What Are R&D Tax Credits

What are R&D Tax Credits?

The R&D Tax Credits are an incentive available for US-based companies which allows for a corporate tax reduction proportionate to their eligible R&D expenditure in a given accounting period. This offset can be claimed against both the federal and state income tax liability. The R&D tax credits are not limited to large companies only – any company that develops new products, processes, software, applications, or works on upgrading and improving existing ones is likely to qualify.

Over the years, California has expanded its R&D tax credits landscape to make it more attractive to businesses. As such, the California R&D Credit reduces income or franchise tax and is permanent. In order to qualify, the activities must take place within the state borders. As with the federal credit, the calculation in California is based upon the excess of California QREs over a base amount.

R&D Tax Credits
R&D Tax Credits in United States

How does it work?

R&D Tax Credits grants are normally processed by the company’s accountant, financial advisor, or CFO, however, by working with us, clients maximise their chances of success. Our highly qualified team of consultants in science, engineering, software, tax and accounting works in tandem with the client’s team to discover unique areas of opportunity that often go unnoticed within the scope of individual research. As part of our process, we look to identify the extent of the qualifying R&D expenditure for each client and decide on the most optimal categorisation as either Core or Supporting R&D for the purposes of their claim, help to evidence progress, define the hypotheses your projects assumed, show the exact progression of a systematic approach as well as calculate the right expenditure amounts which are all crucial elements that the funding bodies look at when reviewing applications.

Oftentimes, we find that devil’s in the details – and even a small change in wording can go a long way. Our methodology is designed to pre-empt any post-submission questions that may arise in relation to a client’s claim. With a turnaround time of 3-4 weeks and one of the highest success rates in our field, BourkeHood uplifts claims for dozens of companies and ensures companies get the maximum net benefit to reinvest back into your business.

Assessing Eligibility 

Part of our process, BourkeHood will assess your business activities in terms of their eligibility for R&D tax credits, part of the Technical Discussion with our consultants which takes place immediately after coming on board with us. This is part of our free service, meaning if we find there isn’t enough R&D activity and expenditure to proceed with the claim, no fees will be due to us. In other words, we shake hands and close the contract at zero cost. Many of our clients found this Technical Discussion to be a valuable ‘checkpoint’ for their business to understand where they’re at in terms of their R&D scope and understand its definitions, even if they were unable to proceed with us with their claim.

R&D Tax Credit FAQs

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. 

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.

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.

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. 

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 amount 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.”

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.

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.

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.
  1. Taxable wages for employees who perform or directly supervise or support qualified activities.
  2. Cost of supplies used in qualified activities, including extraordinary utilities, excluding capital items or general administrative supplies. 
  3. 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.
  4. 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.

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.

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

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.

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
  • Management
  • 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:

  • Administration
  • Training
  • Repairs and maintenance
  • Preproduction planning for a finished component 
  • Tooling-up for production 
  • Trial production runs 
  • Troubleshooting 
  • 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 

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.