R&D Tax Credits

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2. Presentation Overview
I. Introduction
II. R&D Definition
III. Calculations & Structure
IV. Case Studies
V. Audit Process & Method
VI. Engagement Process
VII. Questions
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3. Corporate Overview
• Corporate Headquarters in Houston, Texas.
• Offices Nationwide including Pennsylvania, California, Florida, North Carolina,
Illinois, and Canada.
• Assisting CPA’s and their clients recover millions in R&D Tax Credits.
• We specialize in legal, technical (engineering) and tax knowledge of the Internal
Revenue Code (IRS) Section 41.
• Our Staff includes the industry’s most experienced IP Attorneys, R&D Engineers,
Scientists, and IRS Audit Experts from national tax consulting firms.
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4. Areas of Expertise
Manufacturing
Fabrication
Engineering
Software (ERP)
Chemical
Tool and Die
Machine Shops
Plastics Manufacturers
Pharmaceutical
Biotechnology
Food Sciences/Manufacturers
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5. IRS Definition of R&D
Traditional Definition Tax Definition
1. New or Improved Business
Component
Product,
Process,
Software (Internal or
External),
Technique,
Formula, or
Invention.
2. Technological in Nature
3. Elimination of Uncertainty
4. Process of Experimentation
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6. New or Improved Business Component
A business component can be a product or a
process, and can include the following:
• Manufacturing products • Developing or improving production
• Developing new, improved, or more and/or manufacturing processes
reliable products / processes / formulas • Performing environmental testing
• Developing prototypes or models • Developing, implementing, or
(including computer generated models) upgrading systems and/or software
• Designing tools, jigs, molds, and dies
• Automating and/or streamlining
• Developing or applying for patents internal processes
• Performing certification testing • Expending resources on outside
• Conducting testing of new concepts & consultants/contractors to do any of the
technology above-stated activities
• Developing and introducing new • Attempting the use of new materials
technology and compounds
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7. Technological in Nature
The taxpayer is seeking information
that is technological in nature:
The Technological in Nature component is based on the process of
experimentation used in the research relying on the principles of hard
sciences, such as physical or biological sciences, engineering, or
computer science.
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8. Elimination of Uncertainty
The research and development activities must eliminate uncertainty
either about the capability or method of developing the product. In
addition, the elimination of certainty of the improvement of the product
or its appropriate design is also sufficient to meet this requirement.
Most product development is concerned with the elimination of
uncertainty regarding capability, method, or choice of appropriate design.
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9. Process of Experimentation
The Process of Experimentation involves the evaluation of one or
more alternatives where there exists uncertainty at the outset as to the
appropriate design of the business component.
The Taxpayer may conduct a process of evaluating the alternatives
through systematic trial and error, developing one or more hypotheses,
designing and conducting experiments to test the hypotheses, among
other things.
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10. 3 Part Heightened Software Test
The rules for software development are still somewhat complicated, but one
recent clarification states that if customized software is developed for sale or
lease (not for internal purposes), then it is not subject to the extra hurdles of
the High Threshold of Innovation Test. If a company develops internal use
software, however, it may still qualify for the R&D Credit, providing that:
1. The software is highly innovative;
2. The development involved significant economic risk, and
3. A similar product is not commercially available.
If the above three criteria are met, then the cost of developing software for
internal use may qualify for the R&D Credit.
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11. Quality Control vs. Quality Assurance
1. Quality Control (QC) does NOT qualify if QC relates to the final testing and
inspecting stage before the final product that was mass produced is shipped
out.
2. Quality Assurance (QA) does qualify if QA relates to testing being
performed at the early development stages, such as prototyping or first
article stage. The employees in this department normally get involved in
numerous process improvement activities in addition to testing processes
of different products being manufactured.

12. Qualified Research Expenditures
Wages
• Form W-2, Partnership Earnings subject to Self Employment Tax,
Schedule C, bonuses paid to employees
• Excludes 401(k) & fringe benefits
Supplies
• Cost to fabricate prototypes / items consumed in R&D process
• Any tangible property used in the conduct of qualified research other
than land or improvements to land, and property subject to depreciation
65% of Contract Research
• Fees paid to non-employees, outside consultants / engineers / software
developer
Net Benefit is around 6.5% with Regular Credit
Net Benefit is around 4% with Simplified Credit

13. Substantially All Rule
Substantially all rule was designed primarily for engineers, designer, scientists
and programmers. It refers to when an employee or contractor spends 80% or
more of their time performing qualified work as per Section 41, the employer is
allowed to capture 100% of their salary towards Qualified Research Expenditures
(QREs).
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14. Regular Method vs. Simplified
Method
1. Regular Method
a. Base % and Base Amount is factor in calculation which can hurt the
credit
b. Maximum net benefit is around 6.5% of the QREs
2. Simplified Method
a. Base % and Base Amount is NOT a factor in calculation.
b. Average net benefit is around 4% of the QREs
c. Use this method when Regular credit method is resulting less than 4%
net benefit due to base %
d. If the average QREs for past three years is less than QREs for the year
under study, then net benefit will be more than 4%; otherwise less
than 4%.
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15. Passive vs. Non-passive (Important for S
Corp or Partnerships – Flow Thru Entities)
1. Passive (non active) Shareholders:
a. Their credits are amortized over 10 years
b. In order to utilize these credits over 10 years, the shareholder must be
paying regular taxes
c. They will experience substantial additional tax
2. Non-Passive (active) Shareholders:
a. As long as the shareholder is paying regular taxes, they will receive
refunds.

