One of the surest ways to grow your business is to develop new products or services — or simply improve your existing ones. The time and money needed to conduct research and development processes, however, can seem like a burden that risks falling flat when it comes to return on investment.
Because investment in new technologies, products, and services is key to the health of the economy, it’s in the interest of the united states government to support these processes. That’s where the Research and Development (R&D) Tax Credit enters the equation. The R&D tax credit consistently ranks as one of the most valuable credits leveraged by companies to reap big savings when filing their taxes. Unfortunately, owing to a number of common misconceptions and lack of information, the credit is severely underutilized.
Our purpose in this guide is to introduce you to the R&D tax credit, how it works and whom it benefits, and how to take advantage of it to maximize your tax savings. We will also walk you through the info you need regarding documentation, including filling out IRS form 6765.
The Research and Development Tax Credit, also known as the Credit for Increasing Research Activities, is a business tax credit that helps companies that have spent money on research and development recoup some of these costs. The credit was first introduced in 1981 as a temporary measure to boost economic activity, but has since become a permanent part of the tax code.
While this article offers a clear breakdown of the credit, you can also learn more about how to qualify and the benefits of the R&D tax credit here.
Does your business qualify?
If your business has spent money on research and development in the past year, it’s likely that you qualify for the credit. While it’s commonly believed that only large corporations are able to take the credit, in fact, the R&D tax credit can be claimed by businesses of any size, and across a variety of industries. To qualify, your business simply needs to have engaged in what the IRS calls qualified research expenditures, or QREs.
We’ll discuss QREs in more depth below, but in general, if your company has attempted to develop new products or processes, or has worked to improve existing products or processes, you’ll likely qualify for the R&D tax credit.
How your business can use the R&D Tax Credit
If your business qualifies for the R&D tax credit, you’ll have some discretion over when and how you apply it. For most businesses that are currently turning a profit, the credit will be applied against the company’s income tax liabilities. For companies like startups that have yet to turn a profit, the credit is usually used to offset the company’s payroll liabilities.
Below, we’ve broken down a few common ways the R&D tax credit is used to maximize its benefit to your business:
1. Earning back 5% to 15% of funds spent on qualifying expenses
The amount of your refund will depend on the specifics of your business, but in its most basic form, the R&D tax credit will cover 5% to 15% of your qualified research expenditures. In other words, if your company spent $100,000 on legitimate research costs, you’ll be able to recoup between $5,000 and $15,000.
2. Using the credit to offset payroll taxes
One of the more common methods that small businesses use to claim the R&D tax credit, using it to offset payroll taxes, can be a huge boon for your business. To qualify, your gross receipts for the year in question will need to be lower than $5 million, and you can’t have gross receipts from more than five years ago.
If your business meets these requirements, you’ll be able to use the R&D tax credit to offset up to $250,000 in payroll taxes. You’ll apply the credit to your payroll taxes by selecting this method as an option when filing your income tax return. If you find out that you’ve been qualified for the credit multiple years in a row, you use the surplus-value of the credit to help cover some of your income tax liability as well.
3. Thinking back and looking ahead
If you failed to claim the credit in previous years, while still qualifying for it, you might still be able to access it. It’s possible to go back and amend your income tax return to incorporate the R&D tax credit, which would allow you to receive a refund for that year.
Businesses that haven’t yet achieved profitability but still have research and development expenses may feel like they’re missing out on the full benefits of the credit — if the R&D tax credit is greater than your actual income tax, it’s not refundable. Fortunately, businesses are allowed to carry forward unused portions of the credit for up to 20 years.
Which of your expenses qualify for the R&D Tax Credit?
In general, expenses that have been used to develop new products, technologies, or services, or improve existing products, technologies, and services, will qualify for the R&D tax credit. More specifically, the following activities will usually qualify:
- Engineering processes that involve design, data collection and analysis, and testing.
- Developing proprietary technologies.
- Improving technologies, including software, that power your business.
- Building product prototypes.
- Development processes, even if incomplete.
