If your business isn’t claiming R&D tax credit, you could be throwing money away. You don’t have to be a huge company to take advantage: In fact, many small businesses can even use the credit to cover Social Security employer taxes. The definition of research and development is also wider than you might realize. Here’s what you need to know.
R&D Tax Credit: The Basics
The R&D tax credit is a way to cut several key business taxes based on money you spend on research and development. It’s a separate process to deducting expenses from your taxable income before calculating taxes. Instead, it’s a tax credit: effectively a discount on your final tax bill.
Any business can claim the credit to put towards income taxes, but the business must meet specific criteria to apply the credit to the alternative minimum tax or Social Security taxes. In all cases, the specific expenditure must meet set criteria to qualify for the tax credit. The general principle is that the spending must involve technology to try to improve the business’s operations.
You’ll need to actively claim the tax credit and support this claim with documentation about the research work you did.
History of the R&D Tax Credit
R&D tax credit was originally a temporary measure in 1981 known as a Credit for Increasing Research Activities. It was introduced during an economic downturn. The idea was to give businesses a short-term reason to invest in research that would have longer-term benefits for the business and, in turn, the economy as a whole.
Although the credit was originally designed as a two-year measure, it proved successful enough that Congress repeatedly agreed to renew it, though not without some periods when it lapsed.
In 2015 the Protecting Americans from Tax Hikes (PATH) Act made the credit permanent. It’s now formally known as the Research & Experimentation Tax Credit, though the term “R&D Tax Credit” is still widely used and understood.
The PATH Act also introduced several changes that made it easier for small or new businesses to take advantage of the credit, which are detailed in the relevant sections below.
What the R&D Tax Credit Covers
To be eligible for the credit, the expenditure must be on research and development work that meets four tests. While the tax code has detailed definitions of these tests, these are the principles:
- The work must be designed to either improve an existing business component or develop a new business component. A business component can be a “product, process, computer software, technique, formula, or invention.” The component must either be a product the company will sell (or otherwise monetize) or something it will use as part of its operations.
- The work must be designed to discover new information that makes the improvement or development possible. In other words, it must be necessary research.
- The work must involve experimentation — in other words, testing and evaluating one or more options to find a way of achieving the improvement or development.
- The work must be based on hard sciences such as physics, chemistry, biology, engineering or computing.
R&D Tax Credit Exclusions
Some types of research are specifically excluded from the R&D tax credit. This applies even if they meet the four tests. The excluded research includes:
- Anything that relates to “style, taste, cosmetic or seasonal design factors” — in other words, if the result of the research is primarily decorative rather than functional.
- Research that’s for a business component already in commercial production.
- Research that’s about adapting or reproducing an existing business component. This applies to your own components and those of other businesses. For example, you can’t get the tax credit for money you spend trying to copy somebody else’s widgets or their widget-making machine. This exclusion applies whether you are using blueprints or specifications, or if you’re simply trying to reverse-engineer the process by examining the product itself.
- Research that’s about a management process rather than a production process.
- Efficiency surveys.
- Anything to do with market research and promotions.
- Data collection.
- Quality control.
- Any research you do outside the US, Puerto Rico or any location that is the “possession of the United States.”
- Any research that involves arts, humanities or social sciences (rather than hard sciences).
- Any research expenditure that’s externally funded such as by a grant.
The rules on how the tax credit covers research for developing software are somewhat complicated. The general principle is that it depends on who will use the software and for what purpose.
- If the software is developed for external use (for example, as a commercial product), the tax credit may apply.
- If the software is for internal use for your day-to-day business, the tax credit doesn’t apply.
- If the software is for internal use as part of wider research that itself qualifies for the tax credit, the tax credit may apply.
Because both the wording and application of the rules on the R&D tax credit for software are complicated, it’s particularly important that you take expert advice to make sure you comply.
Depending on your business set-up, you can apply the R&D tax credit to some or all of the following three tax types.
1. Income Tax
Any business that pays income taxes can apply the credit to income tax.
2. Alternative Minimum Tax
You can apply the credit to alternative minimum tax (AMT) as long as you owe the AMT for the current year and your average annual revenue over the previous three tax years is below $50 million.
3. Social Security Employer Taxes
You can apply the credit to Social Security employer taxes if you are a “qualified small business.” This qualification is based on your gross receipts (that is sales income before deducting expenses) for specific tax years.
The gross receipts for the tax year in which you want to apply the tax credit must be $5 million or less. Meanwhile, you must not have had any gross receipts at any point before the five tax years up to and including the one in which you want to apply for the tax credit. In other words, either your company started in the past five years or didn’t start earning income until the past five years.