16. Purpose of Base % and Base Amount
1. Base %: Factor that is calculated based on how the Gross Receipt and QREs
for past years have increased or decreased in comparison
a. If the QREs increase in same or better proportionate to Sales, then the
Base % will be small.
b. If the QRE’s decrease, but Sales increase, then the Base % will be higher
c. Smaller the Base %, higher chance that Base Amount doesn’t hurt the
credit
2. Base Amount: Base % times Avg gross receipts Threshold
a. QREs must be higher than this Threshold to get any credit using
Regular method.
b. To get 6.5% net benefit, QREs must be at least twice as much as Base
Amount Threshold, therefore “increasing” research!
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17. Base % for 80’s Based Company
1. Must have been formed prior to 12/31/1983
2. Must have had QREs and Gross Receipts during at least 3 of the
following 5 years – from 1984 – 1988
3. Base % historically has been around 1% on average.
4. Base % once determined will remain fixed for all years to come
5. Lower the base percentage (max up to 16%), chances are high that the
base amount doesn’t hurt the credit using the regular method.
6. Most 80’s base companies don’t have base period issues and normally
have 6.5% net benefit (max) using regular method.
7. Properly calculating the base % for 80’s is very critical due to its
advantages versus start up companies, as this is one of the red flags in
Audit.
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18. Base % for Start-up Company
1. Must be formed on or after 1984
2. If the first year of conducting R&D is before 1994, for calculation
purpose, code requires to choose 1st R&D year as 1994; unless first year
of conducting R&D is after 1994, then choose that year as 1st R&D year
3. Base % for 1st 5 years is fixed at 3% using regular method
4. 6th Year, the Base % normally drops, and then in time goes up
5. Maximum Base % is 16%
6. Base % historically has been around 3% on average.
7. If the Base % is high which causes the Base amount to hurt the credit
using regular method, then use the simplified method which will result
in about 4% net but may result higher net benefit in some scenarios.
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19. Importance of Statutory and Current
Year Tax Deadlines
1. Statutory deadline:
If missed, the client will miss out on 1 out of 4 years of study, therefore
25% of the credit. That missed year of credit could pay for the entire
study.
2. Current Year deadline:
If missed, the client will have to amend the tax return. It is always
better to file than amend a return. In addition, by amending a return,
sometimes, the client may experience paying additional taxes upfront
if in AMT situation. However, if the client simply files the credit with
the return, the client will elect reduce credit and avoid paying any
additional taxes even if in AMT situation.

