Research & Development Tax Credit
Each year the US government provides billions of dollars to innovative businesses for developing new or improving existing technologies, products, materials, and processes, under the Research & Development (R&D) Tax Credit program. And each year, billions more go unclaimed because many companies either don’t know it exists, don’t think it applies to them or don’t understand how it might benefit. Furthermore, many companies that have claimed R&D benefits have not taken full advantage of them.
The R&D tax credit program can be difficult to understand and navigate. To help, we’ve compiled answers to some the most common questions we’ve received to help you simplify the process.
What Is the R&D Tax Credit?
The R&D tax credit, also known as the Research and Experimentation (R&E) tax credit, is a government incentive designed to reward companies for investing in innovation. Starting as a temporary, trial-based credit in 1981, this program became a permanent part of the federal tax code in 2015 due to its success in stimulating job creation and helping to grow the U.S. as an economic leader. The rules of the R&D tax credit can be found under Internal Revenue Code (IRC) Section 41 and the related regulations. The credit applies to any taxpayer that incurs expenses for performing Qualified Research Activities (QRA) on U.S. soil.
What Are the Benefits of the R&D Tax Credit?
Some of the potential benefits to realizing the R&D tax credit include:
- Up to 13.5 cents of R&D tax credit for every qualified dollar
- Dollar-for-dollar reduction in your federal and state income tax liability
- Reduction of your effective tax rate
- Increased in earnings-per-share
- Improved cash flow
- Credit carried forward up to 20 years
- Recent regulatory developments make claiming the R&D tax credit for companies much more feasible
- Look back studies can recognize unclaimed credits for open tax years (generally 3 years)
How Do I Know If My Company Qualifies?
Regardless of industry, size, or revenue, any company that performs activities that meet the following “four-part test” may qualify for R&D tax credits:
- Technical Uncertainty. The activity is performed to eliminate technical uncertainty about the development or improvement of a product or process, which includes computer software, techniques, formulas, and inventions.
- Process of Experimentation. The activities include some process of experimentation undertaken to eliminate or resolve a technical uncertainty. This process involves an evaluation of alternative solutions or approaches and is performed through modeling, simulation, systematic trial and error, or other methods.
- Technological in Nature. The process of experimentation relies on the hard sciences, such as engineering, physics, chemistry, biology, or computer science.
- Permitted Purpose. The purpose of the activity is to create a new or improved product or process (computer software included) that results in increased performance, function, reliability, or quality.
What Are Some Examples of Qualifying Activities?
- Developing new or improved products, processes or formulas
- Developing prototypes or models
- Developing or applying for patents
- Certification testing
- Developing new technology
- Environmental testing
- Developing or improving software technologies
- Building or improving manufacturing facilities
- Streamlining internal processes
What Types of Activities Are Excluded?
There are numerous activities that are not within the definition of qualified R&D activities. The following are common types of activities that are specifically excluded from the definition of qualified research:
- Research conducted outside the United States.
- Research conducted after the beginning of commercial production or implementation of the business component (with some exceptions).
- Adaptation or duplication of existing business components.
- Market research, testing, or development (including advertising or promotions).
- Routine data collection.
- Routine or ordinary testing or inspection for quality control.
- Surveys, studies, activity relating to management function/technique, market research, routine data collection, or routine testing/quality control.
- Research related to social sciences, arts, or humanities.
- Research funded by any grant, contract, or otherwise by another person (or governmental entity).
What Expenses Can Be Claimed?
The credit comprises the following types of Qualified Research Expenses (QRE):
- Wages paid to employees for qualified services (including amounts considered to be wages for federal income tax withholding purposes).
- Supplies (defined as any tangible property other than land or improvements to land, and property subject to depreciation) used and consumed in the R&D process.
- Contract research expenses paid to a third party for performing QRAs on behalf of the taxpayer, regardless of the success of the research, allowed at 65% of the actual cost incurred.
- Basic research payments made to qualified non-profit organizations and institutions. Basic research refers to fundamental research that focuses on evaluating theories and hypotheses regardless of an application. Basic research payments are included at 75% of the actual expense.
Do R&D Tax Credits Help State Taxes?
Thirty-eight states currently have a state R&D tax credit – and several other states are looking to expand their R&D tax credit or create one. In most cases, if your company is eligible for the federal R&D tax credit, it will also benefit from a state R&D tax credit. For more information, you can check your state government’s list of tax credits online.
How Do I Claim the Credit?
The first step is to conduct an audit of your business’s R&D expenses. Evaluate and document your research activities contemporaneously to establish the amount of qualified research expenses paid for each qualified research activity. Be sure to work with your accountant on this. They’ll be able to determine if you qualify and what research and development costs can be applied.
We’re Here to Help
Whether you need help determining if your business is eligible for R&D tax credits, need assistance evaluating, documenting, and submitting R&D activities, or you want to determine if you are taking full advantage of the benefit through your current claims, our R&D tax professionals can help. We can perform an R&D Tax Credit study that provides the information you need to make an informed decision about whether and how to pursue R&D tax credits. We can determine the maximum value of your federal and state credit(s) and help you secure these credits.
To learn more, contact our John Martin, CPA/PFS, CFP®, Tax Partner.