Arizona’s Research and Development Tax Credit

Small Businesses Must Act Immediately to benefit from Arizona’s Game-Changing R&D Tax Credit Rules

Conventional wisdom has been that research and development (R&D) tax credits were only for the “big” guys; because historically, tax credits could only be used to offset tax liability which is often not present in start-up and early stage companies.

However, Arizona State Senate Bill 1254 has changed the existing R&D tax credit program significantly for small businesses. Under this change — where a tax credit is not currently useful – a small business may elect to receive a cash grant in lieu of tax credits.

The cash grant is calculated at 75% of the earned tax credit. By allowing for the discounted refund as opposed to a credit against tax liability, this new legislation puts cash in the pockets of entrepreneurs who are commonly cash-strapped as they transition from research to prototyping and limited production. In return, the qualifying company forfeits the remaining 25% credit and must pay a modest 1% of the refund processing fee. These grants will not be treated as income.

Here are common questions about these game-changing R&D tax credit rules:

How is “small” defined?

Arizona defines “small” as any organization with 150 or fewer full-time equivalent (FTE) employees as of December 31 of the year the R&D credits are generated.

What work qualifies for the Arizona R&D tax credit?

Arizona’s R&D tax credit applies to “basic research” and “qualified research” conducted in Arizona that have an uncertain outcome. This includes work funded by the organization but actually conducted at one or more of Arizona’s three state universities. Expenditures related to activities organizations perform every day to stay competitive can qualify; including investments in time, capital and resources toward developing new products or improving existing products, developing new materials, building and testing prototypes and models, developing new or improved software applications, testing new concepts, developing or improving manufacturing processes, experimentation and more. The terms “qualified research” and “basic research” are defined in IRC § 41. You do not have to be incorporated in Arizona; however, the work must be conducted within Arizona and an Arizona tax return must be filed.

Aren’t these credits only for high-tech research-focused companies?

No. It’s a common misperception that R&D tax credits are reserved only for companies doing glamorous cutting-edge research in high-tech or bio-tech. In fact, these credits can benefit many kinds of businesses like food processors, construction contractors, engineering firms and wholesale distributors to name a few. Improvements to existing product lines can qualify for R&D credits as long as they are more than cosmetic enhancements.

How do I calculate my Arizona R&D tax credit?

Arizona R&D tax credit calculations are consistent with the federal IRS code except that it provides for a 22% credit which is scheduled to increase in future years. The tax code dealing with R&D tax credits is complex and intricate requiring considerable expertise. The IRS designates the R&D credit area as a Tier 1 audit issue and requires comprehensive documentation that stands up to the IRS’s most rigorous auditing methodologies.

What types of entities qualify for the Arizona R&D tax incentive?

This incentive is available to Corporations and individuals. Credits awarded to pass-through entities such as S Corporations and LLCs may be passed on to their shareholders and members, respectively.

What is the application process?

The forms to apply for a Certificate of Qualification will be available in December 2010 at www.azcommerce.com/BusAsst/Incentives/RD+Income+Tax+Credit.htm. Beginning on January 1, 2011, applicants can submit the completed application along with a 1% processing fee. The Arizona Department of Commerce will make a determination within 30 days of receipt of the completed application.

Why is it critical that I submit an application as early as possible?

Arizona has allocated only $5 million in total for this purpose. These funds will be awarded on a first-come, first serve basis. There is no cap on the amount awarded to an individual applicant. The amount awarded will be refunded with the filing of the 2010 Arizona tax return. Note: January 1, 2011, is the first day to apply for the Certificate of Qualification.

BeachFleischman can assist you.

In recent years BeachFleischman has helped over 80 clients claim millions of dollars in R&D and related credits. BeachFleischman understands the process for identifying qualifying initiatives as well as allocating and documenting eligible expenses. BeachFleischman also continues to monitor the issuance of new guidelines by the IRS and Arizona Department of Revenue.

For assistance completing this time-critical application, please contact immediately BeachFleischman’s Peter Beahan, Jon Bickerton, or David Cohen at (520) 321-4600.