Co-authored by the Holtzman Tax Team
The Research and Development (R&D) Tax Credit has been one of the most valuable credits leveraged by companies, resulting in big savings during tax time. Unfortunately, it is severely underutilized. We often hear that many companies are not fully benefiting from the R&D credit because of common misconceptions about how the incentive applies to their operations. According to AICPA, “Many are unaware of the R&D credit; those that are aware may not believe it applies to them, and those that believe it applies to them may not believe they have enough expenditures to justify claiming it.”
The truth is this tax credit is available to businesses of all sizes across a wide range of industries, not just major corporations. Every year, the R&D credit provides billions of dollars in federal and state benefits to businesses of many sizes for increasing their investment in qualified research activities in the U.S. engaged in qualifying research. Currently, the incentive is available at the federal and state level through certain wage, supply, and contract research expenditures with qualifying R&D activities and projects identified as qualified research expenditures (QREs).
Here is a simple, four-part test can help determine whether your business qualifies for the federal tax credit and the potential benefits it brings to your business:
Note: Companies’ research activities must qualify under IRS Section 41 to be considered qualified research activities for the R&D Tax Credit.
- Section 174 Test: Expenditures must be incurred in connection with the taxpayer’s trade or business and eliminate uncertainty concerning the development or improvement of a product.
- Discovering Technological Information Test: The process of experimentation used to discover information must fundamentally rely on principles of the physical or biological sciences, engineering, or computer science.
- Business Component Test: Companies must intend to apply the information being discovered to develop a new or improved business component. The company must be able to tie the research it is claiming a credit to the relevant business component.
- Experimentation Test: A process designed to evaluate one or more alternatives to achieve a result where the capability or the method of achieving that result, or the appropriate design of that result, is uncertain as of the beginning of the taxpayer’s research activities.
To be treated as qualified research the company must be able to establish that all four of the above tests have been met.
Payroll Tax Offset
A qualified small business (QSB) can apply part or all their research credit against their payroll tax liability instead of the income tax liability.
A QSB for purposes of electing the payroll tax credit is a corporation (including a S corporation) or partnership with no gross receipts for any tax year before the 5-tax-year period ending with the tax year and gross receipts of less than $5 million for the tax year.
The election for the payroll tax credit must be made at the entity level on a timely filed income tax or informational return, including extensions. The payroll tax election cannot be taken if the QSB has made the election for five or more preceding tax years. The payroll tax credit can be applied to offset the employer portion of social security tax up to $250,000 starting in the first calendar quarter following the date on which the return is filed. An excess payroll tax credit is carried over to the next calendar quarter.
Potential Benefits of the R&D Tax Credit?
There are several benefits to realizing the R&D tax credit. Here is one example of how this applies at the federal level with the payroll tax offset credit and at the state level with the offset of the Texas franchise tax liability.
A technology company in year 2 had $4,200,000 in gross receipts with expenditures totaling $3,000,000 in labor and $500,000 of contract labor. After performing the R&D study, our client had approximately $2,500,000 in total QRE. After completing the R&D calculation, the client received a total R&D credit of $200,000. Since the R&D credit was below the $250,000 the client was able to use the entire R&D credit as a payroll tax offset. The client also utilized their R&D expenditures to help offset the franchise tax due in Texas by calculating a $25,000 credit at the state level. Texas allows companies to offset up to 50% of their current franchise tax liability and then carry forward any excess.
Other Potential Benefits
- Improve cash flow
- Carry forward the credit up to 20 years
- Reduce your effective tax rate
The R&D Tax Credit can provide many benefits to U.S. companies that increase their investment in qualified research activities. As a first step, a company should review its operations for eligible activities. For a research activity to be considered qualified it must meet all parts of the four-part test. If the company is considered a QSB it can also qualify for the Payroll Tax Offset. Larger companies that do not qualify for the Payroll Tax Offset can still receive various benefits from the R&D Tax Credit.
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