R&D Tax Credit: One Of IRS's Greatest Tax Incentives You Might Be Missing
Unfortunately a lot of businesses are missing on Research and Development Tax Credit (R&D) opportunity, mainly because the name "research" is a little intimidating for them and they are not sure what the qualifications are. One important thing to know about R&D Credit is that you do not need to be a big corporation in order to qualify for this credit.
R&D credit is available to companies and businesses of all sizes and wide range of categories. Your business need NOT to be in technology or science industry to qualify for R&D credit (a major misconception among most small business owners).
R&D credit is available to companies and businesses of all sizes and wide range of categories. Your business need NOT to be in technology or science industry to qualify for R&D credit (a major misconception among most small business owners).
What is R&D Tax Credit?
The R&D Tax Credit was first implemented in 1981 to encourage US companies to hire new employees, develop and improve new products and services and techniques, and facilitate the growth of the operation. This credit is a dollar-for-dollar credit against the company's income tax. It is subject to the limitation of general business credit. If you cannot utilize the entire amount of R&D credit in your current or prior year tax return, you can carry it forward for 20 years.
This credit is available both for Federal tax and State tax. The Federal credit is listed under Internal Revenue Code (IRC) 41. Most States have their own R&D Credit. The only State that do NOT R&D credit are: Alabama, Michigan, Mississippi, Missouri, Nevada, North Carolina, Oklahoma, Oregon, South Carolina, Tennessee, Washington, West Virginia, Wyoming, and Washington DC. Please not that even if your state does not have an R&D Credit, you still can claim the R&D credit on your federal tax return. In 2003, the congress removed the phrase "new to the world" and replaced it with "new to the taxpayer". This opened the door for many business who did not invent something new, but still were qualified for this credit. In 2015, this credit became a permanent credit, and also it was modified to better benefit small and mid-size businesses and start- ups. According to the IRS, a small business is defined as a business that its average gross receipts for the prior three years is $50 million or less.
This credit is available both for Federal tax and State tax. The Federal credit is listed under Internal Revenue Code (IRC) 41. Most States have their own R&D Credit. The only State that do NOT R&D credit are: Alabama, Michigan, Mississippi, Missouri, Nevada, North Carolina, Oklahoma, Oregon, South Carolina, Tennessee, Washington, West Virginia, Wyoming, and Washington DC. Please not that even if your state does not have an R&D Credit, you still can claim the R&D credit on your federal tax return. In 2003, the congress removed the phrase "new to the world" and replaced it with "new to the taxpayer". This opened the door for many business who did not invent something new, but still were qualified for this credit. In 2015, this credit became a permanent credit, and also it was modified to better benefit small and mid-size businesses and start- ups. According to the IRS, a small business is defined as a business that its average gross receipts for the prior three years is $50 million or less.
Who IS Qualified For The R&D Tax Credit?
To simplify the answer, Federal R&D tax Credit is available to any individual or business that performs significant R&D activities. The company doe snot necessarily have to be technological, scientific, or medical (as most people assume), Although it certainly can be as well. And the main factors regarding "performing significant R&D activities" are as follow:
The Four Part Test
According to IRC § 41, your research activities must meet the "four part test" to qualify for the R&D tax credit.
Qualified R&D expenditure
The following Qualified Research Expenses (QRE) determine your R&D Tax Credit amount:
Non-Qualified Activities
The following are examples of activities that do not qualify for R&D credit:
- Doing actives to develop or improve products, serves, or techniques
- Doing activities that involve application of principles of physics, biology, engineering, or computer science.
- Doing activities that involves evaluation of alternatives used to eliminate technological uncertainties faced during the development process
The Four Part Test
According to IRC § 41, your research activities must meet the "four part test" to qualify for the R&D tax credit.
- Permitted/Qualified Purpose: The purpose of the R&D activity must be to improve the functionality, performance, reliability, or quality of products, software, techniques, formula, or invention that you intend to use in your business.
