Bloomberg Tax
Aug. 10, 2023, 8:45 AM

R&D Tax Credit Supports More Than Just Pharma and Defense Work

Alexandra Colman
Alexandra Colman
Stephen  Boncimino
Stephen Boncimino

With all the buzz around research and development in 2023, it’s no surprise that companies are being aggressive about trying to qualify for the R&D tax credit. A recent Bloomberg Tax article touches on the clothing retail industry and its situation of not having qualified R&D activities.

Although the IRS may have ruled against a specific retailer, it clarified that expenses that relate to the style or design of a product may qualify for the R&D tax credit under certain circumstances. As a result, there are many industries outside of the traditional life science and pharmaceutical space that qualify for the R&D credit.

Generally, Section 41 of the tax code offers a credit for increasing research activities applies to any company that incurs qualified research expenses. For research to qualify for the credit, it must relate to a new or improved function, performance, reliability, or quality. These criteria widely vary across industries—how the aerospace defense industry conducts its R&D drastically differs from that of a technology company.

To determine the applicability of the credit for increasing research activities for a broad array of sectors, let’s examine some specific examples.

Classic R&D Industries

The pharmaceutical and aerospace defense industries are classic examples of R&D expenditures. For a pharmaceutical manufacturer, R&D costs are incurred to develop a drug to cure an ailment for which either no cure exists or the utilized method is insufficient or ineffective.

For an aerospace defense manufacturer, R&D costs are incurred to develop proprietary technology that gives either the government or a private party a competitive advantage over its rivals. Examples of these types of technology include new or improved radar systems, vehicles, and defense systems.

In both instances, these companies require an engineering team to develop the product for the end user. Wages, supplies, and contract research related to the development of the new or improved end product are typically eligible for inclusion in the calculation of the tax credit.

Other Manufacturers

Other manufacturing companies are entitled to the R&D credit, such as the auto industry. At first glance, it would appear that much of what automakers do wouldn’t qualify.

Maintaining an existing product line may not constitute eligible research expenditures under the regulations. If the automaker is conducting research to rectify an issue with an existing product (such as issuing a recall), this also likely wouldn’t be credit eligible.

The key factors are deciding whether the process in question is improving function, performance, reliability, or quality. Addressing a recall of the existing model prior to the defect doesn’t hit these key factors. And when the automaker launches next year’s model of an existing product line, a vast majority of these expenses won’t qualify.

But there’s a glimmer of hope. Qualifying costs may include those connected to the newly improved features of the vehicle. For example, if the 2023 model includes newly developed safety features over the prior year’s model, then this could be tax credit eligible.

Industrial Revolution 4.0

Artificial intelligence and machine learning components rely on software development. New application development of software components, in most instances, are eligible for the research tax credit.

Furthermore, an engineer takes large amounts of data and codes algorithms to formulate automated responses. This is accomplished by a process of formulation, back testing, and ultimately a production-ready environment.

Many refer to these areas as the Industrial Revolution 4.0, where techniques are rooted in the computer sciences, and data analysis is the core research area. With AI and machine learning, those design, development, and test processes would be eligible for the tax credit.

Retail Credit

The retail industry isn’t one where R&D comes to mind. However, there are several instances in which the R&D tax credit may be available.

Let’s look at a footwear retailer. Footwear is functional, where engineering principles are applied to design and fabricate a shoe. Testing is an extensive part of the process where the sole, composites and samples must be validated before assembling a prototype for duration and traction testing. When considering a running shoe, the fabric, breathability and having a supportive sole that can sustain being under pressure for extended periods of time are extremely important.

A footwear manufacturer or retailer will incur significant costs during the trial and error and prototype process of creating the perfect running shoe. The wages related to this development, supplies, and any contracted costs incurred in the US should be tracked to substantiate a claimed credit.

Retailers are also trying to maximize the vast amounts of data they receive from customers. As part of the Industrial Revolution 4.0, retailers now employ teams of data analysts to develop models on how best to serve their customers. These formulas and tools also can be eligible for the credit.

If your company has an engineering team, some of the costs they incur could qualify for the tax credit. Before a process of experimentation begins, there should be a tracking system in place that documents time by project. This is important in case the IRS audits the claimed R&D tax credit. Keeping accurate, detailed documentation can avoid headaches and unexpected fees.

As lucrative as the R&D credit can be for some businesses, there’s no such thing as a free lunch. Since the regulation requiring the capitalization of R&D expenditures became effective in 2022, companies must be certain that their costs qualify for the credit, because they’ll no longer be tax deductible in the year incurred. Instead, they need to be amortized over a five- or 15-year period depending on the jurisdiction where these costs are incurred.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Alexandra Colman is a partner in EisnerAmper’s corporate tax group. She serves clients in a variety of industries, including manufacturing, retail and distribution, technology, life sciences, and pharmaceuticals, as well as start-up tech and internet base companies.

Stephen Boncimino is a manager in EisnerAmper’s corporate tax group. He specializes in working with public and private multistate and international corporations and has a strong background in comprehensive tax consulting services.

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