By: Wendy Landrum, CPA, Partner and R&D Advisory Leader; Mark Heroux, JD, Principal, Tax Advocacy and Controversy Services Leader; and Brian Haneline, CPA, Senior Manager, R&D Advisory
Craft brew popularity is at an all-time high in the United States, with explosive industry growth in the past five years. According to the Brewers Association, craft brewers now make up 98 percent of all U.S. breweries. As new craft brewers continue to enter the industry and existing brewers look to keep up with recent trends, significant financial investments must be made before the first brew can reach the consumer. Whether these costs are related to the formulation of the brew, or how to produce or package the brew, costs can be substantial.
Fortunately, federal and state governments offer an often overlooked but valuable benefit to help offset these costs in the form of R&D tax credits for craft brewers engaging in “qualifying activities.”
R&D credits result in a dollar-for-dollar reduction in income taxes and, if applicable, payroll taxes, providing cash flow for future investments. The R&D credit applies not only to new product development, but also to improvements to existing products and manufacturing processes. Importantly, the activities need only be evolutionary to the organization, not to the industry as a whole, to qualify for the credit.
Because the R&D credit is nonrefundable, startup companies and other small businesses like craft breweries are often limited in their ability to claim the R&D credit in the current tax year because they do not have current income tax liability to utilize the credit. Despite the credit having a 20 year carry forward if not used currently, the company receives no immediate tax advantage from the R&D credit, especially for years in which R&D activities and investments may be high.
Payroll Tax Offset
However, the Protecting Americans from Tax Hikes (PATH) Act of 2015 allows certain small businesses to offset the R&D credit against payroll taxes instead of income taxes. PATH allows for up to $250,000 of annual federal R&D credits that can be allocated against payroll tax liability. This applies to tax years that begin after Dec. 31, 2015.
To qualify for the payroll tax offset in 2019, a business must have gross receipts of less than $5 million in 2019 and may not have had gross receipts for any tax year before the five-tax-year period ending with 2019. For example, if the credit-claiming year is 2019, a company must have had less than $5 million of gross receipts in 2019 and no gross receipts prior to 2015.
The R&D credit may be applied against the FICA portion of payroll taxes beginning in the first calendar quarter following the date on which the business files the income tax return. If the payroll tax credit portion of the R&D credit exceeds the tax liability for any calendar quarter, the excess is carried to the next calendar quarter and allowed as credit for that quarter. The payroll tax election is limited to five taxable years.
Four-Part Test
Naturally, the question then becomes, what are “qualifying activities” to be able to claim the credit and what costs can be captured? Generally, activities must meet the following four criteria (referred to as the “four-part test”) to include the related wages, supplies, or contract research costs in the R&D calculation:
1. The activity must be technological in nature. The activity must be based on the principles of a hard science such as chemistry or engineering.
2. The activity must be for a permitted purpose. The activity must involve the creation of a new or improved level of: function, performance, reliability, quality, durability or cost reduction for a product or manufacturing process
3. The activity must involve the elimination of uncertainty. The activity must explore what was not known at the start of the project.
• Capability: Can we develop the new or improved product or process?
• Methodology: How will we develop the new or improved product or process?
• Design: What is the appropriate design of the new or improved product or process?
4. The activity must involve a process of experimentation. Substantially all activities must include elements of experimentation such as:
• Evaluating one or more alternatives
• Performing testing or modeling
• Examining and analyzing hypotheses
• Refining or abandoning hypotheses
A wide range of technical activities related to product or process development or improvement in the craft brew industry may qualify for the R&D credit. Consider the examples below:
• Developing new or improved recipes and styles.
• Brewing experimental or pilot batches of new or improved recipes and styles.
• Performing lab testing, or other functional testing, on new or improved products or processes.
• Developing new or improved ingredient mixing methods.
• Developing new or improved yeast strains or fermentation processes.
• Developing new or improved manufacturing processes.
• Researching new or improved production techniques.
• Automating existing manufacturing processes.
• Developing new or improved processes or methods to prevent spoilage.
• Developing new or improved bottling or packaging processes.
• Developing new or improved methods to minimize or treat wastewater.
For reference, examples of activities that may not
qualify include:
• General administrative and managerial functions.
• Sales, marketing and business development activities.
