The R&D Tax Credit: What System Integrators Need to Know

Speaker A: Welcome to the Rivergate Marketing Podcast. In this episode, Tim Finnerty of Whipfli, a top 20 national accounting and business consulting firm, discusses the benefits of the R and D tax credit for system integrators. WhipFLI, with roots dating back 90 years, has been assisting system integrators for over a decade, focusing on M and A support and data analytics and tax minimization strategies. Tim shares details on the recent OBBBA which allows system integrators to expense R and D costs immediately rather than capitalizing them. Could you start by introducing yourself and wipflly and share how you're currently helping system integrators?

Speaker B: Thanks Christine for having us. I'll touch base briefly on Wifli. Um, Wifli is a top 20 national accounting and business consulting firm. Roots dated back 90 years. You know, started in Milwaukee, um, recently. About two years ago we joined Wifley, where you used to be called Clayton McKervy. Uh, another strategic expansion was Harbor Results, which also is in the Detroit area. That helps as part of WIFLI now and helps system uh, integrators with benchmarking and other things. I've been a partner at Clayton McCruvy now Wifli for 20 plus years. I started my career at Deloitte, moved over to a smaller accounting firm, kind of focused on that middle market. Grew up doing a lot of manufacturing and distribution type companies and about 10, 15 years ago got into understanding kind of the system, uh, integrators, completely different market. You tried engineering and kind of manufacturing combined together and really liked it. I went on a trade mission to Mexico and uh, met uh, Bob Doyle who was part of A three and then he introduced me to csia which is another control system integrator association. Just kind of been focused on helping integrators learn more about their business and different tax and strategy ideas that are out there that we could help them with.

Speaker A: That's awesome. It sounds like you're uniquely positioned to help our listeners here system integrators. So the R and D tax credit has just come up from this big beautiful bill. You know, it's been discussed broadly, but what does it mean specifically for system integrators? Can you help?

Speaker B: The biggest benefit that happened in the um, in the OBB bill was that we now no longer have to capitalize the R and D cost again. So about three years ago in 2022, system integrators that were taking the R and D credits basically had to capitalize those expenditures, then depreciate or amortize those Over a five, six year period. So what was happening is these companies were getting a credit of, let's just say $100,000 and they would have expenditures of potentially 2 to 3 million dollars. Right. And these expenditures then had to be capitalized and amortized. But all of a sudden you got $2 million of income that you have to pay tax on. And that tax on $2 million effectively is at a 30 or 40% rate. And you're talking about $600,000 of tax and only creating $100,000 of credits. Right. So it becomes like, oh, what is going on here? And so this bill now has allowed us to expense it again. And there's a couple different ways that that can happen through this bill. That is one thing that, that we kind of have to take a look at to make sure that we're doing it correctly. So system integrators again are going to, I believe, the R and D credit as we move forward.

Speaker A: So integrators, they might not see themselves as doing R and D. You know, what kind of activities in system integration might qualify for this tax credit?

Speaker B: Yeah, the way I always look at it for system integrators is engineers always seem to think that what they're doing isn't new. Uh, they're able to always solve, uh, a problem. Well, for the R and D credit, really what we've seen with system integrators is that usually each project that they're doing potentially is unique because something is different with them. And so because of the uniqueness of it, they usually qualify. So there's really a four part test that has to happen for them to qualify. The first one is basically that activity must relate to a new or um, improved product, process or design that is intended to improve the function, performance, reliability or quality of that. So, so again, if you're doing something that's improving that uh, process. Right. That's not like re engineering something, but improving it, then it most likely is going to be qualified. Now it also has to be technical in nature, which for system integrators that's mostly happening. Like for example, an accounting firm might improve a process, but it's not technical in nature. So we don't really qualify for the R and D credit. Right. So it's got to have something to do with physical science, computer science, engineering or biological sciences. Then effectively the third one is elimination of uncertainty. The activity must be intended to discover information to eliminate that uncertainty related to the capability to improve product, process or design, method to improve product, process or design or Appropriateness of design. That's where some of it is out there. I mean, uh, again, we see that a lot of system integrators qualify. Now. There's certain contracts or other things that may not because of the IP rights or the rights are the customer's rights. But usually it makes a lot of sense to really kind of look at that. Right. And really the fourth one is that process of experimentation. Right. What are we doing to eliminate that uncertainty, uh, regarding the development of the product or process, you know, utilizing process to evaluate what alternative are we doing to eliminate that uncertainty. And then testing, implementation, you know, trial and error, those types of things that you're doing to do that. And a lot of times what will, what will happen is the engineers will think, well, I did that on the first project, how can I qualify on the next project? Well, that project's for a different, you know, customer and may have other uncertainties. Right. If I'm building the same unit multiple times, then yes, that first one is the only one that qualifies and the remaining ones don't.

