Many plastic injection molders are unaware that their business may be regularly performing qualified research and development (R&D) activities that can allow them to obtain valuable Federal and State income tax credits. Moreover, some may be already claiming the R&D tax credit, but may not be claiming the appropriate amount of credit.
Because plastic processors produce specialized parts utilized in virtually every industry, the molding industry is constantly evolving and improving upon its technology. Plastic injection molding companies spend significant resources, not only in materials and components, but also in the development of its unique manufacturing processes that are specific to the customer’s part. Processors consider, evaluate, and test (sample) numerous variables in order to eliminate design uncertainty related to the part-specific production process, which are all likely to qualify as research and development activities.
The R&D Tax Credit
The U.S. Credit for Increasing Research Activities (R&D Tax Credit) incentivizes companies of all sizes to invest in innovation, product development and improvement, new technologies, improved processes, new or improved software, new techniques and/or formula development. In addition, approximately 35 states also provide tax credit incentives for qualified research and development.
The R&D tax credit is activity-based, and taxpayers must meet the following four‐part test in order for an activity to qualify:
Eligibility: The 4‐Part Test
1. Qualified Business Component: Plastics processors must be developing a new or improving an existing business component which the company intends to sell or license, or use in its business. A business component is defined as a new or improved products, inventions, processes, techniques, formulas or software. For a research activity to qualify, the activity must be aimed at developing or improving the functionality, performance, reliability, or quality of the business component.
In our experience, plastics processors engage in qualified research activities related to the development or improvement of the following types of business components:
- The development or improvement of part-specific manufacturing processes
- The development or improvement of new injection molds
- The development or improvement of automation techniques and end-of-arm tooling
- The continuous improvement activities meeting the other requirements of the four-part test
2. Technological in Nature: The qualified activities must fundamentally rely on the principles of the physical or biological sciences, engineering, or computer science to satisfy this requirement. Activities relying on market research and aesthetics are specifically identified in the Treasury Regulations as non-qualified.
Processors are not required to expand, exceed or even refine the knowledge of a skilled professional in their industry. Rather, processors are entitled to rely upon existing engineering principles in order to solve for the research uncertainty.
Most commonly, companies utilize the engineering disciplines and physical sciences in order to eliminate the uncertainty related to the development or improvement of the business component.
3. Uncertainty. For an activity to qualify, technological uncertainty must exist at the outset of the research activity. Technological uncertainty exists if the capability of development or improving the business component is uncertain, the method of developing or improving the business component is uncertain, or if the appropriate design of the business component is uncertain. (Emphasis added). Note that only one of the uncertainties must be present for an activity to qualify.
Capability: Can the processor develop or improve the business component? Many times we find that this question relates to tight tolerance parts or geometry that doesn’t lend well to ejection or other processing variables.
Method: How can the processor develop this business component? Often, we find this uncertainty present in the development of production processes, automation techniques, and the development of downstream, post tool processes.
Design: What specific design results in the research being successful? The most frequent uncertainty we encounter, we regularly find that the design of a new tool or part-specific manufacturing process is uncertain at the outset of the research activity.
4. Process of Experimentation: The final element of the four-part test requires the taxpayer to utilize a process of experimentation to eliminate the technological uncertainty. The Treasury Regulations list modeling (including 3-D modeling), simulation (including mold fill analysis), or systematic trial and error (such as sampling a new tool design) as experimentation.
We have found that most plastics processors engage in a process of experimentation in order to eliminate technological uncertainty related to the design and development of new tools (using 3-D modeling), design changes to part (design for manufacturability issues), part-specific manufacturing processes (mold fil analysis), and automation techniques (such as end-of-arm tooling design and experimentation). The trial and error that occurs during the sampling process also regularly qualifies for the credit. The “research clock” stops once the technological uncertainty has been eliminated and commercial production commences (when the approved product or process is found to meet the basic functional and economic needs of the processor).
