The Research and Development (R&D) Tax Credit saves businesses billions of dollars each year, yet less than ten percent of those savings are seized by small-to-medium-sized companies. Also known as the Research and Experimentation (R&E) Credit, the credit for increasing research activities, or simply the research tax credit, this valuable incentive is riddled with misconceptions that unfortunately cause many eligible businesses to leave substantial tax savings on the table each year.
What is the R&D Credit?
The R&D Tax Credit was developed in 1981 with the goal of stimulating innovation and technological advancement within the U.S. by helping businesses offset the high costs of research and development. After years of expiring and having to be renewed on an almost annual basis, the R&D Credit was finally made a permanent part of the tax code in 2015 as part of the Protecting Americans from Tax Hikes (PATH) Act. The PATH Act also expanded the credit, making it more available to smaller and newer businesses.
Who is eligible for the R&D Credit?
The R&D Credit is underutilized by many eligible businesses that erroneously assume that their activities will not qualify. Many taxpayers associate the words “research and development” with highly scientific or technological pursuits, or assume that the credit only applies to large corporations. In reality, the credit is available to businesses of all sizes that are engaged in a wide range of specializations, including architecture, engineering, construction, and manufacturing. Additionally, shareholders in S-corporations and similar types of pass-through entities may be eligible to claim the R&D Credit.
What types of activities qualify?
Qualified research activities are defined by a four-part test:
- The goal of the activity must be to create new or improve the existing functionality of a business component.
- The taxpayer must intend to eliminate some uncertainty about the project.
- In attempting to eliminate the uncertainty, the taxpayer must conduct a process of experimentation.
- The process of experimentation must be technological in nature and fundamentally rely on the principles of the physical or biological sciences, engineering, or computer science.
Examples of common activities that qualify for the R&D Credit include: developing architectural designs; pursuing state, federal, or industry certifications; green building initiatives for contractors; devising a more efficient or sustainable manufacturing process; environmental testing; and developing prototypes or models.
How does it work?
The R&D Credit is calculated on the basis of qualified research expenses (QREs), which include wages paid to employees who engage in R&D activities and amounts paid for supplies used in such activities. Depending on which method of calculation the taxpayer uses, the credit amounts to a percentage of QREs over a certain base amount. The credit is somewhat flexible: a business may elect to carry it back one year or forward twenty years as needed.
What else should businesses know about the R&D Credit?
The PATH Act of 2015 created an opportunity for newer businesses and those without significant income tax liabilities to benefit from the R&D Credit. Businesses that have been in operation for less than six years and have $5 million or less in gross receipts for the current tax year and no gross receipts for the previous five years may now use the R&D Credit against their payroll tax liabilities. They may claim up to $250,000 in R&D Credits, but the credit amount may not exceed the company’s payroll tax burden in a given quarter. However, excess credits may be carried forward for use in future quarters.
In addition to the federal R&D Credit, most states offer some type of tax incentive for research and development. Some of these feature rates that are even more generous than that offered by the federal credit. Businesses seeking to claim state or federal R&D Credits should be prepared to show thorough documentation of qualifying activities, including plans, diagrams, and time sheets.
Wondering whether your firm’s projects may qualify for the R&D Credit? Call CRG today at 877-666-5539 to speak with one of our tax experts and schedule a pro bono analysis!
(Sources: http://www.journalofaccountancy.com/issues/2010/mar/20092122, http://www.ipc.org/3.0_Industry/3.3_Gov_Relations/2008/tax_credit_whitepaper08.pdf, http://www.businessweek.com/small-business/the-rampd-tax-credit-explained-for-small-business-08162011.html, http://bipartisanpolicy.org/blog/what-research-and-experimentation-tax-credit/, http://nydailyrecord.com/blog/2015/04/20/commentary-rd-tax-credits-add-to-benefits-of-green-building).