Research and Development Tax Credits

1. Research and DevelopmentTax Credits Presented by: Luis Rivera Managing Director Encore Tax Consulting Group. Inc. A Tax Credit and Incentives Company 811 Wilshire Boulevard, Suite 1805 Los Angeles, California 90017 Phone: (213) 412-2000 lrivera@etaxgroup.com www.etaxgroup.com

2. What are Research & Development Credits and how does a company qualify for the credits? Assist a company in identifying Research & Development activities and expenses Inform you on the limitations, expenses and calculations that go into computing the Research & Development Credits Objectives

3. The IRS defines R&D expenditures as those “incident to the development or improvement of a product,” including the costs and attorney’s fees associated with obtaining a patent. The IRS definition of “product” includes formulas, inventions, patent, pilot models, processes and techniques. R&D Credits are both a Federal and California credit applied against taxes that an entity or its shareholder’s would have to pay. (Dollar for Dollar Benefit) The R&D Credit can generate refunds on an amended tax returns going back three years for federal and four years for California The regular federal credit is 20% of Qualified Research Expenses in Excess of a Base Amount Limitation (activities and expenses must be performed within U.S. possessions) The regular California credit is 15% of Qualified Research Expenses in Excess of a Base Amount Limitation (activities and expenses must be performed and incurred with in California) Introduction

4. R&D credit has been around since 1981. Due to the strict requirements on the high threshold of innovation only large corporations were able take advantage of the R&D Credit. In late 2000 the Bush Administration reviewed the utilization of the R&D credit and realized that most small to middle size companies were not taking advantage of the credit. So in late 2001 The Bush Administration change the regulations by removing the high threshold of innovation and allowing the innovation to be merely innovative to the individual company not to the industry. 2008 Legislative Victory: Credit seamlessly renewed and strengthened by Public Law 110-343 signed on October 3, 2008, by President Bush.  The 110th Congress passed H.R. 1424, The Emergency Economic Stabilization Act of 2008, which included a retroactive two year extension of the R&D tax credit from January 1, 2008, through December 31, 2009.  Also included is language to strengthen the credit by increasing the Alternative Simplified Credit rate to14% for 2009. Introduction (cont’d)

5. The 2010-11 budget legislation provided an offsetting improvement for businesses by allowing, effective January 2011, the R&D tax credit to be shared among a related group of affiliate or subsidiary companies, unitary utilization. The improvement will help companies that need the flexibility to allocate earned tax credits within their family of companies, but not all companies will benefit due to different circumstances and structures. California conforms to the qualification of the research and development credits under federal law. Other states allow research credits, however, state law must be reviewed to determine conformity to federal law and specific non-conformity issues. In terms of R&D performance, California ranks first among all 50 states. California alone accounts for more than one-fifth of total U.S. R&D. California industry ranked first in R&D expenditures, accounting for $47.1 million in 2003. California universities rank No. 5 in U.S. R&D among universities. More than half the R&D performed in the United States by computer and electronics product manufacturers is located in California, Massachusetts and Texas. Introduction (cont’d)

6. Introduction (cont’d) • General business credits of eligible small businesses for 2010 allowed to be carried back five years. Generally, a business's unused general business credits can be carried back to offset taxes paid in the previous year, and the remaining amount can be carried forward for 20 years to offset future tax liabilities. Under the new law, for the first tax year of the taxpayer beginning in 2010, eligible small businesses can carry back unused general business credits for five years. Eligible small businesses consist of sole proprietorships, partnerships and non-publicly traded corporations with $50 million or less in average annual gross receipts for the prior three years. • General business credits of eligible small businesses in 2010 aren’t subject to AMT. Under the AMT, taxpayers can generally only claim allowable general business credits against their regular tax liability, and only to the extent that their regular tax liability exceeds their AMT liability. A few credits, such as the credit for small business employee health insurance expenses, can be used to offset AMT liability. The new law allows eligible small businesses, as defined above, to use all types of general business credits to offset their AMT in tax years beginning in 2010.

