This presentation was on understanding research and development tax credits in Kentucky and presented at Techfest Louisville 2017.

1. Real Solutions.
Real Relationships.
Beyond the Numbers.
Research & Development Tax Credit:
Overview & Opportunities

2. Real Solutions.
Real Relationships.
Beyond the Numbers.
Learning Objectives
• Understand the history of the federal credit
• Understand the functional components to
the R&D Credit computation
• Understand new rules & regulations
surrounding the credit (PATH Act)
• Understand Indiana and Kentucky incentives
for research and development activity

3. Real Solutions.
Real Relationships.
Beyond the Numbers.
Identifying Opportunities
Does your company….
• Develop new or improved products
• Conduct process improvement initiatives
• Employ engineers, scientists, chemists,
programmers, technical personnel
• Design new tools, molds or prototypes
• Develop or enhance software
• Customize machinery & equipment
• Conduct trial runs or experiments

4. Real Solutions.
Real Relationships.
Beyond the Numbers.
RESEARCH & DEVELOPMENT
TAX CREDIT – HISTORY

5. Real Solutions.
Real Relationships.
Beyond the Numbers.
History – Legislative
R&D Tax Credit Origin
– Introduced in the Economic Recovery Tax Act of 1981
– Initial Purpose
• Economic Stimulus
• Global Competitiveness
– Credit for ‘Increasing Research Activities’
– Tailored to reverse the decline in U.S. Research Spending
– Research credit has expired 8 times and has been
extended 15 times
– PATH Act: Significant Changes

6. Real Solutions.
Real Relationships.
Beyond the Numbers.
Introduction to the R&D Tax Credit
• What is the R&D Tax Credit?
– Tax credit provided by the IRS to companies
that focus on innovation, experimentation,
research & development
– Activity-based incentive
– Dollar-for-dollar reduction in the company’s
federal tax liability
– Benefit is generally 5 cents to every qualified
dollar
– Many states also have R&D tax credits
– 1-year carryback and 20-year carryforward

7. Real Solutions.
Real Relationships.
Beyond the Numbers.
Who Qualifies?
• Credit is available to various types of industries…
– Consumer and industrial products
(Manufacturers/Contract manufacturers)
– Energy production
– Software development
– Food and beverage
– Distribution
– Construction/Engineering firms

8. Real Solutions.
Real Relationships.
Beyond the Numbers.
What Qualifies?
To qualify, must first identify a business component
from one of the following:
Product Process Software
Technique Invention Formula

9. Real Solutions.
Real Relationships.
Beyond the Numbers.
Areas of Focus
-New product development
-Product enhancement
- Activity can be new to taxpayer, NOT to industry
and still qualify (evolutionary not revolutionary)
-Process improvements
- R&D process
- Manufacturing process
-Software development
- Software for sale, lease or license
- Internal use software

10. Real Solutions.
Real Relationships.
Beyond the Numbers.
Permitted
Purpose
Technological in
Nature
Elimination of
Uncertainty
Process of
Experimentation
The activity relates to a NEW OR IMPROVED FUNCTION,
PERFORMANCE, RELIABILITY, OR QUALITY of a business
component (i.e., product, process, computer software, technique,
formula, or invention) which is to be held for sale, lease, license, or
used in a trade or business
The activity performed must FUNDAMENTALLY RELY on principles
of: physical science; biological science; computer science; or
engineering
The activity must be intended to discover information to eliminate
uncertainty concerning the CAPABILITY OR METHOD for developing
or improving a product or process, or the APPROPRIATENESS OF
THE PRODUCT DESIGN
SUBSTANTIALLY ALL of the activities must be elements of a
PROCESS OF EXPERIMENTATION to resolve the technical
uncertainty, documented by explaining: the alternatives considered
and attempted, testing performed on the alternatives, test results and
analysis
&R
D The Four-part Test to Qualify Activities

11. Real Solutions.
Real Relationships.
Beyond the Numbers.
Examples of Qualified Activities
• To advance the design of an
existing product or process
• To correct significant design
defects, obtain significant cost
reductions, or enhanced
function
• Design, construction and
testing of pre-production
prototypes and models
• Conceptual formulation,
design and testing of possible
product or process alternatives
• Launch activities involving a
new component/process
• Design time, tool design and
testing, prototype building, etc.
• Engineering efforts to develop
new plant processes
• Technical redesign of an existing
plant layout, resulting in
substantial production gains
• Efforts to solve production
problems where there was
uncertainty as to the best
solution
• The design and testing involved
in improving the configuration or
altering the composition of an
existing product/process to
increase efficiency or decrease
cost