- Technological Uncertainty: You faced uncertainty regarding the feasibility, design, or methods in your development.
- Process of Experimentation: You conducted activities evaluating alternatives through modeling, simulation, try-and-error, or other methods.
- Technological Nature: The success or failure of your research and development can be determined by principles of Physics, chemistry, engineering, biology, computer science, or other natural or "hard" sciences as opposed to other principles such as economics, consumer performance, etc.
Qualified R&D expenditure
The following Qualified Research Expenses (QRE) determine your R&D Tax Credit amount:
- Taxable wages that are paid to employee who are are directly conducting or supervising qualified activities.
- Cost of supplies used during your research and development process
- Rental or lease cost of computers that were used for your R&D activities
- Contract research expenses that were paid to a third party to perform qualified activities on your behalf, regardless of their success or failure. Please note that IRS regulation allows contract research expenses at 65% of the total cost incurred, and that you must retain substantial right to the result of the activity
Non-Qualified Activities
The following are examples of activities that do not qualify for R&D credit:
- Research activities performed outside the United States.
- Research after beginning commercial production of the business component.
- research related to customize component for a particular customer.
- Activities that are heavily reliant on social sciences, art, or humanities.
- Activities that collect routine data for quality control of existing processes.
- Activities related to market research.
- Activities that adapt or duplicate publicly available information.
- Activities founded by unrelated third party, who retains the rights to intellectual property and carries the financial risk in conducting the research and development.
What Should I Do To Claim The R&D Tax Credit?
The first and foremost thing you need to do in order to claim R&D tax credit is to document your expenses related to research and development. Examples of documentation includes:
How To Calculate R&D Tax Credit?
There are two methods to calculate the tax credit:
Regular Method:
Under the this method, the research credit for the taxable year is equal to the sum of 20% of the excess of the qualified research expenses over the base amount.The base amount is the sum of the fixed-base percentage and the average annual gross receipts of the taxpayer for the four years prior to the credit year.
A fixed-base percentage is the “percentage which the aggregate qualified research expenses of the taxpayer for taxable years beginning December 31, 1983, and before January 1, 1989, is of the aggregate gross receipts of the taxpayer for such taxable years.”
Alternative Simplified Credit Method:
Under ASC method, a business can claim 14% of the amount of qualified research expenses for the credit year as long as it exceeds 50% of the average qualified research expenses for the three prior taxable years.In addition, a company that did not have qualified research expenses in any one of the three preceding tax years can claim a credit equal to 6% of its qualified expenses during the current tax year.
Once the ASC method is used, you are NOT allowed to implement the regular method for any succeeding years.
- Payroll records
- General ledger expenses detail
- Project lists, notes, goals, strategies, etc.
- Testimony from credible employees (if needed)
How To Calculate R&D Tax Credit?
There are two methods to calculate the tax credit:
Regular Method:
Under the this method, the research credit for the taxable year is equal to the sum of 20% of the excess of the qualified research expenses over the base amount.The base amount is the sum of the fixed-base percentage and the average annual gross receipts of the taxpayer for the four years prior to the credit year.
A fixed-base percentage is the “percentage which the aggregate qualified research expenses of the taxpayer for taxable years beginning December 31, 1983, and before January 1, 1989, is of the aggregate gross receipts of the taxpayer for such taxable years.”
Alternative Simplified Credit Method:
Under ASC method, a business can claim 14% of the amount of qualified research expenses for the credit year as long as it exceeds 50% of the average qualified research expenses for the three prior taxable years.In addition, a company that did not have qualified research expenses in any one of the three preceding tax years can claim a credit equal to 6% of its qualified expenses during the current tax year.
Once the ASC method is used, you are NOT allowed to implement the regular method for any succeeding years.
We Can Help
Although R&D Tax Credit evaluation and calculation can be costly and time consuming, its potential tax savings are too significant not to explore its possibility. Here at Quintessential Tax Services, we work with clients of all size to evaluate and implement R&D Tax Credit for their business. Please contact us a free first time consultation.