How can banks use R&D credits to their advantage?

In this  episode of Issues of Interest, BNN tax principal Adam Aucoin speaks with Dave Fleischer, principal at Business Resource Services, about R&D credits, what banks need to consider, and how they can plan ahead and use credits to their advantage.

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Transcript

Joe Jalbert: Hello and thank you for tuning in today to issues of interest from Baker Newman Noyes, where we cover assurance, tax, business advisory, and technology topics and trends affecting the banking and financial services industry. I'm Joe Jalbert and I lead the banking and financial services practice here at BNN. Banks and financial institutions are constantly navigating volatility and change. Here at Issues of Interest, we help you stay current on what's happening in the industry so you can achieve success for your institution. Now let's get into the episode.

Adam Aucoin: Hi everyone. Thanks for tuning in to Issues of Interest, BNN's podcast for the banking and financial services industry. I'm your host today, Adam Aucoin, a tax principal here at Baker Newman Noyes. I'm here today with Dave Fleischer, a principal at Business Resource Services. Hi, Dave.

Dave Fleischer: Hey, Adam. How you doing today?

Adam Aucoin: Doing pretty well, actually. Nice weather outside. Summer starting, so we're ready to go. Great. Just for those who don't know, you can just give a little bit of background on yourself and kind of what you do day in and day out.

Dave Fleischer: Sure. As you mentioned, I am a principal and manage the R & D tax credit practice for business resource services. We are located in South Burlington, Vermont. I'm located outside Boston. Our clients are all over the country and are as small as pre-revenue biotechs to as large as multinational public companies.

Adam Aucoin: Great. And you're here today really just to talk about R & D credits, which is kind of a specialty niche practice that has really developed over the last probably decade or two now. But in particular, we're trying to get a sense of what our listeners who are mostly financial institutions, what they might want to consider and think about as they plan ahead and be able to use these credits to their advantage. But just to get us started, can you just give our listeners a sense of what we even mean when we say R & D credits? We're kind of talking in jargon at this point, so just a little bit more background to bring it back to even level.

Dave Fleischer: Yes. Happy to speak a little bit to that. Basically, the R & D tax credit is, first of all, it's technically called the Credit for Increasing Research Activities, and it's a very misunderstood and underutilized credit. In fact, it's been around since 1981. It was always temporary and extended and approved by Congress every year or two, and it finally became a permanent part of the code with the PATH Act 2015. And even at that point, when it became permanent, they added some additional benefits to it, which enhanced it. And then in 2018, it was preserved under the Tax Cut and Jobs Act. So, it's had some good movement in terms of getting exposure, but it's still very underutilized in general.

Adam Aucoin: I completely agree. It one of those credits that I think sometimes people try to tackle on their own, too, without really talking to people who do it day in, day out. So, it's complicated as well. I had one non-financial institution client who was doing it themselves, and they were getting about a $30,000 a year credit. They finally brought in someone with a little bit more specialty in expertise in there, and then they were getting over $200,000 because they were missing a lot of expenses that qualified. So definitely underutilized and misunderstood sometimes. Do you have some other highlights on the credit and other things people might want to be thinking about?

Dave Fleischer: Well, yeah, to give a little background, the credit itself is for companies that develop new products or processes or improve products or processes. So, it doesn't have to be brand new. If they're just working on improving what they currently are doing and investing in that manner, that can qualify potentially for the credit. Now, there are both federal and state credits for R & D tax credits, and there's approximately 35 or more states that offer this. They are somewhat similar in how they're calculated to the federal credit, but it shouldn't be lost on our audience that they can be very lucrative as well as the federal credits. And the federal credit is a dollar-for-dollar reduction in tax liabilities, and it's used to offset current or future income tax liabilities. 

The other part that's nice about it is you can go back three years, Adam, to claim these, if you haven't claimed them before, and if you don't use them all, the government allows you to carry them forward for up to 20 years. So that's a long runway, if you will, to be able to utilize these credits and bank them, so to speak, no pun intended, if you have to wait to use them. And the other point I wanted to make is, and not to go down this too deep a road, but in that 2015 change, they allowed startups who typically do not have the ability to have income taxes because they're new, they're growing the companies, they can use these to offset the payroll taxes, which is a way to monetize them under certain criteria, right?

Adam Aucoin: Yeah. Which is a great tool for these companies that could use that credit immediately and be able to reduce their taxes, and then in turn, take that cash and inject it back into more R & D and really ramp it up even more so.

Dave Fleischer: Exactly, exactly.

Adam Aucoin: So, in thinking about this a little bit more and trying to hone it in to our audience, just in general, where do you see this in terms of what industries do you see it applying to and how it applies to those industries?

Dave Fleischer: Sure. Well, believe it or not, most industries can take advantage of this. People think of this credit as being someone in a lab doing experiments on mice. And it has evolved over the four decades that it's been around so that it really crosses most all industries. And some of them are, for example, software development companies, robotics, AI manufacturers of all types. You have metal fabricators, food and beverage, of course, life science, where you have biotechs and pharma and medical devices, and including financial services companies.

