Article Summary
- What Is The R&D Tax Credit?
- Eligibility
- Benefits
- Misconceptions
- R&D Tax Credit Eligibility: The Four-Part Test
- Required Documentation
- Changes to the R&D tax credit in 2022
What is the R&D Tax Credit?
The R&D tax credit is available to companies developing improved or new business components, including products, processes, computer software, techniques, formulas or inventions, that result in new or improved functionality, performance, reliability, or quality. It’s available at the federal and state level, with over 30 states (including Texas) offering a credit to offset state tax liability.
It’s an underutilized tax credit that provides opportunities for reducing income tax liabilities that often save companies, small to large, thousands or hundreds of thousands of dollars per year. Many businesses aren’t benefiting from the R&D tax credit due to misconceptions regarding applicability and eligibility.
R&D Tax Credit Eligibility
Regardless of industry, any company that develops new or improved products, processes, or software could qualify under the US tax code. Qualification for the credit is much broader than it may sound because it includes not only physical and digital product development but also operational activities, such as software development, quality enhancements and new manufacturing processes. Start-ups are eligible to apply against their payroll taxes for five years.
Your company could qualify for the R&D tax credit if it:
- Provides time and resources to creating new or innovative products / processes
- Improves existing products or processes
- Develops software, prototypes, patents or processes
- Hires engineers, designers or scientists
Credits can be retroactive. You may be able to claim R&D credits for three prior open tax years, depending on when your claim was filed. Loss companies can go back further depending on state laws for prior claims.
R&D Tax Credit Benefits
No limit to the amount of expenses and credit that can be claimed each year as a dollar-for dollar tax savings that directly reduces tax liability. Although each state has its own carryover laws, if the federal R&D credit can’t be used completely, then any unused credit can be carried back one year or forward 20 years.
Misconceptions on Qualification
Assumptions which prevent companies from claiming the R&D tax credit:
1) No Company Focus on “R&D”
Wherever experimentation occurs, “R&D” may qualify. The credit is not limited to high-tech or sciences companies with dedicated research departments, laboratory, production floors or wineries. It includes technology, construction, retail, professional services, life sciences, health care, manufacturing and consumer services, communications and media, apparel, food & beverage, automotive, agribusiness, aerospace & defense and clean technology.
2) No Federal Income Tax Payments
Startups and small businesses may be eligible to apply up to $1.25 million or $250k each year for up to five years - of the federal R&D credit to offset the FICA portion of payroll taxes each year. Eligibility requires two factors:
- Have less than $5 mm in gross receipts for the credit year;
- Have no gross receipts or interest income dating > 5 years in arrears.
3) Employees Aren’t Degreed Engineers or Scientists
Experimentation performed by third-party contractors and employees who assist in the improvement of projects and processes may be included, regardless of different job titles or backgrounds. The spirit and aim of the credit was created to bolster research and experimentation based on the hard sciences which are largely available to several types of contributors.
4) The Business Is Subject to AMT (Alternative Minimum Tax)
For tax years starting on or after 1-1- 2016, individuals or eligible small businesses (ESBs) who are subject to AMT can offset regular taxes and AMT using the R&D tax credit. ESBs are non publicly traded companies with average revenue of $50mm or less over the three previous years. This means R&D credits that have been previously unusable for ESBs can now be applied to reduce AMT.
5) The Organization Isn’t Developing Anything New
The credit is designed to reward businesses that pursue innovation with increasing investment and is calculated on the basis of increases in research activities and expenditures for taxpayers that design, develop, or improve processes, products, techniques, formulas or software. R&D does not need to be new to the industry. It simply needs to be new to the company that meets the four-part test outlined below.
The Four-Part Test to Determine R&D Eligibility
The Internal Revenue Code (IRC) and Treasury Regulations put forth a four-part test which establishes the criteria to determine whether the work an organization does is eligible. Companies that see their activities to be common business practice may be surprised to learn that they are in-fact considered innovative once they explore the test.
- Technological in nature. The experimentation process relies on the “hard sciences” , such as computer science, engineering, software development, chemistry, biology or physics. Businesses aren't required to expand, exceed or refine existing scientific principles.
- Process of experimentation. A company needs to demonstrate via modeling, simulation, systematic trial and error or some other method - that it has evaluated one or more alternatives for achieving the desired result.
- Qualified purpose. The purpose of the research must be to create a new or improved business component that results in a new or improved function, performance, reliability, or quality. A business component can be a process, product, computer software, technique, formula or invention - all of which comprise a broad definition which applies to many different industries.
- Elimination of uncertainty. A company must demonstrate it has attempted to eliminate uncertainty about the development or improvement of a business component. Uncertainty exists if the information available to the company does not establish the capability or method for developing or improving the business component, or the appropriate design of the business component. Many companies are confident in their ability to achieve tech objectives or have an established method for finding solutions, but the design is not often known or defined at the project’s inception.
Required Documentation
Although taxpayer may estimate some research expenses, the underlying assumptions used to create the estimates must have a factual basis. In order to claim the credit, taxpayers need to evaluate and document the research activities contemporaneously to establish the amount of research expenses paid by each research activity.
Contemporaneous documentation examples include:
- Payroll records
- Project lists and notes
- EMails and other documents an organization produces within in the regular course of business
- General ledger expense details
- Lab results
These records in conjunction with credible employee testimony help create the basis of a proper R&D credit claim.
Changes to the R&D Tax Credit in 2022
According to Focused Energy, post 2021, organizations can no longer immediately expense costs that are treated as specified IRC Section 174 research expenses. Instead, they’ll need to charge US-based research expenses to a capital account and deduct them over a five-year period. Any expenses incurred for research performed outside of the United States will be charged to a capital account and deducted over a 15-year period.
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