12. Real Solutions.
Real Relationships.
Beyond the Numbers.
Examples of Non-qualified Activities
• Research done outside the United
States, the Commonwealth of
Puerto Rico, or any possession of
the United States
• Research in the social sciences,
arts, or humanities
• Ordinary testing or inspection of
materials or products for quality
control
• Market and consumer research
• Advertising or promotion expenses
• Management studies and efficiency
surveys
• Changes related to cosmetic,
taste, style or seasonal design
• Acquisition or improvement of land
or of certain depreciable or
depletable property used in
research
• Acquisition of another person’s
patent, model, production, or
process
• Research funded by another
person, or any governmental entity,
by means of a grant or contract
• Research conducted after
commercial production
• Research for the adaptation of
existing business components
• Research for the duplication of an
existing business component

13. Real Solutions.
Real Relationships.
Beyond the Numbers.
Example – Uncertainty Test
• In a recent exam involving a large engineering firm, IRS engineer
disallowed all but 2 projects under his theory that since taxpayer
consulted existing engineering guidelines, manuals, etc. the
information needed to resolve the uncertainty was “available” to the
taxpayer.
• IRS engineer relied on Reg. §1.174-2(a)(1), which states, in part:
“Uncertainty exists if the information available to the taxpayer does
not establish the capability or method for developing or improving
the product or the appropriate design of the product.”
• Is the engineer correct?

14. Real Solutions.
Real Relationships.
Beyond the Numbers.
Example – Uncertainty Test
• Answer: NO
• IRS engineer misapplied the “available information” rule.
• The available information only provided the method to the taxpayer,
the information did not resolve uncertainty regarding capability or
appropriate design.

15. Real Solutions.
Real Relationships.
Beyond the Numbers.
Software Development
• Software as a saleable product
• Internal use software – must meet
additional three-part “high threshold of
innovation test”

16. Real Solutions.
Real Relationships.
Beyond the Numbers.
Software Development
• Software not considered to be internal use
software:
– Developed for sale, lease or license to
customers
– Used in production process
– Used in conducting qualified research
– Embedded in hardware for sale
– Used in providing computer services to
customers
– Used to interact with third parties or to allow
third parties to initiate functions or review
data on the taxpayer’s system

17. Real Solutions.
Real Relationships.
Beyond the Numbers.
Internal Use Software – Definition
• Software that is developed by (or for the benefit of) the taxpayer is
primarily for internal use if the software is developed by the
taxpayer for use in general and administrative functions that
facilitate or support the conduct of the taxpayer’s trade or business.
• “Primarily for internal use” depends on the intent of the taxpayer and
the facts and circumstances at the beginning of software
development.

18. Real Solutions.
Real Relationships.
Beyond the Numbers.
High Threshold of Innovation Test
• If internal use software, may still qualify for R&D credits if:
1) It is intended to be innovative,
• As measured by a reduction in cost, improvement in speed, or other
measurable improvement that is substantial and economically
significant.
2) Has significant economic risk, and
• Did the taxpayer commit substantial resources to the development,
and there is substantial uncertainty, because of technical risk, as to
whether the resources can be recovered within a reasonable amount
of time?
3) Is not commercially available
• The software cannot be purchased, leased, or licensed and used for
the intended purpose without modifications that would satisfy the
innovation and significant economic risk requirements.

19. Real Solutions.
Real Relationships.
Beyond the Numbers.
Costs Eligible for the Credit
Qualified Research Expenses (“QREs”)
• Wages
– Box 1 W-2 Wages for those employees involved in:
• Direct Performance of Research/Development
• Direct Supervision of Research/Development
• Direct Support of Research/Development
• Supplies
– Raw materials used in the research or experimentation process
– Expenses relating to tangible personal property of a non-
depreciable nature
– Must be used or consumed in the research process
• Contract Research
– Research conducted on behalf of the taxpayer (paid consultants,
engineering firms, etc.)
– Payments must not be contingent upon the success of the research
– Taxpayer must retain substantial rights to use the research results