7. The Alternative Simplified Method of calculating the credit is now available for fiscal year end filers and calendar year end filers. Once elected, the alternative simplified credit applies to the current tax year and all later tax years, unless the election is revoked. The revocation for the alternative simplified credit must be made on an original return filed by the due date (including extensions). To calculate the credit, you take the total qualified research expenses in the prior three tax years, divide it by 6 and multiply by 14%. If there are no qualified research expenses in any one of the years, then you take the total qualified research expenses in the prior three tax years and multiply by 6%. Alternative Simplified Method

8. The IRS defines the R&D credit as: The design or development of any new or improved business component which can be a product or process In this manner the R&D tax credit program encourages companies to improve their products, processes and technology locally in the United States R&D: Definition

9. Expenditures must first be deductible as research expenses under IRC 174 Expenditures must be paid or incurred in carrying on a trade or business Research must use a Process of Experimentation designed to achieve results where capability, method or design of the result is uncertain at the outset of the research This may involve developing one or more hypothesis, testing and analyzing the hypothesis, and refining or discarding the hypothesis as part of a design process Thus the taxpayer must engage in a process of evaluating and testing different alternatives designed to eliminate the uncertainty about the development of a Business Component IRC 41 Requirements

10. Expenses must be Technological in Nature(using computer, engineering, chemistry or physical and biological sciences) and must be incurred in carrying on a trade or business Further, the taxpayer may employ existing technologies and may rely on existing principles to satisfy this requirement The regulations do not require that a taxpayer succeed in obtaining information that exceeds, refines, or expands common knowledge. The research credit also does not require that the advances sought be more than evolutionary Research must be undertaken to develop a new or improved Business Component (Product, process, software, technique, formula and invention) IRC 41 Requirements (cont’d)

11. The R&D credit is both a Federal and State tax credit applied against a Company’s or its shareholders’ income tax liabilities In order to qualify for the credit a company must have qualifying activities in at least one of the following areas: Developing new products - expenses related to the creation of new products that previously did not exist. Includes any pilot model, process, formula, invention, technique, patent or similar property. The definition also includes products to be used by the taxpayer in its trade or business as well as products to be held for sale Improving existing products - expenses related to the significant redesign of products, i.e. functionality. This does not include product redesign and changes related to appearance, individual market or customer tastes if these changes do not change the functionality of the product Developing software - expenses related to developing computer software that is developed as part of the manufacturing process (machines) or for third party use would qualify for the R&D credit Qualified Activities

12. Improving the manufacturing processes - expenses related to improving the way that products are made. This includes efforts to reduce production costs by using different materials, increasing automation or making changes to use less energy. This also includes creating or designing production equipment, tools and dies Engineering Activities Testing - A company must go through a process of removing the uncertainty aspect during the design phase with regards to method, process or capability in developing a product or improving a manufacturing process Qualified Activities (cont’d)

13. R&D Activities that do not Qualify for the Credit under IRC 41: Activities not directed at functional aspects of a product (typically, this includes expenses relating to style, taste, cosmetics, etc.) The adaptation of existing business component to a particular requirement or customer need where no uncertainty element exists (Custom product development does qualify, i.e. job shop, etc.) Duplication of an existing business component (reverse engineering) Routine data collections Funded Research (i.e. by grant, contract or other) Research performed outside of the United States Non-Qualified R&D Activities

14. The R&D Credit can be utilized on both timely filed and amended tax returns to generate refunds on taxes paid for up to three years after Federal filings and up to four years following California State filings The R&D credit is a dollar for dollar credit, and each credit dollar will work to directly offset tax liability For example, if a company owes $150,000 between Federal and California taxes and the company generated $100,000 in R&D tax credits, the R&D credits generated would offset the taxes owed (considering AMT limitation for years prior to 2010), and a tax savings of $100,000 would be refunded to the company Applying the R&D Credit

15. Although many companies qualify for the R&D program, it is estimated that less than ten percent of those that qualify actually claim the credit.

16. Research expenses must be paid or incurred (accounting method of taxpayer) in connection with a taxpayers trade or business and must represent costs incurred in the experimental or laboratory sense Research must be performed for the purpose of discovering information that is intended to eliminate uncertainty concerning the development or improvement of a business component IRC 174 RequirementsDeductibility of Expenses

17. Calculating the CreditQualified Expenses Upon the proper identification of qualified R&D activities, one would be required to identify the qualified research expenses associated with those qualified research activities. Qualified research expenses include: Wages paid to employees involved in the qualifying activities - excluding any fringe benefits, of employees directly engaged in the research, or that provide direct supervision or support of the research. This amount can be found on line 1 of the form W-2. Independent contractors - incurred during the research process. Only 65% of these costs are eligible for the credit. These costs include outside consultants, Patents, software programmers and engineers, Tool & Die Shops, External Test Labs, etc. Materials Consumed in manufacturing - excluding land and depreciable property. These supplies must be consumed in the performance of the research activities. This includes expenses related to prototypes, models, sketches & internal testing.

