IBA, as the premier business brokerage firm in the Pacific Northwest, is firmly established as a respected professional service firm in the legal, accounting, banking, mergers & acquisitions, real estate, and financial planning communities.  Periodically, we will post guest blogs from professionals with knowledge to share for the good of owners of privately held companies & family owned businesses. The following blog has been provided by Reed Showalter of the Alliant Group (www.alliantgroup.com):

The R&D Tax Credit: Driving Innovation, Job Creation and American Enterprise

After years of firsthand experience serving clients and working with CPA and industry partnerships, I can state without a doubt that the Research and Development (R&D) Tax Credit is the single most important tax incentive for U.S. businesses. This has been true since the credit’s inception—and considering its evolution over the last three decades and the growing influence of technology, the R&D Tax Credit has and will continue to be of vital importance in ensuring a thriving and competitive economy.

As my colleague (and alliantgroup’s CEO Dhaval Jadav) often says, the history of the R&D Tax Credit has been one of supporting American enterprise—and understanding its intent as well as its gradual evolution over time highlights the importance of the credit in driving innovation, job creation and American competitiveness.

Founding and Early History

In response to the economic recession of the early 1980s and widespread concern about U.S. economic performance, Congress passed The Economic Recovery and Tax Act of 1981. Included within this legislation was a tax provision that would eventually come to be known as the R&D Tax Credit.

The intent of the credit was tied to a growing consensus that declines in research spending had negatively impacted economic growth and competitiveness. Congress reasoned that reductions in research spending had led to less innovation—which in turn led to inferior products, adverse effects on productivity, the outsourcing of American jobs and declining economic growth.

The struggles of the American economy were perhaps most evident in the automotive industry. According to statistics from the OICA, in 1950 the U.S. was producing three quarters of all the world’s automobiles. By the early 1980s, the U.S. had been overtaken by Japan as the largest automobile producer in the world. Given the industry’s historical significance in creating domestic jobs and in empowering the nation’s economy, the R&D Tax Credit was seen as the perfect stimulant to encourage American automakers to reinvest in their products and regain their competitive edge. Congress deemed the struggles of the automotive industry as symbolic of the larger economy—and thus a credit that rewards companies for technical innovation was born.

After a major overhaul as part of the Tax Reform Act of 1986, the parameters of the credit would be further defined over the next decade and a half by new Treasury regulations and court rulings.

However, the most impactful change would occur two decades after the credit’s creation.

2001-2003: Redefining R&D

Initially proposed in 2001 and later finalized in 2003, new regulations that eliminated the “Discovery Rule” would mark a major shift and expand eligibility of the R&D Tax Credit to countless businesses.

In layman’s terms, the Discovery Rule required that research activities must be “new to the world” to qualify, creating an absurdly high bar for businesses to receive the credit’s tax-saving benefits. With the rule gone, activities now only had to be “new to the taxpayer”, a standard that is much more favorable to U.S. businesses and business owners.

In my time as a consultant in this space, I have found that companies will often incrementally improve their products or processes rather than achieving an immediate industry-wide breakthrough. However, those gradual steps taken to improve efficiencies—be it the iterative technical steps to enhance an existing manufacturing process or updating software to better serve clients or improve operations—are just as valuable as the big technological breakthroughs in increasing productivity and in ensuring U.S. businesses remain competitive.

The elimination of the Discovery Rule is what in fact sparked the founding of alliantgroup back in 2002, with alliantgroup CEO Dhaval Jadav and COO Shane Frank realizing that a whole new market of businesses had become eligible for the credit—and that someone needed to inform these companies (particularly small and mid-size companies) of its far-reaching impact and financial benefits.

Further Expansions: The PATH Act and Tax Reform Changes

In 2015, the Protecting Americans from Tax Hikes (PATH) Act was signed into law. Among a host of other provisions, the new law finally made the R&D Tax Credit permanent and featured two major modifications designed to further expand access to the credit to small and mid-size businesses and open up its availability to startups.

The policy reasons for these modifications dealt with two larger issues—innovation and dynamism.

Much like when the credit was first-passed, there has been a growing awareness that further innovation is needed within the private sector. There have been multiple studies (such as this one conducted by The Brookings Institution) that note how business dynamism (i.e. the churning of established businesses and the formation of new ones) is on the decline, with older and larger companies doing better relative to younger and smaller ones. The result has been a drag on productivity and sustained economic growth, with the economy lacking the competitive forces that push businesses to put labor and capital to the best use. Such concerns explain why expanding access to the R&D Tax Credit became such a high policy priority, along with finally making the credit permanent.

In addition to the PATH Act, the Tax Cuts and Jobs Act of 2017 also further expanded access to the credit, with the laws broader loosening of AMT restrictions having the ultimate effect of making the credit more accessible to small and mid-size businesses.

Taking into account its evolution over the years, it is clear that our policymakers have made the R&D Tax Credit a key part in promoting innovation within our economy—and U.S. businesses looking for additional value to hire new workers would be wise to investigate the credit.

Reed Showalter is the Managing Director of the Alliant Group. If you have questions about the content of this article, the Research & Development Tax Credit, or any area relevant to Mr. Showalter’s expertise please contact him at (916) 949-6904 or reed.showalter@alliantgroup.com.

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