Adam Aucoin: Now, the financial services companies, obviously is a particular interest here, and we've seen it more and more. It's still not overly prevalent in terms of the ability to use it or what we've seen use it. But there are cases where it's pretty powerful credit. When they're doing these activities already. In a lot of cases, it's not like they're going out there and starting to do R & D because they want a tax credit. They're out there doing these activities anyways for business reasons. So, expanding on that, what type of things are you seeing businesses do to qualify for this? What type of activities?

Dave Fleischer: Sure. Well, first of all, there are all sorts of entities that were talking about within the financial services arena, and they not only include banks that could be trading companies or mortgage companies and insurance companies. Within these entities, Adam, you've got qualifying activities that might include software development, modeling and building algorithms and those types of activities. And what I really mean by that to go one level lower, is they could be developing software to interact with outside third parties, such as clients or even vendors, or they could be developing software to improve their capabilities for performance or efficiencies or quality. And beyond working on their own proprietary software. What I've seen a great deal of, and I'm sure you've seen the same, is that these financial institutions, particularly ones that have been around for a while, have a lot of legacy systems and older third-party applications that they're now trying to integrate with newer technologies. And the headaches that that brings and the planning and the requirements gathering, the design, the coding, it's all challenging. And all these things that I just spoke to are qualifying activities for financial institutions.

Adam Aucoin: Right. That's great. And they're definitely all doing more and more of that. And I think it's certainly something that's going to be seen more and more. I mean, every type of software development and every type of software thing being put in place right now, I think it's going to have some type of AI layer that's going to be added to it going forward. I mean, I don't go to any banking conference right now where AI isn't a topic that's being brought up for whatever reason. A lot of times it's fraud reasons too, like these deepfakes and these things going on there. But it's certainly going to get layered onto these applications and there's going to be some development that they need to specialize it and make sure that for fraud and other reasons that they're not trying to be overly expansive in what they do and buying something off the shelf, they're going to have to the capabilities customized to them to some degree, I think so. That's great.

Dave Fleischer: Yeah, no, you're exactly right. And maybe just to piggy onto what you're saying in terms of some of those challenges that you just mentioned, such as cybersecurity and AI and the headaches that they have with all these outside unsolicited third-parties that might be wanting to see what's going on inside an institution, it's really a very challenging environment to be working in. And I think what the financial institutions are doing well is they’re building cloud infrastructures that can count and blockchain development and doing these predictive analytics. And I think that these environments change so fast. And to stay up with it, they do have to invest in what we call qualifying R & D activities. Right.

Adam Aucoin: Great. So just to build on that a little bit more in terms of, you talked about the cloud infrastructure, the blockchain, maybe some work they're doing on the online or mobile banking apps and that type of development. But to get a little bit more into the nitty gritty, what are other things that go into the calculation of the credit itself to know how can you monetize this?

Dave Fleischer: That's a good question. There are three or four categories, I'll say, of expenses that can count. And first, before I talk to them, these all have to be us based because it's a US based tax credit. So, the work and activities that we're talking about have to be performed on US soil. The first and largest typical category are wages. So, an institution's employees that are working on, let's say, software development, to the extent that those people's time are related to these activities, you can add those wages into the calculation of the credit as well as wages. You have outside contract expenses, meaning outside vendors who are assisting with your development efforts. Or they could even be 1099 that are hired. And then the third area, in particular for financial services institutions, is cloud-based computing. A lot of firms use firms such as AWS or Azure to do their development work remotely. And to the extent that those costs, and they're usually pretty significant monthly costs, those can be used in the calculation of the credit as well. So those are the big buckets where our audience here that can count.

Adam Aucoin: Great. So again, thinking about that a little bit more out the box and trying to get that down to some numbers and stuff, do you have a high-level example you might be able to walk through in terms of the financial impact that can come from claiming the credit?

Dave Fleischer: Sure. An example that comes to mind would be, let's assume that an institution has about $500,000 of invested money, whether it's wages or outside vendors assisting them. $500,000. They can expect approximately 10% back in the federal credit, or about $50,000 in that example. And there's no cap to this for using this against income tax liability. So, if someone had a million or $2 million of money invested in qualified activities, then the credits would be $100,000 or $200,000. And of course, we've seen credits in the millions. And the way the government rewards people who invest in R & D, they like to see increasing numbers, increasing investments. And if they are doing increasing research activities, then the actual credits go up exponentially as opposed to linear. So, they reward the taxpayer in that manner. And the other thing I wanted to add that in my example is if you hadn’t claimed the credit before and you did want to go back three years to claim it, and let’s just say you were eligible in the current year for $100,000 credit, and it was the same for those three prior years. If you pay taxes those three prior years greater than $100,000, you'd actually get refund checks of $100,000 for that tax credit. So, it's a very good cash benefit not only for claiming past credits, but future. I can also give a couple quick real-life examples if you'd like to hear them.