18. Calculating the CreditNon-Qualified Expenses Expense related to: Ordinary testing or inspection for quality control Efficiency surveys Management studies or activities Consumer surveys Advertising or promotions Acquisition of another’s patent, model, production or process Research in connection with literary, historical or similar projects (social sciences) Management function or techniques developed for internal use

19. The base amount limitation is computed by multiplying the fixed base percentage by the taxpayer’s average annual gross receipts (net of returns and allowances) for the four years prior to the year of the credit Base Amount Limitation cannot be less than 50% of qualified research expenses (best case scenario is 50% of qualified R&D expenses) Company generates $200K of qualified R&D expenses you apply 50% limitation and take $100K of qualified expenses multiplied by 20% federal and 15% California for a net credit benefit of 35K Attribution Rules apply (If 5 or fewer shareholders who own 50% of current company own 80% of a target company) revenues need to be aggregated in establishing fixed base limitation calculations Fixed base percentage is the total qualified research expenses for the years 1984 through 1988 divided by total gross receipts for those years If there were no research activities or gross receipt for three out of the five years from 1984-1988, then company is considered a start- up company under special rules. R&D Fixed Base Percentage Determination

20. Fixed base percentage for a start-up company is 3% A lower fixed base percentage may be available for companies that have had research activities and gross receipts for each of the years 1994-1998 Fixed base percentage cannot exceed 16% For California calculation purposes, gross receipts are defined as receipts generated from sales to customers in which the goods are shipped to customers in California only R&D Fixed Base Percentage Determination (cont’d)

21. A. "Traditional" Credit - The traditional credit equals 20 percent of the excess of qualified research expense ("QRE") for the current tax year over a base period amount. The base period amount is the product of the taxpayer's (1) fixed-base percentage, and (2) average annual gross receipts for the four tax years preceding the current year. The base period amount cannot be less than 50 percent of qualified research expense for the credit year. The fixed-base percentage is the ratio of qualified research expenses to gross receipts over the 1984-1988 period B. Alternative simplified credit - The proposed alternative simplified credit equals 12 percent of the excess of current-year QREs (as defined under section 41(b)) over 50 percent of the taxpayer's average QREs for the prior three years C. AIRC - The alternative incremental research credit ("AIRC") has three rates (2.65%, 3.20%, and 3.75%), which apply to the extent that QRE exceeds each of three base amounts (1.0%, 1.5%, and 2.0% of average annual gross receipts for the preceding four tax years). The proposed legislation would increase the credit rates to 3%, 4%, and 5% Calculating the R&D Credit

22. A. "Traditional" credit ($6.6) - Company A had total of $270 in QRE and $5,750 in gross receipts in 1984-1988 base period. Thus, taxpayer's fixed base percentage is 4.7%. Company A's average gross receipts over four prior years was $1,425. Company A's base amount is therefore $67 (4.7% of $1,425). Company A's QRE in 2003 is $100. Company A's creditable amount for 2003 is therefore $33 ($100 QRE less $67 base amount). Taxpayer's credit for 2002 is $6.6 (20% of $33) B. Alternative simplified credit ($6.48) - Company A's average QRE for three prior years was $92. Taxpayer's base amount thus is $46 (50% of $92). Therefore $54 of taxpayer's $100 of current-year QRE is eligible for 12-percent credit. Taxpayer's alternative simplified credit thus would be $6.48 (12% of $54), which is slightly less than under the traditional credit C. AIRC ($4.08) - Company A's average gross receipts over four prior years was $1,425. Company A's base amounts are therefore $14.25 (1% of average gross receipts), $21.375 (1.5% of average gross receipts), and $28.5 (2% of average gross receipts). QRE eligible for the 3% rate equals $7.125 ($21.375 minus $14.25), producing a credit of $0.21. QRE eligible for the 4% rate equals $7.125 ($28.5 minus $21.375), producing a credit of $0.29. QRE eligible for the 5% rate equals $71.5 ($100 minus $28.5), producing a credit of $3.58. Thus, the total credit under the AIRC is $4.08, which is substantially less than under the traditional credit and the alternative simplified credit Calculating the R&D Credit Examples