20. Example: Foam Products Manufacturer
Sampling of activities:
• Design of packaging foam
• Design of packaging processing
methods
• Physical design of packaging
components
• Prototype design
• Prototype testing
Annual Payroll
• 2004 – $18MM
• 2005 – $19MM
• 2006 – $20MM
• 2007 – $21MM
Net Credit Benefit for 2004 thru 2007 tax years: $1,200,000
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21. Example: Software Company
Sampling of activities:
• Designing Software
• Coding
• Programming
• Improving Application Features
• Functionality Improvements
• Alpha, Beta Testing
• Improving Modules
Annual Payroll
• 2004 – $5MM
• 2005 – $6MM
• 2006 – $7MM
• 2007 – $8MM
Net Credit Benefit for 2004 thru 2007 tax years: $500,000
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22. Example: Custom Plastic Products
Sampling of activities:
• Pipe and Filtration Systems
• Prototyping
• CAD/CAM
• Precision CNC Machining
• Solvent and Adhesive Bonding
• Quality Assurance
• Thermoforming Process
Annual Payroll
• 2004 – $10MM
• 2005 – $11MM
• 2006 – $12MM
• 2007 – $13MM
Net Credit Benefit for 2004 thru 2007 tax years: $700,000
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23. Example: Tool & Die Shop
Sampling of activities:
• Plastic part manufacturing,
• Rapid prototype modeling,
• Design – AutoCAD,
• Aluminum prototype tooling,
• Silicone tooling,
• Injection, Blow, Compression molding,
• Vacuum forming.
Annual Payroll
• 2004 – $2MM
• 2005 – $3MM
• 2006 – $4MM
• 2007 – $5MM
Net Credit Benefit for 2004 thru 2007 tax years: $200,000
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24. R&D Audit Overview
1. Tier 1 Issue
2. Auditors are comprised of Engineers and IP Attorneys
3. IRS approach is blanket denial of all credits
4. Burden of Proof on the company
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25. IRS Methodologies
1. Project by Project with Established Nexus (Recommended before by IRS but
now required)
a. Timesheet breakdown by Project by Project
b. Discussing activities within each Project
c. Identifying employees and contractors who worked on those Projects and which
activities they contributed their time towards.
d. Only way to maximize the benefit and have proper substantiation
2. Hybrid
a. Identifying few major projects
b. Identifying technical employees and contractors who perform qualified activities
c. But not linking the two (a and b)
d. May maximize the benefit, BUT doesn’t meet the proper documentation requirement
3. Cost Center
a. Extracting cost by departments
b. Allocating rough % to each employee with the technical departments
c. Will NOT maximize the benefit, NOR meet the proper documentation requirement
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26. R&D Audit Process
1. R&D Audit Process is handled by IP Attorneys
2. Due to our litigation, negotiation and engineering resources, we have an Audit
defendable rate of 92%
3. Our Approach is to thoroughly analyze all areas where we are extracting QREs
from to ensure such costs are defendable
4. We draft our engineering report and timesheets in the format IRS like to see if
following project by project approach.
5. Our approach is to give the IRS what they want quickly, efficiently and in an
easy to follow format. This speeds up the Audit and we have better negotiation
power.
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27. Shrink Back Rule
1. Shrink back rule: In IRS Audit, IRS Engineer may question certain
portions of identified Qualified Research Expenditures (QREs). If the IRS
claims that a certain project, activity, or individual’s time doesn’t qualify at
all or doesn’t qualify to a degree that was identified in the Study, they can
try to disqualify that portion of the credit. If they are successful or if the
Client wants the case settled, then the IRS will shrink back the credit.
2. The purpose of this rule is to not deny all the credit, but a portion that the
IRS disagrees with. The government wants to reward this credit to all who
qualifies for this benefit and follows the procedure with proper
documentation. Their intention is not to deny the credit, but simply make
sure the client deserves it and have followed the approved methodology
(i.e. project by project).
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28. The Process
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29. Process – Pre-Qualification
Utilization Analysis
• Collect Financials such as
corporate tax returns, AMT forms,
W-2’s, job titles for each year in
review
•Review Form 6765 to determine if
the credit has been taken
previously and determine if
incremental opportunity exists
Base % Analysis
• Analyze financial information
provided to determine whether
company is “80’s” based or a “start
up” and decipher if base
percentage will significantly
impact or prevent company from
taking credit.
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30. Process – Phase I
Identification
• Identify projects, processes,
technologies, and employees
associated with qualified activities
•Identify supply costs and
contractor costs
Data Collection
• Collect technical documentation
to substantiate qualified research
activities
• Collect remaining financial
information and documentation
for contractor and supply costs
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31. Process – Phase I Cont’d
Interviews
• The interviews are conducted
between Paradigm’s engineers and
IP attorneys and the client’s
technical staff
• Acquire high-level technical
information on qualified projects
• Determine employee and
contractor eligibility towards
qualified R&D activities
• Quantify and determine R&D
expenditures
Calculations
• Perform analysis of financial data
• Accurate determination of Federal
and State R&D Tax credits
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32. Process – Phase II
Reporting
• Finalize technical data through
follow-up interviews as needed
• Create or obtain technical drawings,
schematics, designs, formulas and
mathematical computations
• Preparation of R&D Report
• Release of R&D Tax Credit Forms
and Schedules to CPA and or client
for amendment or filing
Final Review
• Engineering study reviewed by
Production Director to verify
accuracy of all substantiating
documentation
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33. Product Deliverable
The R&D Study / Technical
Report
• The R&D Study / Technical
Report is where all the
arguments, documentation
of qualification and
quantification must
coalesce into a coherent
statement of who, why,
when, where and how
much.
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34. Product Deliverable
• Many clients lack the
engineering drawings
necessary to substantiate the
claim. Paradigm’s engineering
team can recreate the data for
presentation to the IRS.
• Most companies’ R&D Credit
is derived from a wide variety
of activities and processes
therefore the engineering
report is critical.
• The engineering report
serves as the first line of
defense in the event of an R&D
audit.

35. Production Timeline
Collect Phase I Interview Credit Phase II Technical Receive Refund
Financials w/ Client Calculations Report
8– 10 Hrs. 2-3 Weeks (Avg) 6–8 Weeks (Avg) 8–16 Weeks
Proposal Proposal
Letter Letter
Document Key Employees & Qualified Projects
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36. Summary
• IRS Definition of R&D
• QRE Calculations
• Case Studies
• R&D Audit Review
• Study Process and Timeline
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37. Questions?
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38. For more information, Please Contact:
Paradigm Partners
14825 Saint Marys Lane
Suite 102
Houston, TX 77079
Phone: 281-558-7100
Fax: 281-558-7900
info@ParadigmLP.com
www.ParadigmLP.com
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