Speaker A: Is there a big documentation requirement?

Speaker B: There is. I mean, if you ever got audited, you would, you'd want to have a study that was done. Right. And having a third party doing that study usually is much more helpful with the irs. Now, to take the credit off the start, theoretically you do not have to have anything. You have to fill out some forms and go through some different things. But if it were ever to get challenged, yes, you need to have that documentation. And usually what happens is you do a study and you pick some of the projects and you would document those projects, the highest value projects, and you kind of go through all those different four part tests and document it. Right. You put into those projects, what type of simulations did I do? Right. On making sure I got through it, I document the hours that I had into these jobs. Right. And so there's three pieces that qualify for the R and D credit. The wages, supply cost, and then contract labor, which is basically wages, except that you're using someone else. Right. And for system integrators, we sometimes find that the supply costs can be significant. And so that's where there could be large credits that can be taken based off of the uncertainty of a project that you're using robots, you're using some fixtures that may be pretty expensive to design something. Right. And conveyor systems that are putting into place, if those conveyors aren't working. Right. You know, levels and different things moving around. We've had ones that, you know, you're putting certain things into plants that might be, you know, in the south that have a lot of humidity. Right. And therefore, if you're not understanding the controls of how to make sure that certain things get designed correctly, things can stick if you're producing something. Right. And so you want to make sure those are all taken in effect. And that's where, that's where some of the uncertainty and different things come into place because you're, you got so many variables of when you're designing something just dependent on location.

Speaker A: Sounds like you have a lot of experience and would be a great resource for integrators on this.

Speaker B: Whiply has been doing R and D credits for 20 plus years. We've been working with system integrators, you know, for the last, uh, probably 10 to 12 years. It's having the people on the team that understand, you know, this industry because it's, it's definitely different. Different than someone developing computer software, Right. I mean, that's pretty easy and simple to understand. It's brand new. You know that it's different. Right. In this industry, it's, it's okay. We're, what, what does the customer ask us? How do we take it? And, and really trying to find, you know, what makes the most sense and, and trying to do it in a reasonable way that you're not going to have a issue if the IRS comes back and, and, and looks at it.

Speaker A: So the credit just simply goes against the income or is there some special way the deduction is taken?

Speaker B: There's a couple different ways that you can do it. But most people, you know, when you, when you hear about a credit, a credit is a permanent tax difference, right? Uh, so you basically have, on your, instead of when we were talking about before, you had to capitalize the R and D cost and then you would depreciate it over time. That's just a temporary difference, right? So you're capitalizing after a certain amount of years, whatever you capitalize, you depreciate it. So you're not paying any tax at all on it, right. But on a credit, you're getting 100% of that amount as a permanent difference against your taxable income. So for example, you know, and you can't fully offset your taxable income against the credit. You can take your income basically down to almost like, um, a, let's say a 5 to 7% tax rate. Right? So if I'm paying 30% on $1 million and I had $300,000 and I had 100,000 of credits I'd be able to reduce my tax to 200,000. Right. Right off the top. And therefore that's, you know, I only have to now pay the IRS and my tax rate effectively is 20% instead of 30%.

Speaker A: Right, sure. Great. So for integrators who haven't pursued this credit before, are there first steps you recommend to take to see if they qualify? Obviously they should reach out to you and have a discussion.

Speaker B: Probably the easiest on their own they can do some research on like again that four part test and then digging into some of that stu stuff. But you know, one of the things that we do at WIFLI is we do a feasibility study that basically is a no cost type thing. You know, we'll, we'll have a discussion with you, kind of talk through some of the things and then we'll ask for some information and we'll do a feasibility study that then would say, oh yeah, we believe that you would have, you know, $100,000 worth of credits. And if we did that, then we would put a budget together of what we would charge, you know, the company and the amount that we would char anyone would charge is based off of like how much work you have to do on it. Right. How much documentation is needed, how much of that is, is going to um, you know, take the time. Right. If you have some simple projects and different things like that, there's probably some things that, okay, let's, let's you put together the wages you put together kind of where you're at, we can kind of look at it and say, okay, well this, this credit's only going to be about 25,000. Let's you know, look at it, talk through some things, document a few things and then we're done with that. Right. You kind of look at the risk reward on some of that stuff of how much time and effort you want to put into it. You know, if you got a million dollar credit, you want to probably put a little bit more time m and effort into it and it's going to cost some money, but it's definitely well worth the time and effort.

