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Research and Development (R&D) tax credits are becoming increasingly popular amongst startups and companies, as an innovative cash flow tool that allows organisations to inject funds into their projects as quickly as possible while maintaining full control of their business operations.
The R&D tax credit is a dollar-for-dollar offset of federal income tax liability and, in certain circumstances, payroll tax liability. Most states provide a similar credit, making the average potential benefit of the federal and state credit in the range of 10-20% of qualified spending.
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R&D Tax Credits at a glance
R&D Tax Credit is a general business tax credit under Internal Revenue Code section 41 for companies that incur research and development (R&D) costs in the United States.
The Credit can be claimed on all open tax years (typically 3, you can go back 4 years). Eligible entities include C-CORPS, S-CORPS, LLCs and Partnerships.
For small businesses, this provides an incentive to further invest in their R&D activities as they can claim credits for spending on qualified research expenditure.
• Developing or designing new and/or innovative products or processes
• Improving existing products, processes, or prototypes
• Reviewing the potential of several alternatives or methods during the development or improvement processes.
Employee Salaries and Subcontractors
Supplies consumed (e.g. raw materials, consumables, supplies)
Rental or lease costs of off-premise computers (i.e. computer costs, hosting costs)
R&D credit eligibility is much broader than many companies realize, applying not only to product development, but also activities and operations, such as new manufacturing processes, software development, and quality enhancements. Start-ups may also be eligible to apply the R&D tax credit against their payroll tax for up to 5 years
R&D Tax Credits
Benefits of accessing innovation credits.
Having accessed the offset, startups can expedite further R&D activities, bring forward commercialisation plans, R&D Tax Credits software support further growth, delay unnecessary financing or equity injections, and satisfy ongoing cash flow requirements.
R&D Tax Credits are a non-dilutive option to manage your cashflow, allowing founders to retain full control and ownership over their business – preserving the ownership of a company for a future occasion when the product is more mature and a better valuation can be achieved.
Offsetting Your Tax Burden
Companies that haven’t previously taken advantage of the credit also have the option to look back at all open tax years—typically three to four years, depending on when tax returns were filed—to claim the missed opportunity.
If a company doesn’t currently have taxable income or is otherwise limited in how much tax credit it can use, the federal tax credit can be carried forward for 20 years or potentially applied to offset the company’s federal payroll tax under the newly expanded rules. State credits may also be carried forward for a length of time determined by the state.
The amount of R&D tax credit a company can claim will depend on many factors, but the potential tax savings make it worth the time to investigate. For example, R&D tax credits have the potential to offset income tax, which can reduce a company’s tax burden in the years when qualified activities occur.
In order to qualify as R&D, any activity
must meet the Four-Part Test:
Process of Experimentation
You must demonstrate modeling, simulation, systematic trial and error, or other methods that form the process of experimentation.
The activity must be creating new or improved product or process, resulting in increased performance, function, reliability, or quality.
You must demonstrate to attempts to eliminate uncertainty about the development and improvement of a product or process.
The process of experimentation must rely on the hard sciences, such as engineering, physics, chemistry, biology, or computer science.
R&D Tax Credit FAQs
What are the R&D Tax Credits?
- The Research and Development (R&D) tax credit is a government-sponsored tax benefit that allows U.S. businesses to reduce their tax liability.
- The R&D tax credit is prescribed in 26 U.S.C. § 41 and was introduced in 1981 to encourage investment in innovation and technology development.
- It can be claimed by taxpaying businesses that develop, design, or improve products, processes, formulas, or software.
- It’s one of the most valuable tax incentives available to American businesses.
- The R&D tax credit is for businesses of all sizes, not just major corporations with research labs.
- However, what constitutes R&D concerning the credit is much more expansive than business owners realize, now with an extensive list of activities qualifying for the credit, such as processes related to applied sciences or other technical projects.
What industries qualify for the R&D Tax Credits?
The industry generally doesn’t matter. Although most R&D credits are claimed by companies in manufacturing (usually 60-70% of total credits claimed), information (15-20%), professional, scientific, and technical services (10-15%), wholesale and retail (5-10%), and financial and insurance (5%), millions of credits are claimed each year by companies in other industries, including natural resources, like mining and oil-and-gas; services, e.g., health, entertainment, administrative, and hospitality; architecture and construction; real estate, rental, and leasing; transportation and warehousing; agriculture; forestry; fishing and hunting.
What are the benefits of the credit?
The benefits of the R&D Tax Credits include increased cash flow, increased earnings per share, increased return on investment, reduced federal and state tax liability, and reduced effective tax rate. R&D Tax Credits go hand in hand with capital raising and seeking investment for your company. Successfully claiming tax credits is often seen as a valid proof point for potential investors.
When do I claim the R&D credit?
The credit is claimed on a timely-filed (including extension) federal income tax return for the year in which the qualified expenses were incurred. The credit may also be claimed by amending a previously-filed return on or before the statute of limitations date to report credits related to expenses incurred during that period. The statute of limitations generally grants three years after the original deadline or filing date (whichever is earlier) to amend returns.
What is the Four-Part Test?
The Four-Part Test is a questionnaire designed to ascertain whether your activities qualify for the R&D Tax Credits application. In order to qualify, all four conditions must be met:
- Qualified purpose. The purpose of the activity is to improve the functionality, performance, reliability, or quality of a product, process, software, technique, invention or formula that is intended to be used in the taxpayer’s business or held for sale, lease or license (component).
