardless of company size or scope.  

The R&D Tax Credit offers up to 10 cents in benefit for every qualifying dollar identified in a study. Not everyone receives the full 10 cents for every dollar spent, but a good average often used in estimates is 7.9 cents for every dollar. If you have $1M in QREs, you could receive about $79K in Credit, and potentially up to a maximum of $100K. And that’s only the Federal Credit. If there is a state version of the Credit the benefit could be significantly more, and even doubled in states like California.  

Let’s consider an example.  

R&D Tax Credit for Manufacturers A

Imagine that 20% of employee wages qualify as QREs – that’s $1M. Imagine that $1M of supplies/materials also qualify – that’s $2M in QREs, translating to nearly $160K in Federal Credit annually (using the 7.9 cents on the dollar average.)  And in a state like California or Indiana, that number could double. With that dollar-for-dollar Credit, Manufacturer A could hire a new employee, pay down debt, or reinvest in improving technology.  

Remember, the value of the Credit depends on how much a company is spending on R&D, not on the size of the company. This Credit can be extremely lucrative for small firms that invest heavily in their qualified activities. Manufacturer B, has only half the gross receipts of Manufacturer A. However, they could get a similar credit if they spent more on R&D. 

R&D Tax Credit for Manufacturers B

If 40% of Manufacturer B’s employee wages qualify as QREs – that’s $2M in QREs right there.   

Depending on a company’s size and the types of activities performed, typical savings can range anywhere from $50K to $5M through the R&D tax credit. 

What Should a Manufacturer Do Next?  

If you’re interested in learning more about how you might benefit, you need to consult an R&D Tax Credit provider. Your CPA might have a recommendation, or if you’re evaluating providers yourself, be sure to ask these important questions 

Claiming the Credit requires a strong understanding of the manufacturing industry and how the tax code applies. Your provider will be combing through your manufacturing process start to finish, identifying all QRAs and tying QREs to them. It’s important to select an R&D Tax Credit provider with the technical and tax knowledge required to do the job right.  

The Capstan team can review your situation in a 15-20 minute call to get a sense of your activities and expenses, and then provide a Credit estimate. Please don’t hesitate to contact us. Together, we can manufacture success.  

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Manufacturers claim the lion’s share of R&D Tax Credits annually – over $7.5B in the most recent year for which data is available.  

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