Speaker A: Yeah, sounds like it. Especially these projects are often many zeros.

Speaker B: You know, one of the things too is, you know, with these credits, some, some states now I think there's almost 25 states that have credits as well. So the credits can be offset, uh, against your state income tax as well. Some states, one, uh, in particular that I do some work in, Arizona's credit is as good as the federal credit. But you know, the Arizona's tax rate is not as high, so you might have some large carryovers on some of the stuff. But the benefit for some of that could be, is in the future if the system integrator sells, right, you're not going to pay any state income tax on a sale. Right. So again the benefit could have a long term effect of cash flow later on in uh, owner's pockets.

Speaker A: That's very interesting. I hadn't thought about it in those terms. So this obbb, when did it become effective? Is it going to be for the 2025 tax year?

Speaker B: When this thing came out, we had a few clients still that hadn't filed their 915 tax returns. And that time we kind of did a quick analysis of okay, should we take advantage of it in 24 and most of them did where we didn't capitalize. We kind of made an election to kind of take the expense in the current year and then effectively go back and take 22 and 23 expenses. And looking at that because that was, you know, made the most sense because they're going to get some cash back right now. And because this past year for system integrators, some have had a little bit harder time because the uncertainty of all the tariffs, tariffs and things like that. So projects haven't been as, as heavy, uh, and different things like that. So you know, it was opportunities to get some cash back for some of the business owners that really were excited about it. But in reality, you know, the bill goes into effect and you know what, what is now happening is really kind of looking at the benefit of going back. Because if you are a system integrator that's under 31 million in average annual gross receipts for the last three years, you have the ability to potentially one go back and look at whether or not you want to uh, amend tax returns for 22, 23 and 24 and get money back or potentially in 25, basically make an election either to take all that expense in 25 or you can take it over a two year period. And again, some of the reasons that you would look at this, do I want to amend and I got like 30 states that I have to do and some of the states did use the capitalization, some didn't. How does that really affect. And therefore now you got a lot more, you know, work that has to be done on that or is it just as easy to say okay, because I'm going to have a decent year in 25 or you know, I can, I can utilize that, I don't have to pay any taxes going forward. And I have some carry forward R D for the future or different things. And so it's really on a case by case basis on what's going to be done. But uh, again, I think it's better to start looking at it now. And so if you had been taking, you know, the R and D credit for, you know, 22 through 24, uh, you really need to get with your tax advisor to really kind of determine what makes the most sense in either amending or going forward. Now if you're over 31 million in gross receipts, you don't have the option to go back. So you would look at it and say, do I take all of it in 25 or some of it in 26? And part of that gets into, you know, there's different things with NOLs or stuff. So again, some tax planning ideas or different things that are out there. And you know, we'd be happy to um, have those discussions with, with anybody that, that has questions.

Speaker A: Sounds like it gets very complicated very quickly.

Speaker B: That's the tax law.

Speaker A: Right.

Speaker B: You know, and we want to complicate it as much as possible so that we stay in a, uh, you know, have a job for a long time.

Speaker A: So looking ahead, do you see any changes coming to the R and D tax credit? I know we're in a period of a lot of uncertainty and quick changes with government regulations. So anything coming down?

Speaker B: I mean, I don't know that there's going to be any major changes with, uh, the tax credit itself. I think that the hardest thing with the, uh, R and D credit itself has been there's been some court cases out there and some of them have been taxpayer friendly and some of them have not been taxpayer friendly on what qualifies and what doesn't. Right. And the question will become, you know, with the changes going back again, of being able to not capitalize and have these credits and it helps reduce tax revenue, you know, is there going to be more scrutiny by the IRS on whether or not, you know, there'll be audits out there or what you're doing? So it's, you know, really trying to make sure that you're, you're looking at what does qualify in it. It goes both ways and it's hard to understand how something doesn't qualify this way or how it does. And it's really, again, getting back to yes, everybody needs to do a good job of documenting their project so that you can support the credit itself.

