Restaurants Cook Up Tax Savings with the R&D Tax Credit
The new year brings new challenges for restaurant owners. Resolutions to cut back on alcohol or cook at home more can depress check averages, low temperatures outside can deter foot traffic, and high fees from delivery apps can make it feel like your business is cannibalizing itself.
It might seem counterintuitive to look to tax filing season for a silver lining, but for restaurants investing in new recipes or processes, the tax deadline can bring a cash benefit in the form of a research and development (R&D) tax credit. With this credit, eligible restaurants could benefit from a dollar-for-dollar reduction in their tax liability of around 6–12 cents for each dollar of qualified expense generated.
Many people think that development tax credits are only available to high-tech manufacturers or cutting-edge software coders, but the Credit for Increasing Research Activities, as the R&D credit is officially named, is broad in scope and covers activities currently performed by many restaurants. In this post, we'll cover the basics of the credit, including which activities that restaurants engage in can qualify, as well as which expenses can be considered. We'll also present a few real-life examples of companies claiming the credit for activities you may already be performing within your restaurant.
Case Study: Brewing Up a Refund
For a brewery in Michigan, a few different projects led to R&D credits. The brewery made new seasonal and specialty beers each year. Each of these new beers required brewers' time to ideate the flavor profile and supplies to produce prototype batches of beer. The brewery also expanded its production, requiring brewers to develop processes to produce their standard beers on larger equipment. Because the R&D efforts by these brewers took substantially all of their time at work for the year, the brewery was able to include 100% of their lead brewers’ wages, along with supplies used in pilot brews, for the R&D credit. Wages of $750,000 and supplies costing $100,000 were included as qualified research expenses and resulted in a credit of more than $50,000, which reduced the brewery’s tax liability dollar-for-dollar.
At its core, the federal R&D credit is built around activities. A company claiming the credit must intend to develop or improve the functionality, performance, reliability, or quality of a product, process, software, technique, invention or formula. The company must use a process of experimentation to work through uncertainty in whether or how it can achieve its aims, or what the appropriate design of the solution will be. The experimentation must fundamentally rely on technological principles, or those of engineering or the physical, biological, or computer sciences.
Case Study: Getting a Taste of the R&D Credit
A restaurant group in Ohio has a test kitchen where test chefs conceive of and trial recipes before they roll them out to restaurants. In order to keep costs down, the company uses its corporate staff to taste test the new recipes, directing them to focus on texture, smell and flavor, or the sensory characteristics, rather than personal preference.
The restaurant group paid a third-party developer to create a mobile app on which customers can place pick-up orders. The development of the mobile app prompted the company to modify its existing point-of-sale (POS) system in order to integrate the two. The modification of the software to allow it to speak to the mobile app was also performed by a third-party contractor. In addition to deducting all the related expenses as ordinary business expenses, the group was able to claim development credits based on the wages paid to the test chefs ($75,000) and the portion of the corporate staff's salaries related to taste testing ($50,000). The cost of supplies used in the development was also included ($10,000), as was a percentage of the fees paid to the app developer and the contractor who modified the POS software ($100,000). The resulting credit resulted in a dollar-for-dollar reduction in tax liability of nearly $20,000 (Note: Software licenses and off-the-shelf software packages are generally not eligible for the credit. Costs to customize software, though, may qualify).
There are four types of expenses that can qualify for the credit: wages, supplies, computer rents and leases, and contract research:
Case Study: A Process for Success
- Wage expenses are based on taxable wages to employees, whether hourly or salaried. The includable amount depends on the proportion of development activities being performed by the employee, and in a restaurant might include:
- Wages related to a chef conceiving of and trialing recipes before they’re added to the menu
- Wages paid to an employee who wrote a patch for a POS system to allow management to analyze guest data more robustly
- Supply expenses are limited to tangible personal property that is used in development and is not property of a character subject to the allowance for depreciation, e.g., costs for ingredients used by the chef during new recipe trials.
- Computer rent and lease expense are less common, coming into play when cloud hosting is used for software and other development efforts, such as Amazon or other cloud provider web-hosting expenses used for the development of a new app that will enable customers to place take-out orders.
- Contract research expenses are typically paid to independent contractors or third-party companies for development efforts on behalf of the taxpayer. These may be included in the credit after applying a reduction, typically of 35% but sometimes less. Special care should be taken with contract research expenses to ensure that the taxpayer retains some rights to the development’s results and bears the economic risks of development. Contract research expenses may include:
- Costs paid to a third-party software developer to integrate the company’s POS systems across multiple restaurants
- Fees paid to a testing lab to quantify the nutritional content of new dishes
A restaurant franchiser has a commissary where menu items are produced and frozen for distribution to franchisees. A new oven was purchased promised to greatly reduce the amount of time needed to bake flatbread. Although the cost of the oven generally would not be includable in the company's R&D credit because it will be capitalized and depreciated, the time the commissary employees spent developing and documenting the new process to bake the flatbread was captured for the credit, as was the cost of ingredients used while the employees attempted to realize an appropriate design. With qualified employee wages of $200,000 and qualified supplies of $1,000, the company’s credit was nearly $14,000.
Because the company was not yet profitable, they thought they would not be able to see any immediate benefit. However, because their gross receipts were under $5,000,000 and they’ve been in business for less than 5 years, they were able to elect to use the credit to offset their payroll tax, providing the cash flow infusion they needed to keep growing the business.
If you've invested to develop or improve your products, processes, or software, whether by devoting employee time to such projects or by dishing out cash to outside consultants, you should look into whether the R&D tax credit could benefit your company. If so, you could reclaim 6% to 12% of your investment, either in the current year or, if you’re not paying taxes, in a future year to which you could carry the credit forward. And if you’re a start-up company with gross receipts under $5,000,000, you may be able to apply the credit against your payroll taxes now instead of waiting until you owe income tax.
If you think you may be eligible for the credit, BDO has resources to help. If you're already a BDO client, contact your representative to be put in touch with the R&D team. Find more information on the R&D Tax Credit or use our simple calculator to estimate credits at your leisure. BDO's dedicated team of R&D professionals are also available to speak directly, allowing you to access the most relevant information for your unique needs.