Despite the reforms introduced in the Tax Cuts and Jobs Act (TCJA), the Research & Development (R&D) tax credit provides opportunities to bring down income tax liabilities, allowing companies to save millions of dollars.
However, the concept of R&D tax is shrouded with uncertainty. Due to common misconceptions about R&D tax application to business operations, many businesses fail to benefit from the R&D tax credit. Confusion surrounds issues like how to calculate the R&D tax credit, identifying qualifying activities and expenditures, credit utilization, and more.
By understanding, identifying, and claiming the R&D tax credit, your business can benefit by lowering its tax burden.
We will address the following in this article:
- What Is the R&D Tax Credit?
- Who Is Eligible for the R&D Tax Credit?
- How Businesses Benefit from R&D Tax Credit?
- R&D Tax Credits: 5 Misconceptions that Keep Business from Applying
- The Four-Part Test: Are You Eligible for R&D Tax Credit?
- How to Claim the R&D Tax Credit?
- Does R&D Credit Lead to Increased IRS Scrutiny?
- How Tax Reform Impacted the R&D Tax Credit
What Is the R&D Tax Credit?
R&D tax credits can be defined as a government incentive to encourage investment in innovation. It is available to businesses developing new and improved business components that enhance functionality, reliability, performance, or quality.
Companies can attain R&D tax credits on several business components, including products, computer software, processes, techniques, and inventions to enhance functionality, reliability, performance, or quality. It is available on both the federal and state level. Over 30 states offer R&D tax credits to companies investing in innovation. [Back to Top]
Who Is Eligible for the R&D Tax Credit?
Wondering how to calculate the R&D tax credit? First, determine if your business is eligible. One of the leading reasons businesses fail to benefit from R&D tax credit is a lack of clarity regarding R&D tax credit eligibility.
The eligibility criteria for R&D credit are much broader than many companies realize, encompassing product development and several activities and operations.
Companies investing in new manufacturing processes and quality enhancements may be eligible for R&D tax credits. You may be eligible to apply for R&D tax credits if your business devotes resources and time for any of the following purposes:
- Creating new and innovative products
- Enhancing existing products
- Hiring scientists, engineers, or designers that devote their time to the R&D process
- Developing patents, new processes, or software
Start-ups are also strong contenders for R&D tax credits, which can be utilized to offset their payroll tax for up to the first five years of operation. Also, keep in mind that R&D tax credits are retroactive. Meaning, you may be able to claim R&D credits for up to the past three open tax years for federal and in most states, depending on when you filed your tax returns.
R&D Credit Eligibility Examples
Businesses operating in the technology industry are strong contenders for R&D tax credits. For example, software companies make a natural fit for R&D tax credits due to an abundance of research and innovation in the field.
The total amount of credit that can be claimed each year depends on multiple factors, including how much a company invests in innovation. In many cases, software and technology companies can save 10% to 15% of the total qualified expenses. Another deciding factor is the salary amount paid to software engineers who were employed by the company to work on the R&D process.
The food, beverage, hospitality, and leisure industries are also full of opportunities. Companies operating in these fields are continually developing new and improved products to meet high consumer expectations. They also invest heavily in evaluating and improving their equipment and processes to improve quality and reduce costs.
Moreover, following the COVID-19 pandemic, these industries have been at the forefront of innovation to improve employee, product, and customer safety. Considering the innovation and development activities across these industries, businesses operating in these sectors are likely eligible for the R&D tax credit. The amount of claim primarily depends on expenses geared towards product or process innovation instead of revenue generated by the company. [Back to Top]
How Businesses Can Benefit from R&D Tax Credit
R&D tax credits can help businesses invest in innovation and improvement, creating improved products, services, and processes that ultimately help businesses on several levels. From gaining a competitive edge over competitors to gaining a greater market share and improving revenue, companies can benefit from R&D credits in many ways.
The financial aspect of the business is also impacted by the R&D tax credit. It acts as an extra source of cash for businesses. Moreover, it is important to understand that R&D is a dollar-for-dollar tax saving, which means it helps in reducing the company’s tax liability.
Further good news is that there is no limit on the amount of credit or expenses that can be claimed each year. In case the company cannot utilize the federal R&D credit immediately or completely, the remaining credits can be carried forward for up to twenty years and carried back one year for federal tax purposes. The rules may vary from state to state for the R&D credit.
The R&D tax credit also creates an additional tax benefit for start-ups and small companies thanks to the 2015 Act – Protecting Americans from Tax Hikes (PATH). Furthermore, the R&D cash credit is permanent, which means businesses can incorporate it into their annual tax planning to gain maximum benefits. [Back to Top]
R&D Tax Credits: 5 Misconceptions that Keep Business from Applying
Despite the several benefits of R&D tax credits, many companies give in to common misconceptions that prevent them from claiming the credit. Here are the top five reasons why companies think they do not qualify for the R&D tax credit.