Speaker A: Good advice. So beyond the financial benefit, are there strategic advantages that integrators can gain by leveraging anything, uh, beyond what we've already discussed that you want to share.

Speaker B: It depends. I mean the financial benefit is huge. Where there is some benefit I've seen a little bit, it just depends on um, who's buying it or not. So as system integrators are looking at going to market, right. They need to understand that this has a benefit, that potentially if the buyer is somebody that's taking the credit, there could be an additional uh, benefit. Or let's say Instead of getting a 5 multiple, maybe they'll give a 6 multiple because they under understand how the R D credit works. Right. And so part of that is making sure that, that you're understanding all the value. Because you know, when you sell a company effectively in this market, everyone kind of goes by ebitda, which is, you know, earnings before interest, taxes, depreciation and amortization. Well, it's also a focus on sometimes, you know, cash flow, especially debt, paying down debt quicker. Well if you're not having to pay tax because you have these credits, you can pay down debt much quicker. And therefore you know the private equity or different things that would come in potentially has the opportunity to get that debt down and when they sell there'd be bigger cash flow type type items as well.

Speaker A: So Tim, are there any other services that Wipfly offers or any additional information you'd like to share?

Speaker B: As you know we're a full service accounting advisory firm. We help system integrators with a lot of things. We've been working with a lot of system integrators on the M and A side to help them uh, with quality of earnings before they go to market. One larger um, one we've started to do some data analytics and benchmarking for them. You know, so you're kind of looking at what you're comparing to your peers or internally how your realization and your, you know, different things. We're also, as you're continuing to grow, a lot of times you're thinking about hiring a controller or cfo. We have those services to help like navigate. Instead of hiring someone right away, we could jump in and see if there's opportunities to see where you need to be right and what's the right place to go. And then doing the typical accounting stuff, you know, trying to look at how can we minimize your taxes and not uh, just with the R and D credits but you know, the, the new bill, uh, had some, some different uh, things. The bonus depreciation came back. You know, there's some, still some energy credits that are still available out there, uh, potentially for system integrators that are doing some different things. So you know, there, there definitely is, um, you know, a lot of opportunity out there and if you have any questions, you know, I'm m always happy to have a, you know, 30 to 60 minute call, just uh, kind of see where we could help in any way.

Speaker A: Great. Now I know that a lot of the system integrators are on the smaller side. Um, just CSIA says I think a large percentage of them are under 7 million. Is there a lower limit on the size of an integrator that it makes sense to work with you?

Speaker B: I work with uh, a few system integrators that are under 5 million and I work with some system integrators that are over, you know, 100 million. Right. I think it's, it's dependent on, you know, where you want to be and if you got growth goals, um, you know that those are easy for us to, you know, definitely jump in. But looking at the R and D credit. Right. I mean that potentially if you're making money and you're not taking advantage of that R and D credit and you think you're too small, you know, there's, there's opportunities in there that definitely happen. I mean we got one that's under 10 million and getting a couple hundred thousand dollars in, in credits. And I got some that are 30 million that are only getting a couple hundred thousand as well. Right. But um, it's just dependent on what you're doing. And you know, we're always, we're always open to have conversations with system integrators that are looking to, you know, kind of make sure that they're getting that proactive holistic tax advice or holistic approach to their entire advisory business. Right.

Speaker A: Makes a big difference that your firm is familiar with the industry.

Speaker B: I'm sure it definitely is helpful. And I've had a lot of clients say, say that, you know, understanding the nuances of what's happening with various projects and how to help them navigate, especially when they're, they're looking to sell. Why, you know, a certain project that went sideways may be an add back rather than an expense, uh, to the bottom line.

Speaker A: The system integrator is listening today and wants to see whether they qualify. How can they connect with you?

Speaker B: Probably the easiest way would be my name, Tim Finnerty. And then it would be just iffley.com or just, you know, go to the Withly website and search on my my name and and send me a email or happy to connect and um, talk through you know what we can.

Speaker A: Well thank you so much Tim for joining me today on the podcast. I look forward to sharing this information with our audience.

Speaker B: Justine, thank you very much for having me.

Speaker A: Founded in 2009, Rivergate Marketing is a full service digital marketing agency serving small to mid sized B2B companies trying to reach technical and engineering buyers. We are passionate about building strategic and data driven marketing and PR programs to help our clients compete and be found in a crowded digital space against much larger companies with seemingly endless marketing dollars. For more information, visit us online@rivergatemarketing.com.