- Developing patents.
When it comes to the standards set by the IRS, there are four main categories of research and development costs that can be counted as legitimate expenses:
- Supplies. Supplies that were used during the research and development process can be counted as expenses, though they can’t be general administrative supplies that would otherwise be used in the course of ordinary operations.
- Wages. W-2 taxable wages going to employees who worked on, supported, or supervised research processes can be counted as expenses.
- Computer services. If you rented computers or took advantage of cloud service providers in the course of your research process, or used them to host software in development, you can count this as an expense.
- Outsourcing. Contract research — even including some subcontractor expenses — can still qualify for the credit (typically at a lower rate), as long as you retain substantial rights to the results.
How is the R&D Tax Credit calculated?
If your company qualifies for the R&D tax credit, there are standard ways to calculate it, both of which we’ll discuss below.
The standard method. Under this method, the R&D tax credit will be worth 20% of the company’s qualified research expenditures over a base amount, which will be a product of a fixed-base percentage and the average annual gross receipts from the past four years.
The Alternative Simplified Credit method. Under this method, the R&D tax credit is worth 14% of the company’s qualified research expenditures over 50% of its average QREs from the past three years. If there are no QREs from previous years, the credit is worth 6% of the current year’s QREs.
How should you choose between the methods? Consulting with tax experts can help you make the best decision, but in general, companies who are new to claiming the credit will find the ASC method slightly easier.
How to claim/apply for R&D Tax Credits
Figuring out how to claim the R&D tax credit, and then how to best apply it to receive the most benefit, can be a difficult process. Below, we’ve broken down how to determine if you qualify, how to claim the credit, how to apply it, and which documents you’ll need to claim it.
The R&D Tax Credit Claim Process
Claiming the R&D tax credit can seem like a difficult process, but it essentially comes down to three major steps:
- Studying your processes. Internally, you’ll want to review the research and development processes that you intend to claim. Which activities did you undertake, and how much did they cost? This step will involve checking and reviewing your bookkeeping and other internal business documents.
- Making your case. Once you have a good grasp of the R&D activities your company undertook, you’ll build your case by gathering the proper documentation to serve as proof for the IRS, as well as filing the relevant forms, which will list the total expenses you’re claiming.
- Applying the credit. To claim the credit, you’ll complete Form 6765 and file it along with your business’s federal income tax return.
How to Apply the Federal R&D TAX Credit to Payroll Taxes
In some cases, the R&D tax credit can be used to offset a company’s federal payroll tax. This might be a good strategy for new companies or startups that tend to have smaller tax liabilities and larger research expenses. To qualify, a company needs five or fewer years of gross receipts and less than $5 million in gross receipts for the year the credit is being claimed. Applying the R&D credit to your company’s payroll taxes needs to be done on an income tax form filed in a timely fashion. From there, the credit will cover up to $250,000 of the employer’s portion of Social Security payroll taxes.
The Four-Part Test to Determine Whether You Qualify
Here is a simple, four-part test that can help you determine whether your business qualifies for the federal R&D tax credit and the potential benefits it offers. Under IRS Section 41, your company’s activities must meet these criteria to be considered qualified research expenditures.
1. 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.
2.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.
3.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 as a credit to the relevant business component.
4.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 treat an expense as a qualified research expenditure, a company must be able to establish that all four of the above tests have been met.
As with any credit, proper documentation is essential for successfully receiving the benefits of the credit, while also avoiding the potential for an audit. When claiming the R&D tax credit, you should prepare the following documentation and records:
- Form 6765. The standard IRS form to figure and claim the credit for increasing research activities.
- A clear list of research and development activities that qualify for the credit, according to the four-part test described above.
- Substantiating information for qualified research expenses — in other words, documents that prove your claim, including wage reports, supplies, and other research expenses and receipts.
- Time-tracking information for employees whose W-2 taxable wages are being claimed as part of the credit.
- Contracts and other subsidiary information if you outsourced any elements of the research and development process.