20. Real Solutions.
Real Relationships.
Beyond the Numbers.
Research Credit Keys to Success
Permitted Purpose
Technological in
Nature
Eliminate
Uncertainty
Process of
Experimentation
Wages
‒Qualified Research
‒Direct Support
‒Direct Supervision
Supplies
Raw materials used in
research
Contract Research
Research performed on
your behalf
Sample Documents
•Project List(s)
•Time Tracking
• Prototype Designs
•Test Results & Analysis
•Project
Schedules/Timelines
•Meeting Minutes
•Executive Presentations
•Project Summaries
•Customer Contracts
•Engineering Notes
•Project Budgets
•Requirements Documents
•Email Correspondence
Projects Costs Documentation

21. Real Solutions.
Real Relationships.
Beyond the Numbers.
Documentation is Key to Success
• Maintaining documentation is a key component of
claiming the R&D tax credit & sustaining upon audit
• IRS requires that each business component satisfy the
4-part test
• Documentation should be maintained to help support
and substantiate:
1) Qualifying activities AND
2) Costs associated with qualified activities

22. Real Solutions.
Real Relationships.
Beyond the Numbers.
Examples of Documentation for Activities
• Test results of experiments
• Hand sketches, design concept drawings, CAD designs showing
the evolution of product designs
• Presentations & summaries to management, the board of
directors, review committees or other similar groups regarding
research projects, activities, expenditures and the credit
• Meeting minutes, notes, or other similar recordings from
budget, board of directors, managerial or other similar meetings
concerning research activities
• Project authorizations, budgets or work orders that initiated the
research project
• Internal authorization policies for approving a research project
• Project summaries, progress & milestone reports and project
notes (informal)
• Email correspondence describing technical challenges

23. Real Solutions.
Real Relationships.
Beyond the Numbers.
RESEARCH & DEVELOPMENT TAX
CREDIT – CALCULATION METHODS

24. Real Solutions.
Real Relationships.
Beyond the Numbers.
Traditional Credit Calculation – Overview
• Generates a credit of 20% of qualified
research expenses (QREs) in excess of
the base period amount.
• Reduced Credit is 13% of QREs over base
period amount.
• Base Period amount cannot be less than
50% of qualified research expenses for
the credit year.

25. Real Solutions.
Real Relationships.
Beyond the Numbers.
Traditional Credit Calculation – Base
• Product of the taxpayer’s fixed-base
percentage and average annual gross
receipts for the four tax years preceding
the credit year.
• Fixed-base percentage is the ratio of
qualified research expenses to gross
receipts over the 1984-1988 period.

26. Real Solutions.
Real Relationships.
Beyond the Numbers.
Traditional Credit Calculation – Base Illustration
Tax Year QREs GRs QRE%
1984 10,000 1,000,000 1.00%
1985 10,000 1,100,000 0.91%
1986 10,000 1,210,000 0.83%
1987 10,000 1,331,000 0.75%
1988 10,000 1,464,100 0.68%
50,000 6,105,100 0.82%
Tax Gross
Year Receipts Average
2012 100,000,000
2013 110,000,000
2014 121,000,000
2015 133,100,000
2016 116,025,000
Fixed-base percentage = 116,025,000 x 0.82%
Fixed-base percentage = $951,405

27. Real Solutions.
Real Relationships.
Beyond the Numbers.
Traditional Credit Calculation – Start Up
• For taxpayers incorporated after December
31, 1983
• For taxpayers with fewer than 3 years of
QREs and gross receipts between January 1,
1984 and December 31, 1988
• Traditional Method vs. Start Up Method

28. Real Solutions.
Real Relationships.
Beyond the Numbers.
Traditional Credit Calculation – Start Up Base
• Fixed-Base Percentage remains at 3% for each of the
taxpayer’s first 5 taxable years
Gross Fixed Fixed Base %
QREs Receipts QRE % Base % Calculation
1 2016 10,000 100,000 10.00% 3.00%
2 2017 10,500 110,000 9.55% 3.00%
3 2018 11,025 121,000 9.11% 3.00%
4 2019 11,576 133,100 8.70% 3.00%
5 2020 12,155 146,410 8.30% 3.00%
6 2021 12,763 161,051 7.92% 1.42% 1/6 of 4,5
7 2022 13,401 177,156 7.56% 2.70% 1/3 of 5,6
8 2023 14,071 194,872 7.22% 3.95% 1/2 of 5,6,7
9 2024 14,775 214,359 6.89% 5.14% 2/3 of 5,6,7,8
10 2025 15,513 235,795 6.58% 6.26% 5/6 of 5,6,7,8,9
Tax Year