1. Business Is Not Focused on Research & Development
R&D credits are not only for businesses operating in science, innovation, or high-tech sectors that indulge in high levels of research. You do not require dedicated R&D laboratories to be eligible. You may be eligible for the R&D credit even if the company is not primarily focused on R&D.
As long as research and experimentation are part of the process, it does not matter where it takes place. For example, many companies that are deemed eligible for R&D tax credit perform R&D in their test kitchens, wineries, distilleries, open fields, or even the production areas.
2. Employees Do Not Possess Degrees
Companies that hire a large number of engineers, scientists, and other specialized degree holders are the ideal candidates for the R&D tax credit. It is because these tax credits and incentives are provided to encourage research and development in fields related to hard science. A large number of engineers and scientists on the payroll indicates that the nature of work may be innovative or research related.
However, not having specialized professionals on the employee list does not mean you are ineligible to apply for R&D tax credits. Employees may come from different backgrounds and possess different job titles. Moreover, research and experimentation performed by third-party contractors who engage in project or process improvement may also be included. [Back to Top]
3. The Company Does Not Pay Federal Income Tax
A common misconception is that if a company is not yet paying federal income tax, it is not eligible to apply for federal income tax incentives.
Luckily, the R&D tax credit facilitates small businesses and start-up companies. In other words, small business and start-up companies may be eligible to claim up to $25,000 per year for up to five years in a total amount of $1.25 million ($250,000 x 5 years) to offset payroll taxes. Companies that are eligible for R&D tax credits check two main boxes:
- They possess less than $5 million in gross receipt for the credit year.
- They have gross receipts for five years or fewer – interest income is included in the gross receipts.
Wondering how to calculate the R&D tax credit in this case? The amount is based on the usual federal income tax return and may be applied against payroll taxes beginning the quarter following the elected credit. On the other hand, calendar-year taxpayers can apply for R&D credit against payroll taxes by the fourth month of the next year.
4. The Company Is Not Working on Novel Products or Services
R&D covers a wide range of activities and processes – not just the development of something “new” that the world has not witnessed before. Therefore, R&D tax credits are for companies that research, design, develop, or simply improve on existing processes, products, techniques, software, or formulas.
All these activities contribute to innovation and result in enhanced business performance. The bottom line is that R&D tax credit is not limited to activities geared towards “invention” only. You may be eligible to apply for R&D credit tax as long as your business activities include “innovation.”
5. Business Subject to Alternative Minimum Tax
Many times, companies do not benefit fully from R&D credit tax because either the company or its shareholders are subject to the Alternative Minimum Tax (AMT). An AMT tax places a floor on the tax percentage that the filer – company or shareholders in this case – must pay regardless of any number of credits or deductions. However, that is no longer the case.
For tax years after January 1, 2016, individuals, and eligible small businesses subject to AMT, can offset their AMT and regular taxes with the R&D tax credit. Eligible small businesses, more commonly known as ESBs, can be defined as companies that are non-publicly traded and have maintained average annual gross receipts of $50 million or less for the last three years. [Back to Top]
The Four-Part Test: Are You Eligible for R&D Tax Credit?
With the common misconceptions surrounding R&D tax credit eligibility cleared, you can determine if your business is eligible. The best approach is to determine if the company’s operations meet the criteria established by the Four-Part Test explained below.
Four-Part Test for Determining R&D Tax Credit Eligibility
The four-part test is set forth in the Internal Revenue Code (IRC) and Treasury Regulations. Many companies find their business activities are related to “innovation” after considering the four-part test.
Part 1— Qualified Purpose
Identify the purpose of the research. In order to be eligible for R&D tax credits, the purpose of research carried out by the business must be to improve on an existing business component or develop an entirely new business component.
A great advantage is that the definition of business components is extremely broad, covering everything from products, software, and processes, to techniques, inventions, and formulas. Furthermore, the goal of the research should be to enhance the function, performance, quality, or reliability of the business component.
Part 2—Elimination of Uncertainty
If you are applying for the R&D tax credit, you must be able to demonstrate that there is uncertainty involved in the R&D process and you intend to develop methods to eliminate that uncertainty in order to improve or develop business components.
You can do that by providing information regarding methods, designs, or techniques that establishes your company’s capability to improve or create business components. Even if you are confident in your abilities to achieve technical objectives, uncertainty exists in the process and you will be required to eliminate that uncertainty.
