The R&D Tax Credit Plays Hard to Get

It seemed straightforward. In 2003, the federal government announced that the research and development tax credit would no longer be limited to work that was truly groundbreaking. Instead, a company could claim it for advancing its own work in a novel way. And it could often be claimed retroactively, going back as far as 10 years. So on the advice of its CPA, family-owned Tech Molded Plastics in Meadville, Pa., filed for $89,078 in tax refunds. Over the years, President Scott Hanaway's company, which has about $14 million in revenues, had spent that money developing molds for customers who used them to create complex plastic parts. Hanaway, whose parents founded the 65-person business in 1973, says almost no mold design works perfectly the first time. Getting the tax credit didn't work perfectly, either: Despite a long audit, Tech Molded remains embroiled in a series of lawsuits with the Justice Dept.

Tech Molded is far from the only company to jump at the chance to claim tax credits for work long completed. In 2008 stovemaker Viking Range in Greenwood, Miss., filed for the credit, for the first time, for work done by its engineering staff of 65. Livermore Software Technology in Livermore, Calif., had been developing computer simulation software since 1987, but it didn't start taking the credit until 2007, when it filed for work going back to 2003. Companies claimed $5.5 billion worth of research credits in 2003, according to IRS data. By 2010 that number is expected to hit $7.9 billion, according to Congress' Joint Committee on Taxation. Much of the difference, experts say, comes from small and midsize companies.

But getting the credit approved is a lot harder than merely claiming it. "The credit is not easy," says Cheryl Claybough, an IRS official. "It's very complex to determine what are qualified expenses and what are not." Tax experts say large companies are much likelier to get approval. Deb Crumley, an R&D credit expert at Fort Worth consulting firm SourceCorp, says her large clients have seen very little pushback from the IRS and generally get all or almost all of their credit approved. But small companies spend three to four times the effort to support their claims, Crumley says, only to have the whole claim denied in most cases. "They have very valid R&D, and in some cases will even have better support," says Crumley. "The IRS still isn't satisfied. On that smaller-client's always denied."

HIGHER SCRUTINYSoon after the 2003 changes, auditors began to see prepackaged tax claims that often contained little information relevant to the company at hand, says Claybough. The claims were often supported by only broad estimates of how much time had been devoted to research, with little concrete documentation of hours spent or costs incurred. In 2007 the IRS raised the historical research claims to what it calls a Tier 1 issue. That's the same designation given to tax shelters, and applications for the tax credit suddenly required a much higher level of scrutiny. Claybough says the move was aimed at making the credit's review more uniform, improving fairness. "If taxpayers are entitled to the credit, we want them to get it," she says.

But small companies and their auditors complain that the shift has meant that companies such as Tech Molded are getting dinged—their application for the credit ultimately was denied—while large corporations sail through. Tax preparers say part of the issue is that larger companies have better records. But they also say larger companies are audited by IRS agents who know the company's business and research well, while smaller outfits are audited by agents who often have little or no familiarity with the research tax credit or a particular business. The whole process has "a disproportionate effect on small business vs. large," says Mark Hanaway, Tech Molded's director of marketing and sales and Scott's brother. "It gets in the way of creativity and innovation."

Most smaller companies that are rejected for the credit give up. But Tech Molded decided to press on. Says Mark Hanaway: "Right is right, and wrong is wrong. If we were to roll over every time we hit adversity, we wouldn't last long."

While they were being audited, a process that took well over a year, Tech Molded executives met repeatedly with both their local IRS auditor and an IRS engineer who traveled from Pittsburgh to assess their operation. The agency declined the claim, Mark Hanaway says, on the grounds that their industry is not eligible, even though manufacturers are the largest group taking the credit. (The IRS won't discuss individual cases.)

The Hanaways appealed. Not long after, in August 2008, the Justice Dept. filed suit against them to recoup the tax refunds they had received based on the credit. So far the family has spent as much defending the credits as they got for claiming them. Tech Molded's outside accountant, Robert Power, says that in his 39 years in business, with more than 5,000 returns prepared, this is the first time he has ever had to appeal on behalf of a client, though he has since had a number of other clients start this same process over research claims. "It's been a nightmare for us. You don't sleep at night worrying about this," he says. Power estimates that his firm has spent 500 hours defending the Tech Molded claim alone.

Ron Antal, a veteran CPA, has launched a software business designed to help companies keep track of research on an ongoing basis, betting that entrepreneurs won't be scared away from the tax credit for too long. Says Antal: "A lot of companies could use this money right now."

Return to the BWSmallBiz October/November 2009 Table of Contents

    Before it's here, it's on the Bloomberg Terminal.