The Research and Development (R&D) Tax Credit is a tax incentive that is aimed towards helping small businesses save big on tax. Too often business owners don’t claim the R&D credit because they have not heard of it or they do not feel that they qualify for it. Fortunately, with the help of R&D tax credit software and tax experts, you’ll be able figure out if your business qualifies and how much you’re entitled to get.
What is the R&D Tax Credit?
The R&D tax credit is a tax incentive for US-based companies to encourage them to increase spending on research and development. In general, it reduces the amount of tax they owe or increase a tax refund. If your company performs activities that you feel qualify for the R&D tax credit, you can apply for it.
There are two ways you can calculate how much R&D tax credit you’re entitled to and they are through the traditional method and the alternative simplified credit method.
Traditional Method
With the traditional method, the credit is calculated at 20% of the company’s current year qualified research expenses over a base amount.
It’s not easy to calculate the base amount because it is the byproduct of a fixed-base percentage and the average annual gross receipts of the company for the last four tax years.
Companies that have not claimed their R&D credit in the past or do not have enough data on their historical qualified research expenses will find the second method a bit more convenient.
Alternative Simplified Credit Method
The Alternative Simplified Credit (ASC) Method for calculating R&D credit involves a four-step process:
- Determine the average qualified research expenses (QREs) of the company for the past three years
- Multiply that average by 50%
- Subtract the result from the company’s current year QREs
- And lastly calculate the credit by multiplying the result from step 3 by 14%
Most companies use these methods to calculate the R&D credit, but there are R&D Tax credit software that makes it easier for companies to calculate the credit as well.
Who Can Claim the R&D Tax Credit?
The R&D credit can be claimed by any business that incurs expenses while performing research and development on products and processes while on US territory.
You can find out if your company or business qualifies for the federal tax credit using this simple, four-part test:
- Eliminate uncertainty –you must have performed research to eliminate doubt or certainty over the development or improvement of a particular product or method. This simply means that developments or research done solely for aesthetic purposes do not qualify.
- Process of Experimentation –the activities must involve some experimentation that aims to find solutions to technical uncertainties, such as modeling, systematic trial and error, simulation, and other methods.
- Technological in Nature –the research must be based on the hard sciences, such as biology, chemistry, physics, engineering, and computer science.
- Qualified Purpose –the research or activity must be done for the purpose of creating a new or improved product or process that leads to increased function, better performance, reliability, or quality.
There are certain activities that the tax code specifically excludes from the R&D tax credit and they are as follows:
- Research done after the start of commercial production
- Research adjusting to an existing product or method to fit a particular customer’s needs
- Copying or replicating an existing product or process
- Surveys or studies
- Research that involves certain internal-use computer software
- Research done outside the USA, Puerto Rico, or a US territory
- Research in humanities, social sciences, or arts.
- Research funded by a private individual or another governmental entity
What Expenses Can You Use to Calculate the R&D Credit?
In order to calculate the R&D tax credit, you need to document your company’s “qualified research expenses” which include:
- Salary paid to people working directly on, supervising, or directly supporting the development process.
- Supplies used or expended during the development process
- Contract research expenses paid to a third party for conducting qualified research activities in lieu of the company
- Paying cloud service providers for leasing computers used in research activities
It should be noted that the research doesn’t have to be a success and you don’t have to produce a successful product or process in order to qualify for the tax credit. Even if the research resulted in failure, you can still claim the credit.
You can get help calculating your tax credit with a tax expert or an R&D tax credit software.
New Rules for New or Startup Businesses
One thing to note is that the R&D tax credit is non-refundable, but if your available credit is higher than your tax bill, you can carry it forward for up to 20 years. But there is an alternative for new businesses that incur a lot of research costs with little to nor tax liability. They can immediately reduce their tax burden thanks to the Protecting Americans from Tax Hike (PATH) Act of 2015. The Act allows new and small businesses to apply the R&D tax credit against their payroll tax (FICA) for up to five years. This way companies can receive tax benefits from their research activities regardless of whether they’re profitable or not.
Companies can qualify for the payroll tax offset if they have:
- No more than five years of gross receipts
- Less than $5 million in gross receipts for the credit year
Qualified businesses can apply for up to $250,000 R&D credit to its payroll tax liability each year. But you have to delegate this option on an originally filed tax return. This means that if you were unable to apply the R&D credit to payroll taxes a year before, you won’t be able to rectify your mistake by filing an amended return.
Thanks to the PATH Act, small businesses that qualify can use their research tax credit to offset alternative minimum tax (AMT).
For a business to qualify, a business must:
- Not be publicly traded
- Have at least an average of $50 million or less in gross receipts for the past three tax years
Conclusion
Major corporations are not the only ones that can qualify and take advantage of the R&D tax credit, but they’re the ones that usually claim it because they have great legal teams and accountants that educate them on the rules.