23. Taxpayer must meet one of the material participation tests of 469(h) Allocable share of a taxpayer’s qualified research expense are capitalized and amortized over 10 years as an add-back to AMTI Utilization of the R&D credits generated for Federal purpose only can reduced regular tax but is limited to tentative minimum tax for tax years prior to 2010 (If taxpayer is in AMT for Federal tax purpose then taxpayer can not utilize the R&D credit) Federal credits not utilized can be carried back one year and forward for 20 years and for tax years 2010 and 2011 can be carried back five years. California can be carried forward indefinitely (no AMT limitation) Section 41 R&D Tax Credits are part of the General Business Credit and subject to the same limitation on use. Thanks to the Small Business Jobs Act of 2010 General Business Credit can be applied against AMT and any unused carried back five years R&D Alternative Minimum Tax (AMT) Limitation

24. What type of industry are you in? What do you manufacture? Do you spend money on: Developing new products Improving existing products Improving manufacturing process * Every Manufacturer does this to stay competitive in their marketplace even if they don’t realize it! Have you applied for or obtained any patents? Do you employ Engineers or Chemists? How many years have you been in business? Probing Questions

25. Entity type (C-corp., S-corp., LLC or Partnership) Did the company have profits in any of the last four years? Do you employ programmers for software development? Do you have a budget allocated to product development and/or R&D? Do you require custom tooling or molds in your manufacturing process? Do you hire independent contractors such as Software Programmers Tool & Die Lab Testing Probing Questions

26. Qualified R&D activities can be found in a variety of industries: R&D Qualified Companies • Manufacturing • Electronics • Injection Molding • Aeronautics • Formulations • Food & Drug • Packaging Systems • Processing Systems • Filling Systems • Entertainment • Software • Design & Draw • Movie/ Television Production • Graphic Designer • Interactive Media

27. R&D Qualified Companies Qualified R&D activities can be found in a variety of industries: • Industrial • Bakers • Water Treatment • Biotechnology • Precious Metals • Pharmaceutical • Biological/Chemical Waste Treatment • Semi-conductor Industry

28. R&D Qualified Companies • Food Processing • Water Feature Design • Lighting • Aerospace • Water Filtration System Manufacturers • Environmental Equipment Manufacturers • Rockets • Vitamins • Cosmetics Manufacturing • Software Development

29. Over the last few years, there have been an increasing number of IRS and FTB audits scrutinizing the R&D tax credit taken on a company’s tax returns. IRS considers R&D credit claims as a “Tier 1 audit issue”. Companies are recommended to keep good records to support the R&D claim made on their tax return. This includes any contemporaneous documentation that would support the credit in the year it is being taken. Examples of Contemporaneous Documentation: W-2’s &1099’s Time charged to specific projects Reports generated through a costing system Specifications (Contracts) Drawings (including multiple past revisions) Prototypes / First Articles Paperwork Documenting a Process of Experimentation (Hypothesis, Testing, Test Results, Conclusion) Patents & Patent Applications Meeting Minutes / Presentations / Release Notes Correspondence (Email / Letters) Interviews conducted with employees documenting the R&D process IRS & FTB Audits

30. Process: Once a notice of an audit is received, as consultants we work on putting together the information the auditor is requesting through the Information Document Request (IDR) in a presentable format. Keeping in mind that most auditors are not familiar with the industry for which they have been assigned to audit, it is our job to prepare the documentation they are requesting in a format where they will be able to follow and clearly see that the R&D claim meets the requirements presented under IRC Sections 174 and 41. In some cases, an auditor will determine that the business component that has been presented as support for the R&D claim does not meet the IRC Sections 174 and 41 requirements. The company may decide to pursue their case further through the IRS Appeals process and the FTB Board of Equalization. There have been many cases where the auditor has disallowed the credit due to the supporting documentation not meeting the requirements, but have been accepted and settled through the Appeals process. IRS & FTB Audits

31. Business Component: In Trinity Industries, Inc. v. U.S., 105 AFTR 2d 2010-871 (691 F. Supp. 2d 688), the Court upheld the taxpayer Corporation’s (Trinity) position that the Corporation was entitled to the research credit refund claims, for expenses incurred by shipbuilding division in connection with design and construction of “first in class” (FIC) ships built under contracts for customers. The Government argued that because FIC ships were special order as opposed to sold out of inventory, they were not held for sale for purposes of Code Sec. 41 and business component test. However, the Court indicated that “the government cited no authority for that proposition and the Court sees nothing in the statute that would require such a narrow reading.” Rather, the district court found that each FIC ship was so held after being completed and before being conveyed to customers, and so qualified as business component. Similarly, the court also rejected the government’s argument that design work and integration of subassemblies was little more than “picking off menu,” and noted instead the simple fact that a new vessel incorporated existing systems was not dispositive of the QRE question. IRS & FTB Audits Sample Court Case

32. Questions & Answers