What are the benefits of the R&D Tax Credit?
The primary purpose of the R&D tax credit is to boost economic activity by encouraging companies to innovate and invest in new technologies, products, and services. For individual businesses that claim the credit, the benefits include:
- Improved cash flow.
- Reduced federal and state taxes.
- Increased market value.
- Lowered effective tax rate.
- More profits in hand.
Which businesses are eligible?
The R&D tax credit often goes unclaimed by companies and businesses that qualify for it, simply because it’s so little understood. In fact, some estimates suggest that there are 6,000,000 corporations in the US eligible for the credit, while on average only around 20,000 companies claim it each year. To put it another way, according to the National Science Foundation, in 2010 almost $9 billion in R&D tax credits were claimed — while an additional $4 billion went unclaimed.
Contrary to what many people think, the R&D tax credit is open to companies of all sizes. In fact, roughly half of all companies that claim the credit are classifiable as small or middle-sized businesses. Qualifying for the credit depends only on whether or not your company spent money on qualified activities that the IRS considers to fall under the umbrella of research and development.
While this isn’t an exhaustive list, these are some of the industries that often qualify for the R&D tax credit:
- Software and Tech
- Financial Services
- Food and Beverage Production
- Pharmaceuticals, Healthcare, and Life Sciences
Regardless of your industry, it’s a good idea to investigate potential tax credits that could improve your financial performance. Doing so won’t only ensure you’re taking advantage of all the possible credits at your disposal — it can also give you insight into ways you might reallocate funds or spending to maximize your tax benefits.
How does the R&D Tax Credit benefit industries?
The R&D tax credit can offer a number of important benefits — including cost savings and the ability to fuel growth — to a number of industries. As we’ve seen, misunderstandings about what might qualify a business for the R&D tax credit can prevent companies from taking advantage of this valuable asset. Below, we’ve broken down some common industries that can benefit from the R&D tax credit.
Unsurprisingly, tech companies — think companies involved in software or app development, electronics, or even telecommunications — have a lot to gain from the R&D tax credit. As the pace of technological innovation continues to grow, most tech companies will invest in data analysis, product design and development, and testing as a matter of course. Even if these processes are aimed at optimizing current technologies rather than developing new ones, they can still qualify for the R&D tax credit.
To learn more about how the R&D tax credit can be applied to software companies, click here.
If your business model incorporates some aspect of the engineering process, you likely qualify for the R&D tax credit. Developing new designs or creating new products are activities that typically require a large amount of research and testing, which means they’ll typically meet the R&D tax credit requirements.
Manufacturing is probably the widest umbrella in terms of industries that qualify for the R&D tax credit. If your company engages in a number of common internal processes, from customer analysis to part or product design, and even establishing your production line, you probably meet the R&D tax credit requirements.
Life and natural sciences
Pharmaceutical and biotechnology companies, manufacturers of medical devices, and even agricultural companies all typically qualify for the R&D tax credit. Since many of these industries rely heavily on high-quality research processes, they’ll easily meet the requirements, but there are other ways to qualify as well. Product testing, lab maintenance, and any attempts to improve an existing product will all typically qualify a company for the R&D tax credit.
Common myths and misconceptions
Many businesses that easily meet the requirements for the R&D tax credit don’t take advantage of it, simply because they aren’t aware they qualify. We’ve broken down some of the most common myths and misconceptions surrounding the R&D tax credit below.
1. What exactly qualifies as “research”
Most companies are convinced that if they don’t have a team of PhDs constantly conducting cutting-edge studies, they aren’t really doing research. But that’s simply not true. The definition provided by the IRS is broad enough that a wide variety of activities can qualify a company for the R&D tax credit, from researching customer behavior to improving a pharmaceutical recipe and even designing a building.
2. How “risky” claiming the credit is
Because the R&D tax credit initially began as a temporary incentive, the rumor persists that claiming the credit might increase your company’s chance of being audited. Again, this simply isn’t true. As a permanent incentive, the R&D tax credit is designed to encourage companies to develop new products and technologies.