Examples of Qualifying Activities
Examples of the most common types of qualified activities for plastics processors include, but are not limited to:
- Developing new part design designs for manufacturability;
- Developing new mold designs;
- Improving functionality, performance or reliability, of a production process;
- Rapid prototyping or 3-D models aimed at eliminating uncertainty related to a prototype design;
- Modeling (including 3-D models) new tool designs;
- Mold fill analysis to predict the fill of the part;
- Performing experimental testing or sampling new tools;
- New materials or resin testing; or
- PPAP or FAI on new parts / molds / designs.
Qualified Research Expenditures
If the processor’s activities meet the four‐part test, the said activity is considered qualified and the following types of expenditures are used in determining qualified research expenditures:
- Wages: Wages paid to employees for qualified services. Qualified services includes engaging in qualified research (the activity meets the four-part test), directly supporting qualified research (such as a production employee sampling a new tool or a quality director testing the design of a new part), and directly supervising qualified research (such as an engineering manager directly overseeing the qualified research of a process technician).
- Supply Costs: Eligible supplies include costs used in the conduct of qualified research activities. The supplies and/or materials must be tangible and not subject to the allowance for depreciation (capital expenditures). It is also worth noting that a plastics processor (TG Missouri Corporation) was successful in tax court arguing that new, novel, unique one-of-a-kind tools can be supplies used in the conduct of research. In fact, this court case gave way to new Treasury Regulations indicating that it’s irrelevant whether the results of the research are sold to a customer (like the molds developed by TG Missouri) or used in its business in determining whether a supply can qualify, as long as the design uncertainty still exists at the time the tool is being used in the conduct of research and experimentation.
- Contract Research: Any amount paid to a 3rd party for the performance of research on the processors’ behalf. This could include 3rd party engineers or testing facilities.
- Computer Leasing/Rental: Any amount paid for the lease of computers in the conduct of qualified research.
Calculating the Credit
The IRS tax code allows for two methods of calculating the R&D Credit: The Regular Method (RRC) or the Alternative Simplified Method (ASC).
The Regular Method consists of 20% of the taxpayers qualified research expenditures in excess of the base amount. This base amount consists of the greater of 50% of the current year‐end research expenditures, or the product of the average gross receipts from the prior four tax years and the fixed based percentage. The fixed base percentage consists of the aggregate qualified research expenditures over the aggregate gross receipts during the base period. The base period is specific to each taxpayer, and it is dependent upon when the company was form, when the company began performing research, as well as other factors. For some taxpayers, this method can be complicated and less than practical.
The Alternative Simplified Credit (ASC) is equal to 14% of the taxpayers qualified research expenditures in excess of its base amount. The base amount is equal to 50% of the average qualified research expenditures paid or incurred in the prior three tax years. Ironically, this method even allows processors that are not increasing their research activities.
New Legislation-Offsetting Tax Liability
Recent legislation has made the credit permanent and enhanced its application, removing past limitations for certain taxpayers. The Protecting Americans from Tax Hikes Act (The PATH Act) allows for eligible small businesses, defined as those with average sales of less than $50 million over the prior three tax years, to use the credits to offset the Alternative Minimum Tax (AMT) using credits generated in tax years beginning after December 31, 2015.
Moreover, the PATH Act allows a qualified small business to apply up to $250,000 of its research credit against its payroll tax liability (the employer’s portion of FICA). In order to offset FICA, the business must have had gross receipts of less than $5 million in the current year and could not have had gross receipts for any taxable year preceding the 5-taxable-year period ending with the current tax year (e.g., for tax year 2016, the taxpayer may not have had gross receipts in 2011 or earlier). Both changes are effective for beginning after December 31, 2015 and thereafter.
Claiming the Credit & Supporting Documentation
Claiming the R&D Tax Credit entails a study that includes both quantitative and qualitative substantiation. While it is obviously important to provide the quantifiable information, the taxpayer must also provide qualitative information necessary to support and prove that that qualified activities are being performed. Qualitative supporting documentation can consist of several items. Commonly, business documents pertaining to the qualified activities that are already prepared as part of the company’s development and engineering process are adequate to support the qualified activities. Examples of these documents include, but are not limited to, CAD/3D design drawings of parts or new tools with iterations, conceptual sketches, photographs, test (sample) data, research notes, meeting/collaboration notes, emails and purchase orders. This R&E supporting documentation can usually be obtained with little to no interruption of the company’s daily routine and procedure.