• Routing data collection (e.g., management studies, efficiency surveys).
• Day-to-day production activities.
• Routine quality control and inspection.
• Maintenance and installation services.
• Training (even if related to new equipment or technology).
• Research conducted outside the U.S.
Qualifying Costs
As mentioned above, the following costs are included in the R&D calculation:
1. Wages paid or incurred to employees who are directly engaged in qualified research activities, or who directly supervise or support qualified research activities. Qualified wages are computed by multiplying the percentage of an individual’s annual time attributable to qualified research activities against W-2, box 1 wages.
2. Supplies include any tangible property, other than land and depreciable property, which is used or consumed during the development process.
3. Payments to third parties to perform research and development activities on your behalf. The services must be performed within the U.S. and you must have financial risk (with T&M or hourly contract terms paying for the services versus final product).
There are two calculation methodologies to consider, alternative simplified credit and regular credit, both with alternatives for start-up companies.
Documentation Requirements
Federal and state regulators focus on whether a taxpayer can document: 1) the process of experimentation, and 2) the development of a new or improved product or process (also referred to in a research credit discussion as “the business component”).
To maximize the credit taxpayers are well-advised to conduct a disciplined, documented research process. It is important to document every step of the research process, particularly the process of experimentation used to eliminate uncertainty and the identification of the business components, i.e., the new or improved product or process. Sales increases and customer surveys will help to identify improved products, but will not be conclusive. It’s the contemporaneous recording of the research activity that will carry the day in an IRS exam.
It’s also important that breweries identify the amount of time that professionals spend performing qualified research activities. Time tracking software that identifies the various activities that take place when creating a new or improved product or process is the best option to document time spent by professionals in the conduct of qualified research activities. Taxpayers that do not use time tracking software generally use estimates provided by the research professionals, through the use of time surveys, as to the percentage of time that they spend conducting creditable research activities.
Case Study
To see how the credit can benefit a craft brewer, the following case study is instructional. In this example, XYZ Brewery in Texas wants to design a new brew from scratch. Once research is conducted to determine the ideal end product (and this research should qualify for the R&D credit), here is the process employed by the brewer (pre-bottling) and who is involved:
General R&D process including potentially qualifying activities:
1) Mashing – malts are mixed with adjunct flavorings and liquor (pure water) and heated to allow enzymes to break down starch into sugars.
2) Lautering – consists of three steps: mash out, recirculation, and sparging.
3) Hops boiling – once the mash is sparged, the resultant wort is sent to a hops boiler where hops are added for flavor and boiled according to a recipe hops schedule.
4) Fermenting – the wort is sent to a fermentor where the sugars undergo fermentation, via the glycolysis which causes a chemical reaction.
Who might be involved in the process:
1) Head R&D Brewer
2) R&D Brewery Manager
3) Production Manager
4) Assistant R&D Brewer
5) Brewery Quality Control/Lab
The brewer in this case provides their tax advisor with a W-2 box 1 wage listing and supply expenses for the current and previous three years, and had no contractors that assisted with the development process. Your tax advisor conducts technical interviews with the employees below to help identify the qualifying activities and to allocate a percentage of time to each qualifying activity:
Assumptions:
• Head R&D Brewer’s time qualifies at 100%
• R&D Brewery Manager time qualifies at 100%
• Production Manager’s time qualifies at 50%
• Assistant R&D Brewer’s time qualifies at 100%
• Brewery Quality Control/Lab’s time qualifies at 100%
Qualified supply expenses by year:
• 2018: $60,000
• 2017: $50,000
• 2016: $50,000
• 2015: $40,000
Once the data is gathered, analyzed and quantified, your tax advisor calculates a federal and state R&D credit. In this case, the brewer will generate a federal credit of $10k and a Texas state credit of $6k.
As can be seen from the case study above, the R&D credit can be a valuable tool for craft brewers to help offset startup or other operational costs, either in the way of credits to offset tax liability or refundable payroll tax credits in certain cases.
While it may not be readily apparent that the R&D credits are in-play for the craft brew industry, many craft brewers have taken advantage of this opportunity. Craft brewers should take notice of the activities that they engage in and consider whether R&D credits might be an option.
For more information, contact the authors at Baker Tilly or 608-240-2334.