Note that a section 501 tax-exempt organization doesn’t qualify, regardless of its income.
A qualified small business can apply the tax credit to up to $250,000 of Social Security employer taxes in a year, for a maximum of five years. This is the case even if the business isn’t profitable.
The amount of R&D tax credit you can claim depends on your “qualified research expenses,” made up of the following.
- 100% of money spent on wages for employees working on the research.
- 100% of money spent on supplies (such as equipment and materials, but not land) used in the research.
- 100% of money spent on licensing or hiring computers for the research.
- 65% of money spent in contract fees for non-employees working on the research.
- 75% of money paid to educational institutions and scientific research organizations as part of the research.
Calculation and Application
Your qualified research expenses figure is the starting point for calculating the actual amount of R&D tax credit you get. The calculation also takes into account:
- when your company started;
- when it first had gross receipts;
- when you first had qualified research expenses; and
- your gross receipts in recent years.
In some cases these factors affect the calculation method as well as the figures themselves.
The process and final figure also depend on which of two calculation methods you choose: Regular Credit or Alternative Simplified Credit. As a rough rule of thumb, Regular Credit is better suited to companies that increase their research spending over time. Alternative Simplified Credit is often simpler to file and calculate but may lead to a lower tax credit.
Once calculated, the tax credit is taken off the total amount you owe in income taxes or alternative minimum tax.
If you are a “qualified small business” (as detailed above), you can decide how to split the credit between income taxes (including alternative minimum tax) and Social Security employer taxes. You can apply it all to income taxes, all to Social Security employer taxes, or split between the two in any proportion. Remember though that you can only use the R&D tax credit to reduce your Social Security employer taxes by a maximum of $250,000 a year.
If you’re claiming the R&D tax credit for income tax or alternative minimum tax, it’s applied to the income tax due for the year in which you make the claim. If the credit is higher than the tax you owe in that year, the unused credit is effectively lost: you don’t get a refund and you can’t carry over the unused credit.
One way around this is to instead carry some or all of the research expenses forward to use for a claim in a future tax year. You can do this for up to 20 years. In some cases you can carry the expenses back to previous years, retrospectively reducing your tax liability so that you get a refund.
If you put some or all of the credit towards Social Security employer taxes, you can start using this credit towards the taxes that come due from the calendar quarter after you file the claim. The credit covers all Social Security employer taxes, not just those relating to employees who worked on the relevant research. If you don’t use all of the credit in the first quarter, the remainder can carry over into future quarters until it’s used up.
Note that unlike with income taxes/AMT, if you use R&D tax credit for Social Security employer taxes, you still pay the taxes up front. You then get back the relevant amount as a refund check.
Claiming R&D Tax Credit
You make your claim for the R&D tax credit by completing and submitting IRS form 6765 (Credit for Increasing Research Activities) as part of your annual tax filings. Once you’ve calculated the amount of the tax credit, you’ll also need to include this figure in the relevant line of form 3800 (General Business Credit).
If you’re a “qualified small business” and want to use some or all of the credit towards Social Security employer charges, you need to claim via form 8974 (Qualified Small Business Payroll Tax Credit for Increasing Research Activities).
When you complete form 6765, you’ll need to include total amounts for each of the different types of qualifying expenditure (staff wages, supplies, computers, licensing, contracting external staff, payments to educational institutions and scientific research groups).
You don’t need to provide supporting evidence for the figures with the tax return. However, it’s vital you have documentation in place in case the IRS audits the claim. As a general principle, this documentation needs to have been created when you did the relevant research work, not created later. The documentation also needs to show when the work happened and prove that it meets the four tests (improves a business component or develops a new one, designed to discover new information, involves experimentation, based on hard science).
The IRS has the right to audit your claim for an R&D tax credit to check the expenses you list are accurate and eligible. If they decide this isn’t the case, the credit could be denied. You could also face a penalty charge and interest charge if the IRS determines your denied claim means you didn’t pay enough tax.
If your research involves pharmaceutical drugs, it may be more financially efficient to claim tax credits under section 280c instead. Seek expert advice before making any decisions about this.
Some states offer their own form of R&D tax credit to use on state taxes. The rules vary significantly from state to state, though the general principles are similar to those in the federal IRS program. The most common differences are that the relevant expenses must have been incurred in the state in question and that often there’s a limit on how low you can reduce state taxes through credits.
The Next Step
As with many areas of tax, R&D tax credit involves some straightforward principles but some exceptionally detailed rules. Tax and accountancy experts such as Founders CPA can help you navigate this minefield and make sure you take full advantage of the tax credit. Contact FoundersCPA today to get the ball rolling.