Adam Aucoin: That'd be great. If you have one or two other examples, it'd be great to walk through them.

Dave Fleischer: Sure. Okay. So, we work with a medium sized bank, has about 70 branches, and a few years back they started to really elevate the amount of efforts that they were doing with software development a lot because of what's happening in the marketplace and the technological world. And we were able to, over four years, get them approximately a quarter of a million dollars. So, they were able to, over four years, get a million dollars of these credits that they can use to offset tax liabilities which follow to their bottom line, of course.

Adam Aucoin: Right.

Dave Fleischer: Another example would be we have a very young company that's building a trading platform, and they have about 40 employees total. And this last year, they saw $300,000 credit that they have used to offset payroll taxes. And soon they'll be using them to offset income taxes.

Adam Aucoin: Yeah, very powerful. I mean, especially for a newer company to come in there with $300,000. I mean, that's not a little chump change we're talking about here. That's, as the bank might think a material amount of cash. So.

Dave Fleischer: Exactly. Exactly.

Adam Aucoin: That's great. So, yeah, thinking about some of the financial institutions, everything, again, these are permanent differences that can impact you, impact your bottom line, and can come into play with your tax credit strategy in general. I mean, a lot of times you're looking at other tax credits, too. Low-income housing, new markets credits, things along that line. And these can come into play in terms of your overall tax strategy and tax credit planning and implementation. But again, it's extremely useful to think about these and doing these studies. If you have activities you're doing anyways as part of your normal course of business, I think it's great. I think that's about time to wrap up. We've covered quite a bit here already, but is there anything else you want to touch on quickly before we head off or that you think listeners should walk away with knowing?

Dave Fleischer: Yes, I think the, probably some of the high-level takeaways would be that number one, this credit is a tremendous vehicle for receiving immediate, significant cash benefits. It assists in a very positive way with tax planning efforts. It can improve your bottom line. You can go back three years to claim it, and you can carry these forward for up to 20 years if you haven't used them all. And in addition to the federal credits, you should always look into whether there are state credits available where their firms are located.

Adam Aucoin: Great. One kind of last question just comes to mind as I'm thinking about this and going through the processes. Do you want to quickly go over how this process would go overall, step by step? Look at how you would go about claiming the credit? Or you could go about claiming the credit.

Dave Fleischer: Sure. That's a good question. I can suggest how we've been working with our clients briefly. First, we would have a call that lasts about 30 minutes to understand a little bit what they do and get a little bit of information. And literally within that half an hour, we can tell if they will be a potential firm that can qualify for the credit or not. And then at that point, if they're interested, we would gather more information, do some analysis, and have a couple discussions. And it would not take a lot of the client’s time. And we could come up with a very good estimate of their credits. And at that point, we would know what our fixed fee was if they wanted to work with us and claim the credits in partnership.

Adam Aucoin: Thats great. Yeah. And it’s extremely helpful to be able to have some of those conversations and some idea what you’re doing upfront, because similar to looking at other cost segregation study or some type of other tax credit study, sometimes it’s good to know what you’re even looking at what the cost benefit is. And these are all things they’re going to be considering as they look at rate of return and everything else. Thats a great little process to be thinking about in terms of being able to provide a lot upfront and get a sense before you get too deep into the weeds and, you know, fully commit.

Dave Fleischer: Exactly. And you've just said it. It's a way for both parties to understand what they're about to potentially walk into at literally no cost. It's just gathering information.

Adam Aucoin: Great. So, Dave, great to chat with you. And certainly, we covered a lot today. These credits have been around for a while, but certainly I think we're still learning something new about them almost every year. And it's something that we thought our financial institutions and financial service companies, as you mentioned, that covers much broader realm as well that they should consider taking advantage of because it seems like they're here for the foreseeable future. Doesn't seem like the credit's going away. It's pretty popular politically, just a matter of whether politically they can agree on anything at times. But I think it's probably here to stay and something to consider going forward as well.

Dave Fleischer: I agree with you, and I want to thank you for inviting me and sitting down to talk about the R & D credits. And I also wanted to thank our listeners for tuning in. I hope it's been helpful. Yeah.

Adam Aucoin: Great. Thank you, Dave. Appreciate it. And as always, at Baker Newman Noyes, we're monitoring and sharing updates and developments. So, stay tuned for more articles, podcasts, and resources from our team. Thank you all.

Dave Fleischer: Goodbye.

Joe Jalbert: Thank you for listening to issues of interest from Baker Newman Noyes. The BNN banking team thrives on solving complex business challenges and helping institutions meet their goals. You can find more of our industry content and subscribe to our newsletter@bnncpa.com dot. If you'd like to connect with a member of our team, email info@cpa.com. Bye now.

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