Of course, it’s still possible you might experience an audit, which is why it’s important to make sure you’ve filed properly, and have the right documentation prepared, just in case. Working with an experienced tax preparation expert can make sure you’re ready to answer the questions the IRS might ask you — as well as making sure you safely get the most out of the R&D tax credit.
3. How “successful” your company is
A common misconception is that only profitable companies are able to claim the R&D tax credit. In fact, the PATH Act of 2015 introduced new changes to the R&D credit, one of the most important of which makes it easy for startups and other companies that haven’t yet turned a profit to access the credit. The new change allows businesses to reclaim part of their R&D investment by reducing their payroll tax liability.
How much money can I expect from the R&D Tax Credit?
The federal R&D tax credit is typically worth up to 15% of qualified research expenditures, or up to $250,000 of payroll costs each year, meaning successfully applying for the credit could potentially save your company millions of dollars over a period of several years. In more specific terms, companies will usually receive a credit of between 5% and 15% of the total amount of expenses that meet the requirements of the IRS.
In addition, most states in the US offer their own version of the R&D credit, which can further increase the value of this deduction for companies that qualify.
How to maximize your R&D Tax Credit while having your PPP loan forgiven
One of the key stimulus initiatives of the CARES Act is the Paycheck Protection Program, or PPP, which offers forgivable loans to small and medium-sized businesses to help cover payroll, mortgage or rent payments, and utilities. Understanding how a PPP loan will impact your company’s tax filings can be a difficult matter, however.
According to the latest guidance from the IRS, federal income tax deductions are allowed for any of a business’s expenses that have been covered by a forgiven loan, which includes PPP loans. In other words, if the Qualified Research Expenditures (QREs) that make up the R&D tax credit are also expenses covered by a PPP loan, you can use them to claim the credit.
How to take advantage of the R&D Tax Credit and the Employee Retention Credit
Another initiative of the CARES Act, the Employee Retention Credit, or ERC, provides employers with a refundable tax credit for employee wages and health plan expenses paid while the company’s operations were fully or partially suspended due to a pandemic-related shutdown. You cannot use the same wages to calculate both the ERC and the R&D tax credit.
If you’re interested in learning more about the Employee Retention Tax Credit, how it might interact with the R&D Tax Credit, and how you can leverage it to maximize your tax benefits, you can visit our website here.
You may want to consult these helpful resources
For more information about the R&D tax credit, and to find out whether you qualify, consider taking a look at some of the resources below:
- To find out if your business qualifies, check Section 41 of the Internal Revenue Code and its related regulations.
- To better understand the information you’ll need to successfully claim the credit, take a look at Form 6765, the standard IRS form to figure and claim the credit for increasing research activities.
- To understand how small businesses can claim a payroll tax credit for increasing research activities, consider Notice 2017-23.
- To learn about the Employee Retention Credit, an initiative of the CARES Act, visit the IRS – Employee Retention Credit webpage.
How a CPA firm can help, or why you need a tax expert
The R&D tax credit commonly goes unclaimed because of misinformation and lack of knowledge, but that doesn’t mean deciding to claim it is necessarily an easy process. The R&D tax credit is a complex credit based on projects, meaning that your research needs to actually qualify for the credit. From there, it needs to be properly and accurately documented. Bringing in an experienced tax expert can ensure you’re claiming as large a credit as possible, and that you’ll be doing it successfully.
In other words, you need someone who knows taxes and understands research and development processes and practices.
Our Approach To R&D Tax Claims
At Holtzman, we pride ourselves on our deep experience with the R&D tax credit. We offer end-to-end service aimed at taking the lead in the claim research and filing process, while our deep expertise and experience with documentation means that even in the off chance of an audit, you’ll be protected.
Simply put, our team of tax experts is well versed in the intricacies of R&D tax credits. For more information about this incentive or reducing your company’s risk of facing penalties, consider checking out our Tax Services today, or get in touch with any questions.