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Calif. Tax Credit Is Largely Underused By Manufacturers

Research and development could qualify businesses for a tax break if used correctly, says consultant

Posted: April 18, 2013 2:00 a.m.
Updated: April 17, 2013 5:42 p.m.

Though California ranks first in the country in research and development performance, many businesses shy away from applying for a type of tax credit that could help them save considerably, a tax consultant said during a seminar in early March.

Because of confusion or fear of attracting an audit, businesses sometimes pass up on opportunities to apply for research and development tax credits, said Luis Rivera, managing director of Encore Tax Consulting Group in Los Angeles.

The R&D tax credit is underutilized, and businesses often don’t have as comprehensive of an understanding as they should, Rivera said.

However, Santa Clarita businesses can make use of the credit without fear of retribution if they understand the qualifications.

“This is not a new credit,” Rivera said. “But many business owners are still afraid of it because they don’t know how to use them, and they are afraid of an audit.”

The research and development tax credit, which became effective in 1981, is both a federal and state credit applied against taxes that a business would normally pay.

 “Most businesses are in need of an R&D consultation,” he said.

A Santa Clarita Valley Economic Development Corporation board member, Rivera spoke to the local business community during a breakfast seminar hosted by the center in early March.

Many business owners, CPAs and financial advisors from Santa Clarita attended, as well as a few out-of-towners, totaling about 30 people.

“The R&D tax credit is something the SCVEDC hasn’t really explored in terms of seminars and workshops,” a SCVEDC spokeswoman said. “We asked Luis Rivera to speak because he is the aficionado in all things R&D.”

Californiaaccounts for more than one-fifth of the country’s total research and development, Rivera said.  With strong manufacturing and aerospace industries, along with others, many Santa Clarita businesses should be able to take advantage of the credit, he said.

“Our state has more manufacturing than any other state,” he said. “We have been losing some manufacturers, but we still have the most in the country. The intent of the R&D tax credit is to create competition in theU.S.”

To qualify, businesses have to spend the research and development dollars in theU.S., encouraging businesses to domestically improve their products, processes and technologies.

In addition to the domestic spending requirement, specific guidelines determine which product, process and technology improvements qualify as research and development.

Research and development encompasses the design or development of any new or improved business component, according to the IRS.

Qualifying activities include: developing new products, improving existing products, developing software, improving manufacturing processes and testing.

Cosmetic changes, reverse manufacturing, routine data collections and research funded by an outside source, such as a grant or contractor, do not qualify.

However, opportunities for R&D tax credits are often missed in the area of process improvement, Rivera said. Researching ways to reduce production costs, increase automation or use less energy qualifies as process improvement. 

“It has to make a ‘significant’ change to the product or process,” Rivera said. “You can’t just change the color and expect to get R&D credits.”

A business, for example, spending time trying to figure out the most manageable way to manufacture or complete a process, that’s R&D tax credits, he said.

This also includes collaborative process improvement, during which a business might work with a third party.

“If you send a product out to a third-party contractor – and that product was manufactured according to the correct, stateside processes – that’s R&D credit,” Rivera said.

However, outsourcing to anyone outside theUnited Statesdisqualifies the research for the tax credit, Rivera said.

Some restrictions apply to the credit, but there are usually opportunities to earn the credit somewhere within the process.

And while reverse engineering by itself doesn’t qualify, businesses can pick up R&D tax credit immediately once the manufacturing process begins on the new product, Rivera said.  

Though grant- or otherwise-funded research doesn’t qualify, manufacturing done after the funded research can qualify, Rivera said.

With such detailed qualifications, business owners often worry an audit is certain, but that is a huge misconception, he said.

“People think every company that applies for the R&D tax credit will get audited,” Rivera said, “but only about 10 percent get audited.”

 Auditors used to focus more on big money, but they now pay attention to the “small money,” as well. However, having the correct documentation is absolutely vital and will keep a business from harm in the case of an audit, Rivera said.

“Get a tax consultant to do an analysis. If your business qualifies, work with the consultant to find out how much can be used for R&D tax credit,” Rivera said. “That’s the first step.”



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