How Should Manufacturers Fund Innovation? An Examination of R&D Tax Credits vs. Government Contracts

Imagine this: Company X is a plastics manufacturer attempting to develop new products that can be used in medicine. The company has grown in recent years, generating approximately $40 million in revenue last year, and has invested heavily in developing biodegradable plastics that can be used for the treatment of bone and bodily injuries and in various other medical procedures, as well as accelerating its 3D printing capabilities to achieve greater scale.

Company X believes it is on the brink of developing a breakthrough biodegradable formula that could be widely adapted in the medical field and is weighing options to fund its ongoing research and development (R&D) activities. Specifically, Company X’s management team is evaluating whether pursuing R&D tax credits or a government contract would be most beneficial to its efforts.

To better understand the pros and cons of each option, Company X should ask itself the following seven key questions to determine which option best suits its operations and strides toward innovation:

1. What are the benefits and uses of R&D tax credits?

Enacted in December 2015, the Protecting Americans from Tax Hikes (PATH) Act permanently extended the federal R&D tax credit, better enabling companies to factor these credits into their long-term tax planning. R&D tax credits can result in cash savings of up to 20 percent of qualified spending —potentially more if the qualified activity occurs in certain states.

R&D credits can be used to offset regular income tax liability and, for some smaller businesses and startups, the alternative minimum tax (AMT) and a portion of their payroll taxes. If a company isn’t paying taxes, the credits can be carried back one year and forward for 20 years. These credits can reduce a company’s effective tax rate, increase its cash flow, improve its earnings per share and provide additional funds for investment in new business opportunities or additional employees.

2. What are the benefits of government contracts?

Cost-reimbursable contracts with the government can minimize financial risk by providing reimbursement for actual costs incurred, plus a profit or fee on top of the costs incurred by the organization. The government will also reimburse a proportionate share of indirect costs, including overhead, general factory expenses and administrative costs. Because these costs generally aren’t recovered, having the government pay a share of indirect costs can especially benefit manufacturers.

Further advantages for manufacturers that hold government contracts include developing new customer relationships, expanding and diversifying their client portfolio, unlocking new business opportunities and the potential to receive multi-year, high-dollar contract awards from the government, bringing in additional predictable cash flow.

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This article originally appeared in BDO USA, LLP’s Manufacturing Output Newsletter – August 2016. Copyright © 2016 BDO USA, LLP. All rights reserved.


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