- Technological uncertainty. The taxpayer encounters uncertainty regarding whether it can or how it should develop the component, or regarding the component’s appropriate design.
- Process of experimentation. To eliminate the uncertainty, the taxpayer evaluates alternatives through modeling, simulation, systematic trial and error, or other methods.
- Technological in nature. The success or failure of the evaluative process is determined by the principles of engineering, physics, chemistry, biology, computer science, or similar natural or “hard” science, as opposed to principles of, e.g., economics, social sciences generally.
What expenses qualify?
- Taxable wages for employees who perform or directly supervise or support qualified activities.
- Cost of supplies used in qualified activities, including extraordinary utilities, excluding capital items or general administrative supplies.
- 65%-100% of contract research expenses for qualified activities, provided the taxpayer retain substantial rights to the activity’s results and must pay the contractor whether it succeeds or fails.
- Rental or lease costs of computers used in qualified activities, e.g., payments to cloud service providers (CSPs) for the cost of renting server space to develop or improve a component.
Don’t you have to achieve a major scientific breakthrough or do revolutionary or pioneering research to qualify?
No! Even more so, your activities don’t have to be successful to qualify. You can claim R&D on failed projects too. Generally, they have only to attempt to discover technological information lacking to a taxpayer who is trying to develop or improve a business component’s functionality, performance, reliability, or quality by systematically evaluating whether or how it could do so, or the component’s appropriate design.
Can the R&D tax credit be used to offset the Alternative Minimum Tax?
Yes! The Protecting Americans from Tax Hikes (PATH) Act of 2015 leveled the playing field among companies, irrespective of size, allowing start-ups and small corporations alike to mitigate alternative minimum tax (AMT) limitations against the R&D tax credit.
What companies can benefit?
In general, any company (in any industry and of any size) can benefit if they carry out eligible R&D activities, and company paid/ pays/ expects to pay:
- Regular federal income tax;
- A similar state tax in one of the more than 40 U.S. states that provide for incentives for R&D and R&D-related investments; or
- In certain circumstances outlined below, federal payroll tax; or
- Similar taxes in one of the more than 35 non-U.S. countries that also provide for such incentives.
I’m not paying income taxes this year. Can I benefit?
You may still be able to benefit currently from your R&D credits. Startup taxpayers in certain circumstances may offset up to $250,000 of their federal payroll tax liability using R&D credits. Many states provide credits that are refundable, i.e., states pay the amount of the credit as a refund whether you’re paying income tax now or not. And if you don’t owe income taxes this year but paid income taxes last year, you can carry your credit back to the preceding year to offset some or all of that year’s tax liability.
Can I offset state taxes as well as federal?
Yes. Most states offer a credit for expenditures to attempt to develop or improve a product, process, or software, and most adopt or follow rules similar to those of the federal R&D credit.
Some states require taxpayers to file an application other than just the tax return on which the credit is claimed to be eligible for their credits. Some also limit their credit to certain industries or the number of credits that will be allowed each year.
In many cases, though, state credits are even more generous than federal credit. For example, some states have higher credits rates; or they allow taxpayers to sell or to transfer their credits to other taxpayers; or they pay taxpayers the value of their state credits even if the taxpayers aren’t currently paying taxes; i.e., their credits are “refundable.”
What Qualifies for the R&D Tax Credit?
Many businesses are still unaware that R&D credit eligibility extends beyond product development to include activities and even operations such as the latest manufacturing methods, software development, and quality improvements. Even start-ups may be able to utilize the R&D tax credit against their payroll tax for up to 5 years.
So, if your company does any of the following, your business likely qualifies for the R&D tax credit:
- Develops or designs new products or processes,
- Enhances existing products or processes,
- Improves upon existing prototypes and software,
Can I claim the R&D Tax Credit every year?
Yes. Businesses need to continuously evaluate and document their research activities to authenticate the expenses consumed for each qualified research activity in a given year. Since companies may claim the credit for both current and prior tax years, they can benefit from documenting their R&D activities to ensure that they are eligible to claim the credit in both situations.
What documentation do I need to apply?
Businesses need to continuously evaluate and document their research activities to authenticate the expenses consumed for each qualified research activity. While some estimations may be involved, they must have a genuine basis for the assumptions used to create those estimates.
Examples of such documentation include:
- Payroll records
- General ledger expense detail
- Project lists
- Project notes
- Other documents a company produces throughout the regular course of business
What activities don’t qualify?
Some activities are excluded because they weren’t judged to incentivize an increase in the kind of R&D in the U.S. the credit was designed to stimulate. Excluded activities include:
- Research conducted outside the U.S.
- Routine data collection or ordinary testing for quality control of existing components
- Market research
- Consumer preference testing
- Research “funded” by an unrelated third party, i.e., for which the taxpayer either doesn’t retain rights to the results of the activity.
Other activities that don’t qualify because, generally, they don’t meet the four-part test:
- Repairs and maintenance
- Preproduction planning for a finished component
- Tooling-up for production
- Trial production runs
- Accumulating data relating to production processes
- Activities relying on the social sciences, arts, or humanities
- Research after commercialization
- Adapting existing components to a particular customer’s need
- Duplicating an existing component via reverse engineering