July 6, 2020
The Benefit of the Research & Development Tax Credit
The Benefit of the Research & Development Tax Credit
Related Solutions: R&D Tax Incentives Payroll
Is your organization working to improve existing products, processes or software? Or are you developing new ones? The research and development (R&D) tax credit has the potential to benefit your organization by providing valuable tax savings.
Fixed asset planning can help you identify deductions and tax credits.
What is the research and development tax credit?
Business tax credits, like the R&D tax credit, are government incentives designed to encourage and reward certain types of behaviors. Tax credits often reduce your tax liability on a dollar-for-dollar basis and can be claimed in addition to the deduction for the expenses that generate the credit.
In the case of the research and development tax credit, the goal is to encourage and incentivize businesses to undertake research and development related activities, either through new or improved processes, products or software.
Research and development expenditures that qualify for the credit include:
- Wages paid for technical, support or supervision personnel
- Supply expenses for materials used in R&D activities
- Outside contractor costs for third parties assisting with R&D activities
In addition to the federal R&D tax credit, many states also offer R&D tax incentives.
When did the research and development tax credit take effect?
The R&D tax credit was first enacted in 1981. The permanent extension of the R&D tax credit was effective as of Jan. 1, 2015.
Who Qualifies for The Credit?
Any company that develops, designs or improves products, processes, formulas, techniques, inventions or software can be eligible for the credit. Typically, small companies overlook research and development because they do not have a lab or scientists. Research and development can come from engineers, software developers, factory workers, tooling workers and a variety of other tasks performed in daily business.
A wage-based credit is also available to offset supply costs and contracted labor. This credit is a general business credit and a dollar-for-dollar reduction in the tax liability for the company. It is also available for flow-through entities such as S-Corporations and Partnerships and would directly reduce the individual owner’s tax expense.
As of January 1, 2016, eligible small businesses ($50 million or less in gross receipts), can now claim the credit against alternative minimum tax ("AMT").
Furthermore eligible startup companies (those with less than $5 million in gross receipts and earning revenue for less than 5 years) can claim up to $250,000 of the credit against the company’s payroll taxes.
Four Basic Requirements
- Qualified research activities are defined as, "the development or improvement of a business component (defined as a process, technique, product, invention, formula or software)."
- The research must be technological in nature and must rely on the physical or biological sciences, engineering or computer sciences.
- The research must be intended to eliminate uncertainty in the development or improvement of the business component.
- Elimination of technical uncertainty must be accomplished through a process of experimentation, including trial and error, simulation or modeling. Failure before success in the research is not a requirement in this area.
Eligible Industries
- Aerospace and Defense
- Agriculture
- Architectural and Engineering
- Biotech
- Manufacturing, including but not limited to Chemical, Boat, Computers, Electronics, Electrical Equipment and Components, Medical Devices, Plastics, Rubber and Transportation Equipment, Signs
- Construction
- Dental Labs
- Design-Build Manufacturing
- Metal Fabricating and Casting
- Oil and Gas
- Pharmaceutical
- Software Development
- Tool and Die
Qualifying Activities
- Designing New, Improved or More Reliable Products, Processes or Formulas
- Designing New Products (For the Company’s Use, Not Consumers/Customers)
- Designing Tools, Molds, Jigs and Dies
- Developing and Applying for Patents
- Certification Testing
- New Concepts and Technology
- Improving Manufacturing and/or Production Processes (Includes Incorporation of New Equipment in the Process)
- Building New Manufacturing Plants
How do you qualify for the research and development tax credit?
At a high level, in order to qualify for the R&D tax credit, you must be trying to develop something new or improved, where some kind of technical design uncertainty exists, and where an iterative process of design and testing is in place to evaluate different design alternatives. Activities related to product development / improvement, manufacturing process development / improvement, or software development / enhancement typically meet the qualification criteria for the credit.
Examples of qualifying activities include:
- Development of new, improved or more reliable products, processes or techniques
- Development of prototypes or models
- Design of tools, jigs, molds, fixtures or dies
- Development of customization of software
- Automation and/or streamlining of internal processes
In order to qualify, businesses must pass a four-part test:
- Permitted purpose. Develop a new or improve an existing, product, process or software.
- Eliminate uncertainty. Discover information to eliminate uncertainty concerning capability, methodology, or appropriateness of design.
- Process of experimentation. Substantially all the activity constitutes a process of experimentation.
- Technological in nature. Discover information that fundamentally relies on principles of hard sciences.
Learn more about the four-part test to determine your R&D tax credit qualifications.
Do small businesses qualify for the research and development tax credit?
The tax credit was made permanent as part of the Protecting Americans from Tax Hikes (PATH) Act of 2015. Prior to this legislation, the research and development tax credit could only be used to offset regular tax. This rule limited many small to mid-sized businesses in their ability to use the credit if they were subject to alternative minimum tax (AMT). This is especially true for many owners of pass-through entities.
With the permanency of the R&D tax credit came an enhancement that specifically benefited small businesses. “Eligible small businesses” may now claim the R&D tax credit against AMT liability. An eligible small business is defined as a business with less than $50 million in average gross receipts (i.e. revenues) for three preceding years.
Research & development tax credits can be of great benefit to your organization.
Research and development tax credits can also benefit "Qualified Small Businesses." A Qualified Small Business, defined as a business with less than $5 million in annual gross receipts and having gross receipts for no more than five years, can use the R&D tax credit to offset the FICA employer portion of payroll tax. The amount of credit that can be used to offset payroll tax is capped at $250,000 for each eligible year. The credit will be available to offset the FICA employer portion of payroll tax for the first calendar quarter beginning after the date on which the Qualified Small Business files its income tax or information return for the taxable year.
How do I apply for the research and development tax credit?
There is no formal “application” for the federal R&D tax credit; the credit is simply claimed by filing a form on your original or amended return to claim the credit.
The R&D tax credit has various rules and criteria that need to be met to qualify for the credit. For example, the definition of a “qualified activity” includes a set of criteria outlined in the tax code that must be met in order for the associated costs to be eligible for the credit. The R&D credit also involves a number of computation rules that must be followed to properly compute and claim the credits.
When to consider the research and development tax credit
The R&D tax credit offers opportunity to receive cost-saving benefits to organizations trying to improve their existing products and services, as well as create new ones. There’s a potential your organization could qualify.
Don’t leave money on the table.
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