Take Advantage of R&D Credits for Government Contractors

ERIC POPPE: Hello, welcome to Cherry Bekaert's GovCon Podcast, where we discuss current government contracting trends, compliance matters, and best practices to guide federal contractors forward.

ERIC POPPE: My name is Eric Poppe. I'm a managing director here at Cherry Bekaert. I help co-lead the GovCon industry.

ERIC POPPE: With me today are Vivian Kohrs and Bryan Weems from our Tax Credits and Incentives Advisory team. Vivian is a director, and Bryan is a senior manager.

ERIC POPPE: First, thank you both for joining today.


VIVIAN KOHRS: Thank you for having us.


BRYAN WEEMS: Thank you.


ERIC POPPE: I appreciate it.

ERIC POPPE: Today we are going to talk about R&D tax credits and Section 174, and dive into why government contractors should care about this, what it means, and how it might be different for a government contractor versus another commercial organization.

ERIC POPPE: This should be a good discussion, and I'm excited to talk about it because this topic comes up a lot in conversations with clients and prospects.

ERIC POPPE: If you guys are ready, we can jump in.


VIVIAN KOHRS: Yes. I feel like it's important when we think about government contractors and all the wonderful things they do that there are two sides to the coin.

VIVIAN KOHRS: There's the R&D tax credit, which is the happy side because you get to save on taxes. But more recently, there has been Section 174, which covers research and experimentation costs that are required to be capitalized for tax purposes.

VIVIAN KOHRS: Again, we're just talking about tax purposes as opposed to books, so that's important to note. Section 174 has been a recent bad topic that's been brought up. We're going to cover both today.

VIVIAN KOHRS: We'll start on the happy side, Eric.

VIVIAN KOHRS: What is the R&D tax credit? A lot of people have heard about R&D tax credits in passing, but maybe they don't know much about it in detail.

VIVIAN KOHRS: The R&D tax credit was a way for the government to incentivize research and development in the U.S. The real name of the R&D tax credit is the Credit for Increasing Research.

VIVIAN KOHRS: If we're looking at your 2023 tax year, you actually have to establish a base. So you may have to go back three prior years to establish what your research and development spend was in those prior years.

VIVIAN KOHRS: Some rules of thumb would be: to the extent you're hiring smart people to do complicated things in the U.S., and they're doing that work in the U.S., the wages for the portion of time they spent on research and development would be qualifying research expenses.

VIVIAN KOHRS: A second tranche would be any third-party vendors or subcontractors you're working with who are assisting or supporting you in development. That would also potentially be qualifying research expense.

VIVIAN KOHRS: The last two types of costs would be around supplies or prototypes that you're building, or supplies consumed in your development process. That would be the third tranche.

VIVIAN KOHRS: The last tranche would be any cloud hosting costs. Azure, Google Cloud, and AWS, to the extent you're standing up dev environments, would be the last part of the cost.

VIVIAN KOHRS: Bryan, what types of activities do you think people need to be doing?


BRYAN WEEMS: That's a great question, Vivian.

BRYAN WEEMS: A common question that hits our desk is, "Does my industry even qualify for this credit?" To Vivian's point earlier, it's really an activities-based incentive.

BRYAN WEEMS: To the extent the team is working on something new or improved for the company, it's technically challenging, and there's an iterative development process to resolve that, that's really the crux of what the R&D credit is all about.

BRYAN WEEMS: If we're looking at government contractors and typical activities we're able to pick up for the credit, that could be anything from software development activities for different government systems, defense contracting, critical infrastructure for government, manufacturing process improvements, and tangible products.

BRYAN WEEMS: Granted, that's all for external customers.

BRYAN WEEMS: Another critical point is internal research and development. Before a contract is awarded to a particular taxpayer, any internal development for creating a new process, developing a new product, or developing a new system could all be fair game.

BRYAN WEEMS: Eric, do you have any insights on IR&D and maybe bridging the gap between book and tax and how we look at that from a definition standpoint?


ERIC POPPE: You're teeing me up.

ERIC POPPE: I was actually just about to jump in on that. It's very similar when talking with you all about the FAR Part 31 cost principles and the definition of internal research and development.

ERIC POPPE: It's not tied to a contract, funding source, or sponsor in any way. It is basic research, applied research, development, or another type of concept formulation.

ERIC POPPE: From a cost accounting standard standpoint, if it's pre-contract and internally funded, it sounds like it really is two birds with one stone from an inclusion and treatment standpoint: hitting the FAR Part 31 definition from a cost accounting standpoint and also potentially from a tax credit standpoint.