29. Real Solutions.
Real Relationships.
Beyond the Numbers.
Traditional Credit Calculation – Mechanics
2016
Qualified Research Expenses
Qualified Wages 50,000
Qualified Supplies 10,000
Qualified Contract Research 5,000
Total QREs 65,000
Fixed Base Amount 50,000
A Difference 15,000
B 50% of Qualified Expenses 32,500
Lesser of A or B 15,000
Multiply by 13% 13%
Regular R&D Credit 1,950
Fixed Base % 1.00%
Average Gross Receipts 5,000,000
Fixed Base Amount 50,000

30. Real Solutions.
Real Relationships.
Beyond the Numbers.
Alternative Simplified Method – Overview
• Generates a credit equal to 14% of the
current year QREs that exceed 50% of
the average QREs for the 3 preceding tax
years.
• 280C Election on the original tax return
allows taxpayer to claim 65% of credit.
• If taxpayer elects ASC and no QREs in
any one of the 3 preceding tax years,
then 6% of current year QREs.

31. Real Solutions.
Real Relationships.
Beyond the Numbers.
Alternative Simplified Method – Mechanics
2016
Qualified Research Expenses
Qualified Wages 50,000
Qualified Supplies 10,000
Qualified Contract Research 5,000
Total QREs 65,000
Prior 3 Years QREs
2014 Tax Year 60,000
2013 Tax Year 50,000
2012 Tax Year 40,000
Total Prior Year QREs 150,000
Average of Prior 3 Years 25,000
Current Year QREs 65,000
Average of Prior 3 Years 25,000
Difference 40,000
Multiply by 14% 14%
Gross Research Credit 5,600
280C Reduction 65%
Reduced Research Credit 3,640

32. Real Solutions.
Real Relationships.
Beyond the Numbers.
RESEARCH & DEVELOPMENT TAX
CREDIT – RECENT DEVELOPMENTS

33. Real Solutions.
Real Relationships.
Beyond the Numbers.
Credit Now Permanent
• § 121(a)(1) of the Protecting Americans from
Tax Hikes Act of 2015 (“PATH Act”, P.L. 114-
113, 12/18/2015)
• Repealed former §41(h) effective for amounts
paid or incurred after 12/31/2014
• Effects:
– Permanent extension
– Retroactive extension to last date of termination

34. Real Solutions.
Real Relationships.
Beyond the Numbers.
Small Business Opportunities
• AMT offset
– PATH Act added an amended version of
§38(c)(4)(B)(ii) providing for the allowance of R&D
credit amounts for use to offset AMT for eligible
small businesses
• Payroll tax offset
– PATH Act added new §41(h) addressing treatment of
R&D credit for qualified small businesses

35. Real Solutions.
Real Relationships.
Beyond the Numbers.
AMT Offset for Eligible Small Businesses
• Eligible small businesses can offset regular
tax and AMT with R&D tax credits.
• Eligible small business defined under
§38(c)(5)(C) as:
• A corporation that is
not publically traded;
• A partnership; or
• A sole proprietorship
F
The average annual
gross receipts for the 3
prior taxable years
does not exceed $50
million.
IF

36. Real Solutions.
Real Relationships.
Beyond the Numbers.
Payroll Tax Offset
A qualified
small business
Corporation
or
Partnership
Other
(non-
corp/pship)
Person
Gross receipts are less than
$5 million for taxable year
No gross receipts for tax
years before 5-year period
ending with tax year
Gross receipts are less than
$5 million for taxable year
No gross receipts for tax
years before 5-year period
ending with tax year
Only use aggregate gross
receipts person receives for
his trades/businesses

37. Real Solutions.
Real Relationships.
Beyond the Numbers.
Payroll Tax Offset
may elect to
Form
6765
Annually
with
return
Specify
the
amount
Made on
entity
level

