What Businesses Qualify for the R&D Tax Credit and Which Expenses are Eligible?
The federal research and development tax credit (R&D credit) is one of the U.S. government’s primary means for rewarding businesses that invest money in research. It was initially implemented as a temporary measure in 1981, but was made permanent and expanded in 2015 through the Tax Cuts and Jobs Act. In addition to the federal R&D tax credit, many states provide businesses with a similar credit to promote innovation.
While the federal credit has proven to be popular, there have been several studies showing it is often underused by taxpayers who qualify. Additionally, many small businesses start-ups are not aware of how they can benefit from the credit through provisions that were added in 2015.
A Broad Array of Businesses Qualify for the Federal R&D Credit.
Not all of the businesses that qualify for the R&D credit consider themselves to be engaged in research and development. Many eligible businesses are simply trying to build something better than their competitors, or improve an existing product to stay ahead of the competition.
However, one common feature of most businesses that qualify for the credit is that they are undertaking some amount of risk as part of their business plan. That risk can be classified as either technical or economic. Companies taking on technical risk are those that attempting to manufacture or design a new product where there is a chance of failure. Economic risks are those in which a company will only be paid if they successfully launch a new product.
As a general rule, the businesses that qualify for the federal R&D tax credit tend to be those that do at least some of the following:
- Employ programmers, engineers, or scientists;
- Develop and improve new or existing products and processes;
- Build prototypes for testing purposes;
- Purchase raw materials for use in product development or improvement; or
- Contract out engineering, development or testing functions.
IRS Has Developed a Four-Part Test to Determine Credit Eligibility
If you think your business is eligible to claim the R&D credit, then you or an accounting professional needs to establish that the work you are doing meets the criteria the IRS has established for claiming the credit. These are known as “qualified research activities.” When conducting an audit the IRS is looking for these four things from a business:
Eliminating uncertainty. You must show the IRS that your company’s business activities are an attempt to eliminate uncertainty about the development or improvement of a product or process. In other words, you are improving a product for the consumers’ benefit, not just making cosmetic changes.
Experimentation. You must show that you are actively conducting experiments as part of your efforts at product development. There must be some aspect of trial and error, simulation or modeling that is part of your efforts.
Technological Involvement. The experimentation or simulations you are conducting must rely on some aspect of the hard sciences, whether it be computer, engineering, physical or biological science.
Business Purpose. You must show that the research being conducted is part of an effort to improve a marketable product or process that you are, or will be, offering the public.
Start-Ups and Newer Small Businesses Receive Additional Benefits.
Start-up companies and newer small businesses with less than $5 million in annual gross receipts may be eligible to claim a federal R&D credit of up to $250,000 annually for five years ($2.5 million total) to offset their Federal Insurance Contributions Act (FICA) payroll tax for those years. A qualifying business must also have no more than five years of gross receipts.
Qualifying businesses may apply the credit against its FICA payroll taxes beginning the quarter after claiming the credit.
R&D Credit May Be Claimed by Entities Paying the AMT
Until the passage of the Tax Cuts and Jobs Act in 2015 companies (and shareholders in the case of some pass-through entities) could not take advantage of the federal R&D credit if they were paying the alternative minimum tax (AMT). Under the act individuals and pass-through entities which are small businesses can use the R&D credit to offset both their regular taxes and AMT. To be eligible a small business must be a non-public company with an average revenue of no more than $50 million over the prior three years.
What Expenses Qualify for the Federal R&D Credit?
The IRS has also outlined specific qualified research expenses (QREs) necessary for claiming the credit. Those expenses include:
Wages. Wages that are paid employees who perform qualified research activities.
Supplies. Amounts that a business pays for supplies that are used to conduct qualified research activities. Property that is subject to the depreciation allowance does not qualify.
Contract research expenses. These are calculated as 65 % of any expenses paid or incurred by a person other than the taxpayer’s employee that the taxpayer may claim as qualified research activities, including computing services. The contractor must perform the research in the United States for the expenses to be eligible. The IRS has issued a three-part test which states that the expenses must be incurred under an agreement entered into before the research is performed, provide that the research is performed on behalf of the taxpayer, and requires the taxpayer to bear the expense of any unsuccessful research.
Documenting R&D Expenses for Claiming the Credit
The rules and regulations for the federal R&D credit do not lay out any specific record-keeping requirements for claiming the credit. This allows taxpayers some degree of flexibility when it comes to documenting their claims for the credit. However, there are some steps that businesses can take to make more difficult for the IRS to challenge claimed credits.
Businesses claiming the R&D credit should develop a methodology for tracking the wages of employees who are working on qualified research. Usually, this is done through some sort of time-tracking system which tracks the hours an employee works on projects qualifying for the credit.
As a general rule it is not difficult for businesses to track qualified supplies that are used for a qualified research activity. That is because the IRS will allow businesses to use their general ledger, invoices, purchase orders and charts of account as documentation.
Finally, qualified contract research expenses are generally documented using the following documentation: general ledgers, third-party contracts, Invoices, Form 1099s, purchase orders and charts of account.
California’s R&D Tax Credit
Like many states, California offers businesses that are conducting research activities in the state its own version of the R&D tax credit. That credit is available to C-corporations, S-Corporations, limited-liability companies and partnerships and is filed along with their California returns. To claim the California R&D credit a business must document its qualified R&D expenses and its gross receipts for the prior four years.
California businesses are allowed to claim the sum of 15 % of the qualified research expenses over the base period research expenses and 24 % of basic research expenses for university-based research for the taxable year. The unused credit may be carried forward indefinitely.
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This post was written by Sean Allaband