ERIC POPPE: What's interesting here, Bryan, is when you're going through critical infrastructure, defense contracting, software development, and so on, it's hitting the whole gamut of government contractors.

ERIC POPPE: It could apply from software, cyber, and technology companies, to more professional services, all the way to medical, healthcare, and large-scale manufacturers. It could really hit anyone.


VIVIAN KOHRS: Exactly. There's also something that you just reminded me of.

VIVIAN KOHRS: In certain instances where you have bid and proposal time, some of that bid and proposal time may actually qualify for the credit too, if there's technical solutioning that you're doing before your contract is awarded.

VIVIAN KOHRS: That's also something you want to make sure you're not missing and that you're evaluating when you're doing an R&D tax credit.


ERIC POPPE: Really good to know.


VIVIAN KOHRS: When we talk about contracts, we kind of covered internally funded research and development. I'm sure the majority of our government contractors' work is contracted research and development.

VIVIAN KOHRS: When it comes to R&D tax credits, rights and risks are exceptionally important.

VIVIAN KOHRS: I think it's important to get your tax team involved early on because the way you structure your contracts impacts your R&D tax credit and your Section 174 capitalization.

VIVIAN KOHRS: On the R&D tax credit side, there's a concept called rights and risks. Your taxpayer needs to retain development rights and also financial risks when it comes to the research and development.

VIVIAN KOHRS: What that means is you need to show that the taxpayer bears financial risk for the development. Maybe it's a firm fixed price type contract as opposed to a time and materials or cost-plus contract.

VIVIAN KOHRS: The same kind of concept applies with subcontractors too. Subcontractors could potentially qualify for the credit, depending on how you structure your contracts with subcontractors.

VIVIAN KOHRS: In that instance, who retains the development rights and who bears the financial risks? It's all within the four walls of that contract. The way you structure it would impact your ability to claim the credit.


ERIC POPPE: That's good to know.

ERIC POPPE: Anything from a state standpoint to consider? I know each state is unique and different. Some states have an R&D credit, and some do not. Bryan, Vivian, any thoughts there?


BRYAN WEEMS: Eric, I think you hit the nail right on the head in terms of each state being unique in its own way.

BRYAN WEEMS: Over half of the states have their own R&D incentives. Some piggyback off the federal mechanic and are very similar. Others have different nuances.

BRYAN WEEMS: Based on our clients' locations and where we're seeing a lot of activity, the Virginia credit comes to mind. It mirrors some elements of the federal credit, but there are nuances.

BRYAN WEEMS: There's an application deadline of September 1, so it's timely to talk about that. Each year there can be changes. Big wheels turn slowly in the world of tax, but every once in a while we get an update.

BRYAN WEEMS: For Virginia, for instance, we had changes to the pool of allocated R&D credits that companies could claim. For the basic R&D credit, we saw an increase in the available pool, doubling the previous amount. Now we're approaching $16 million.

BRYAN WEEMS: For the major R&D credit that's available, that was actually reduced by a third.

BRYAN WEEMS: There are changes and variability between states, so it's important to check in, see what legislative updates are hitting each individual state, and understand the unique mechanics for each one.

BRYAN WEEMS: That said, that's just one state of many. There are other states like Georgia and Texas. Vivian, any others to highlight?


VIVIAN KOHRS: The mechanics of calculating the credit are different, but sometimes the mechanics of claiming the credit can also be different.

VIVIAN KOHRS: Georgia is unique in that if you don't have income tax in Georgia, you can also monetize your credit through an offset of your Georgia payroll tax withholdings.

VIVIAN KOHRS: That's also something unique in the federal credit. To jump back to federal so we can mirror that, you have what is called a qualified small business.

VIVIAN KOHRS: Basically, you need to have less than $5 million in gross receipts, and you can't have gross receipts within the five years of your company starting. It's kind of like a startup rule.

VIVIAN KOHRS: You actually get to offset your federal payroll taxes with your R&D credit if you're not profitable yet. That's something to keep in mind.

VIVIAN KOHRS: Texas involves evaluating between the use of a sales and use tax offset or franchise tax credit. Maryland is application-based, with an application deadline of November 1.

VIVIAN KOHRS: Florida is fun. That application is so early that it makes it logistically complicated because your books haven't closed yet. You have to figure out all of your credit, and a lot of that sometimes involves estimates.

VIVIAN KOHRS: For the 2024 tax period, the application for Florida will open March 20, 2025, and it'll probably close within a week. So it's a short timeframe to complete a study. Keep that in mind while you're evaluating.

VIVIAN KOHRS: Bryan, do you want to be the bad-news bearer on Section 174?