Part 3—Experimentation Process
To pass the four-part test for R&D tax credit eligibility, the company must also demonstrate that it has one or more alternatives for achieving its goals. It can be done in multiple ways, such as through modeling, systematic trial and error, simulation, or other methods.
Once again, it works in favor of most companies as several activities and processes naturally follow an iterative trial and error process. Common examples include software development, engineering processes, and clinical research activities.
Part 4—Technological Nature
The nature of research and experimentation must rely on hard science, including engineering, computer science, physics, chemistry, and biology. Keep in mind that companies are not required to perform groundbreaking research in these fields to exceed, refine, or expand existing principles. [Back to Top]
How to Claim the R&D Tax Credit?
Businesses must understand how to calculate the R&D tax credit and how to claim it. The total amount of R&D tax credits that a company can claim depends on multiple factors and can be challenging to calculate. However, the effort is worthwhile as the R&D tax credit can bring down the overall tax burden on a company.
Plus, companies that have never received R&D tax credit can take a look at open tax years to claim any opportunities they might have missed in the past. Typically, companies can consider three to four years, depending on when the tax returns were filed.
In cases where the business does not have a taxable income or the tax credit use is limited, the federal R&D tax credit can be carried forward for up to twenty years. Another option is to use it to offset the company’s payroll tax. State tax credits can also be carried forward; however, the duration varies from state to state.
Necessary Documentation to Claim the Credit
Documentation of R&D activities may play a pivotal role for companies that have claimed R&D tax credits or plan to do so in the future. Here it is important to reiterate that R&D tax credits can be reclaimed for both current and previous tax years.
Therefore, documenting all R&D activities can help position the company to increase the number of credits.
To claim tax credits, R&D documentation must establish the amount of expenses on qualified research activities. The documentation must be contemporaneous.
Examples of contemporaneous documentation can include payroll records, project lists, project notes, general ledger and expense details, laboratory results, emails, and any other documents that the company produces on a regular basis during the course of business.
Combined with reliable employee testimony, such contemporaneous records can lead to a successful R&D credit claim. [Back to Top]
Does R&D Credit Lead to Increased IRS Scrutiny?
The Internal Revenue Service (IRS) regards claims for the R&D tax credit as a “Tier One” priority. It means that these claims are examined very carefully to determine company eligibility and validity of the claim.
Therefore, whether a company is already benefiting from tax credits or wants to determine eligibility, it must know how to calculate the R&D tax credit and document the activities properly. Otherwise, it may be looking at credit claim disallowance as R&D credits lead to increased IRS scrutiny.
However, increased scrutiny should not be a problem if you are eligible and document all R&D activities. Here are some taxpayer-friendly facts regarding qualified research expenses that may work in your favor.
- Companies do not have to employ professionals with specialized degrees to establish that they participated in technical activities as part of R&D.
- The time span for solving technical uncertainties is not limited to the credit year. Therefore, technical uncertainties can span more than a year.
How Tax Reform Impacted the R&D Tax Credit
Increased Credit, Decreased Tax Rates
Under IRC Section 174, taxpayers were not allowed to take a deduction equal to the amount of R&D credit. As a result, companies could not enjoy double tax benefits. They were also required to bring down their R&D expenses by the amount of the credit. The expense reduction created an income increase. Consequently, the corresponding taxes also hiked.
In line with IRC Section 280 C(c) (3), taxpayers could prevent a reduction in research expenses by opting for reduced credit. However, as the maximum corporate tax rate was reduced, the AMT rate was eliminated, boosting credits.
Retention of ESBs Credits
Prior to the tax reform, owners of pass-through companies and businesses with average revenue of less than $50 million over three years were deemed eligible to use the R&D credit to offset AMT. However, TCJA eliminated AMT, benefiting individual taxpayers and allowing them to benefit from businesses in which they have ownership.
Retention of Qualified Small Businesses and Start-Up Payroll Credits
Start-ups with less than $5 million in revenue can make select options that allow them to offset payroll taxes for up to the first five years they have gross receipts. They can offset up to $250,000 in payroll taxes.
Usability for Individual Taxpayers
Prior to tax reforms, AMT at the individual level kept business owners from using R&D credits. Fortunately, things have changed. AMT exemptions for individuals are on the rise. In other words, individual taxpayers can employ credits from their businesses. [Back to Top]
Windes Can Help. As the leading accounting firm, we deliver tax, accounting, and consulting services to help businesses. Our experts understand how to calculate the R&D tax credit and provide high-value state and federal tax preparation expertise to maximize tax credits and incentives. For more information, connect with Windes at 844.494.6337 or send us a message at firstname.lastname@example.org. [Back to Top]