As we head into tax season, we wanted to kick of 2020 by answering some common questions we get about the R&D tax credit. Let’s dive into it!
What is the R&D tax credit?
The R&D (research and development) tax credit is a federal (and some states) tax incentive, that provides cash benefits to companies conducting research and development in the United States.
How do tax credits work?
A tax credit is a dollar-for-dollar reduction of a taxpayer’s income tax. It is NOT a tax deduction!
Who can claim the R&D tax credit?
All types of business can claim the R&D tax credit including sole proprietorships, partnerships, S-corps and C-corps. Credit that are claimed but not monetized are carried back one year and carried forward for twenty years.
Historically, the R&D tax credit benefitted large, profitable organizations that owed income taxes. Startup companies that clearly conduct research often raise capital and may not owe an income tax during its early years. They could claim the R&D tax credit but could not monetize it and were forced to carryforward the credit until they owed an income tax. This changed starting in 2016 with the PATH Act.
What changed with the PATH Act?
The Protecting Americans from Tax Hikes (PATH) Act was signed into law in December 2015 and made the R&D tax credit permanent starting in 2016. In addition, qualified small businesses (QSBs) can monetize their R&D tax credit against future payroll taxes and eligible small businesses (ESBs) can apply their R&D tax credit against the alternative minimum tax (AMT).
What qualifies as research and development per the IRS?
The IRS’s definition of research and development is very broad – lots of companies in nearly all industries can qualify for this tax incentive. Per §41 of the Internal Revenue Code a qualified research activity must meet these requirements:
- New or Improved Business Component – The intent of the research is to create a new or improved business component (product, process, formulation, invention, software, or technique) resulting in increased functionality, reliability, quality, or performance.
- Elimination of Uncertainty – The taxpayer must demonstrate an attempt to eliminate uncertainty in capability, methodology, or design during the research
- Process of Experimentation – The taxpayer must apply a process of experimentation such as: an evaluation of alternatives, the scientific method, trial and error, modeling, or simulation while attempting to eliminate uncertainty.
- Technical in Nature – The research must rely on the hard sciences (math, engineering, computer science, engineering, physics, biology, chemistry, etc.) not soft sciences (psychology, sociology, philosophy, etc.)
How much could you get?
The R&D tax credit is driven by the amount of qualified research expenditures spent by your company on qualified activities in a given tax year. Qualified research expenditures include wages, supplies, contractor costs, and rental and lease of computer space.
The actual R&D tax credit calculation can get complex, but your credit should land somewhere between 7% to 10% of the total qualified research expenditures.
What do you need to do to take advantage of the R&D tax credit?
It is important to substantiate your claim with proper documentation. Documents needed to calculate and substantiate the R&D tax credit include (but are not limited to):
- Previous tax returns
- Vendor invoices
- Project documents
Due diligence is required to ensure compliance and accuracy. Consult with your CPA and consider using a tax consultant that specializes in the R&D tax credit.