BRYAN WEEMS: Exactly. It's kind of funny. We've been doing this for years and years, and we've always been the good guys. Now with mandatory capitalization, there's a bad-guy role we have to play.

BRYAN WEEMS: For years starting after December 31, 2021, companies that incur research and experimental costs can't deduct those timely. They need to be capitalized over a five-year period if incurred domestically.

BRYAN WEEMS: There's a geographic lens we have to apply. If they're offshore, whether you have employees or contractors engaged overseas, that's amortized over a 15-year period.

BRYAN WEEMS: This was one of the budget-balancing items from the Tax Cuts and Jobs Act that kicked in, along with the limitation of SALT deductions on the personal side and a few others.

BRYAN WEEMS: This really was a major impact to quite a few companies that, even though it was on the radar, rolled the dice hoping it would be delayed, repealed, or otherwise changed.

BRYAN WEEMS: What we have to look at is all costs incident to development. We're not only expanding the pool of activities that are included for the R&D credit that have to be capitalized, but also the cost pool.

BRYAN WEEMS: It's the fully burdened cost of employment for your development resources. If you have a software engineer physically coming into the office, you actually have to allocate a portion of rent to that individual, a portion of utilities for that individual, and fully burdened labor costs rather than W-2 box one equivalents.

BRYAN WEEMS: There are quite a few nuances to this. Big picture, it's all costs incident to development, and it is a mandatory capitalization period of either five or 15 years.

BRYAN WEEMS: With that, we got some late notice on this one. Vivian, do you mind walking through that notice that we got back in September?


VIVIAN KOHRS: Yes. For government contractors, this had a huge impact, and people were waiting for clarification on it. The government didn't issue the clarification until September, maybe a week before the September 15 deadline. That was a lot of fun for tax preparers.

VIVIAN KOHRS: Big picture, instead of being able to deduct your research spend as COGS, that's now something you have to capitalize and amortize for tax purposes. That's having a huge cash flow impact on government contractors.

VIVIAN KOHRS: The notice essentially addresses research being performed under contract. Instead of rights and risks, as in the case of the R&D tax credit, it's rights or risks, which opens up your pool.

VIVIAN KOHRS: If you're doing R&D under time and materials, and if you retain the rights to the R&D you're performing, you actually have to capitalize and amortize those costs, and you don't get the R&D tax credit benefit.

VIVIAN KOHRS: Again, that's why it's important to get your tax team involved in contract negotiations. If it's not a right you can benefit from, then it might make sense to reevaluate contractual language within the four walls of the contract to assign those rights away.

VIVIAN KOHRS: A lot of times, the government is like, "I don't care if we have shared rights." But if it doesn't make sense for you to retain the rights for Section 174 purposes, and you already don't have the risk because you're getting paid time and materials or cost plus, it's something to evaluate and think through. Bring your tax team in early.


ERIC POPPE: That's really interesting because a lot of government contractors, when they're writing technical narratives and proposals, sometimes use boilerplate. They copy and paste from the last similar proposal and roll it forward.

ERIC POPPE: Having that nuance, that little bit of difference in language, can really go a long way and probably impact you positively or negatively from a tax perspective.

ERIC POPPE: I thought that was very interesting, Vivian, how you brought that up: really paying attention to the proposal language and the statement of work language.

ERIC POPPE: We are getting close to time for this podcast, but I do want to see if you have any other recommendations for government contractors when it comes to R&D or Section 174.

ERIC POPPE: To close us out, any thoughts there?


VIVIAN KOHRS: Absolutely. When it comes to setting up project accounting, and I know, Eric, this is your favorite topic, you've got to love timekeeping.

VIVIAN KOHRS: As practitioners, we love time tracking. Time tracking is the contemporaneous way to establish nexus between your activities and who's getting paid.

VIVIAN KOHRS: Getting the task level set up right and getting the project set up right can better capture data needed for R&D tax credit calculations and Section 174 capitalization calculations.

VIVIAN KOHRS: That minimizes touchpoints with your development team as a result of setting things up early and correctly.

VIVIAN KOHRS: Again, talk to us now. Talk to Eric now. We can all help make sure you are thinking about things from the big picture, not just from the book perspective.


ERIC POPPE: That's a really good point.

ERIC POPPE: Typically, timekeeping and detailed timekeeping are probably one of the biggest cultural hurdles a lot of organizations have to go through, especially if you're just getting into government contracting.

ERIC POPPE: With that, Vivian and Bryan, thank you for joining us on Cherry Bekaert's GovCon Podcast. I appreciate you both joining and sharing your expertise.

ERIC POPPE: Thank you, everyone, for tuning in and listening. We appreciate the time. Make sure to follow our podcast wherever you get your podcasts.