What is the R&D tax credit?
The R&D tax credit is a tax incentive, in the form of a tax credit, for U.S. companies to increase spending on research and development in the U.S. A tax credit generally reduces the amount of tax owed or increases a tax refund. If a company’s activities qualify for the R&D tax credit, there are two ways to calculate it.
Under the traditional method, the credit is 20% of the company’s current year qualified research expenses over a base amount.
Calculating the base amount is complicated. It’s the product of a fixed-base percentage and the average annual gross receipts of the company for the prior four tax years. You can read more about calculating the base amount and the fixed-base percentage here.
Companies that have not claimed the R&D credit in the past or that don’t have the data necessary to determine their historical qualified research expenses will likely have an easier time using the second method.
Alternative Simplified Credit method
The Alternative Simplified Credit (ASC) method for calculating the research credit involves a four-step process:
- Figure the company’s average qualified research expenses (QREs) for the past three years
- Multiply that average by 50%
- Subtract the result of Step 2 from the company’s current year QREs
- Calculate the credit by multiplying the result of Step 3 by 14%.
To illustrate, say A to Z Construction had the following QREs for the past three years:
A to Z Construction’s average QREs for the past three years would be $48,333. Fifty percent of that average would be $24,167.
If, in 2023, A to Z Construction had qualified research expenses of $70,000, they would calculate the available R&D credit as follows:
$70,000 - $24,167 = $45,833 x 14% = $6,417
If the company had no research expenses in any of the previous three years, the tax savings is 6% of qualified research expenses for the current year.
Several states have their own R&D tax credit programs as well. These come with their own rules and limits, so it’s a good idea to talk to a tax professional in your state to find out whether you can benefit from both a federal and state credit.
Who can claim the R&D tax credit?
The R&D credit is available to any business that incurs expenses while attempting to develop new or improved products or processes while on U.S. soil.
A simple, four-part test can help determine whether your business qualifies for the federal tax credit.
- Eliminate uncertainty. You must have carried on the research in order to eliminate uncertainty about the development or improvement of a product or process. In other words, changes solely for aesthetic purposes don’t qualify.
- Process of experimentation. The activities must include some experimentation to resolve the technical uncertainty, such as modeling, simulation, systematic trial and error, or other methods.
- Technological in nature. The research must rely on the hard sciences, such as engineering, physics, chemistry, biology or computer science.
- Qualified purpose. The purpose of the activity must be to create a new or improved product or process, resulting in increased function, reliability, performance, or quality.
The tax code specifically excludes some activities from the R&D tax credit.
According to the IRS Instructions for Form 6765 (the form used to claim the R&D credit), excluded activities are:
- Research conducted after the beginning of commercial production
- Research adapting an existing product or process to a particular customer’s need
- Duplication of an existing product or process
- Surveys or studies
- Research relating to certain internal-use computer software
- Research conducted outside of the United States, Puerto Rico, or a U.S. possession
- Research in the social sciences, arts, or humanities
- Research funded by another person or governmental entity
What expenses can be used to calculate the R&D credit?
Calculating the R&D credit requires documenting your company’s “qualified research expenses.” These include:
- Wages paid to people directly working on, supervising, or directly supporting the development process
- Supplies used or consumed during the development process
- Contract research expenses paid to a third party for performing qualified research activities on behalf of the company
- The cost of cloud service providers or leasing computers used in research activities
The research doesn’t have to lead to a successful product or process for the expenses to count. Even if the project or research failed, you can still claim the credit.
Special rules for new or startup businesses
The federal R&D tax credit isn’t refundable, but if your available credit is bigger than your tax bill, you can carry your credit forward for up to 20 years. However, new businesses that have a lot of research costs and little or no income tax liability have an alternative that can help them reduce their tax burden immediately.
Thanks to the Protecting Americans from Tax Hike (PATH) Act of 2015, new and small businesses can apply the R&D tax credit against their payroll tax (FICA) for up to five years. This allows companies to receive a tax benefit from their research activities whether or not they’re profitable.
To qualify for the payroll tax offset, the company must have:
- No more than five years of gross receipts, and
- Less than $5 million in gross receipts for the credit year
An eligible business can apply up to $250,000 of its R&D credit to its payroll tax liability each year. However, you have to elect this option on an originally-filed tax return – meaning if you missed out applying the R&D credit to payroll taxes in a prior year, you can’t correct your mistake by filing an amended return.
The PATH Act also allows eligible small businesses to use the research tax credit to offset alternative minimum tax (AMT). To qualify, the business must:
- Not be publicly traded
- Have an average of $50 million or less in gross receipts for the prior three tax years
Major corporations aren’t the only ones who can benefit from the R&D tax credit, but they’re typically the ones who claim it because they have a team of lawyers and accountants helping them navigate the rules.
If you’re still confused about whether your business’ R&D activities qualify for the credit, ask yourself these questions:
- Do you make something? If your company is involved in software, manufacturing, architecture, engineering, food, or construction, you may be eligible for the credit.
- Are you making the same product the same way? Your new product or process doesn’t have to be new to the industry – just new to the company. Businesses rarely make their products the exact same way, year after year. If your business conducts research to make your products or processes cleaner, greener, quicker, or cheaper, you may qualify for the credit.
If you answer “yes” to the two questions above, you might want to talk to your CPA at Bench. We’d also recommend using Neo.Tax, a firm that focuses on identifying and claiming R&D tax credits while optimizing tax outcomes for companies ranging from startups to large enterprises.