38. Real Solutions.
Real Relationships.
Beyond the Numbers.
Payroll Tax Offset
• Applies against §3111(a) 6.2% tax on employee wages for
employers who have employees (“payroll taxes”)
• Eligible for first calendar quarter that begins after the taxpayer
filed the return and Form 6765
• The credit cannot exceed the payroll tax for any calendar quarter
• Any excess can be carried forward to the next calendar quarter
• Payroll offset is not taken into account for determining payroll tax
deduction, but is still treated as a credit for purposes of §280C
offset payroll taxes

39. Real Solutions.
Real Relationships.
Beyond the Numbers.
Payroll Tax Offset
• Limitation on amount of credit applicable for
offset:
– May not exceed $250,000
– Cannot elect to offset payroll tax if the taxpayer
has elected to do so for 5 or more preceding tax
years
with a portion of
the R&D credit.

40. Real Solutions.
Real Relationships.
Beyond the Numbers.
Payroll Tax Offset – Example
TECHCO, a small tech company founded in 2014, had acquired substantial
R&D and payroll expenses in tax year 2015, however no revenue was
produced. Since it worked at a loss, TECHCO did not claim any R&D Tax
Credit in 2015. Moreover, the small company expects 2016’s activities to
be comparable with those of 2015.
• TECHCO can secure the $150,000 of credits in 2016 and elect to
offset $100,000 against payroll tax liability.
• TECHCO can carry forward the remaining $50,000 to offset against
future payroll tax liability.
Business Form of Taxpayer C-Corp
R&D Tax Credit Eligibility 150,000$
Payroll Tax Liability 100,000$
TECHCO 2016 Activity

41. Real Solutions.
Real Relationships.
Beyond the Numbers.
Payroll Tax Offset – Example
TECHCO, a small tech company founded in 2014, had acquired
substantial R&D and payroll expenses in tax year 2015, however no
revenue was produced. Since it worked at a loss, TECHCO did not
claim any R&D Tax Credit in 2015. Moreover, the small company
expects 2016’s activities to be comparable with those of 2015.
• In 2017, TECHCO began to turn a profit. TECHCO can apply their
$200,000 R&D Tax Credit against their income taxes.
• TECHCO can apply the remaining $100,000 of credits to offset
$100,000 of their payroll tax liability.
Business Form of Taxpayer C-Corp
R&D Tax Credit Eligibility 200,000$
Income Taxes 100,000$
Payroll Tax Liability 150,000$
TECHCO 2017 Activity

42. Real Solutions.
Real Relationships.
Beyond the Numbers.
State incentives for
research activities

43. Real Solutions.
Real Relationships.
Beyond the Numbers.
Indiana Research Credit
• Very similar to federal credit
– Uses federal tax code as foundation for credit
– Regular and Alternative Incremental Credit
computation options
– Differences
• Research activities must be conducted in Indiana
• No provision to use credits against payroll tax

44. Real Solutions.
Real Relationships.
Beyond the Numbers.
Other Indiana Research Incentives
• Sales tax exemption for “research and
development property”
– Definition:
1) Property not previously used in Indiana for any other
purpose
2) Acquired for the purpose of R&D activities devoted to
experimental or lab R&D for new products, new uses of
existing products, or improving or testing existing
products
– Computers, software, office supplies,
consumables, hand tools, and repair parts also
qualify

45. Real Solutions.
Real Relationships.
Beyond the Numbers.
Kentucky Research Incentives
• Research Facility Credit
– Credit for constructing, remodeling, and
equipping research facilities in Kentucky or
expansion of existing facility:
1) Definition of research follows federal definition
2) Construction costs to build/remodel/expand the facility
3) Credit is equal to 5% of construction costs
4) Equipment-property used to conduct research activity and
subject to the depreciation rules (no supplies, repair parts,
or replacement property)

46. Real Solutions.
Real Relationships.
Beyond the Numbers.
Kentucky Research Incentives
• Kentucky Enterprise Initiative Act
– Refund of sales tax paid on construction
materials and equipment purchased as part of
an “economic development project”
– Same definition for building costs and R&D
equipment
– Must be a pre-approved project with a
minimum $500,000 investment

47. Real Solutions.
Real Relationships.
Beyond the Numbers.
Contact Us
Thank you for attending today!
Contact for follow up questions:
John M. Rittichier, CPA
jrittichier@hsccpa.com
502.882.8484
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