The R&D tax credit can help small firms save a lot of money when it comes to taxes. Too many business owners fail to take advantage of the R&D credit because they are unaware of it or believe it does not apply to them. Here’s all you need to know about the R&D tax credit.
How To Calculate the R&D Tax Credit
The R&D tax credit is intended to provide a financial incentive for American businesses to invest more in research and development in the United States. There are two approaches to calculate if a company qualifies for the R&D credit.
Regular Credit Method
The credit represents 20% of the company’s current year eligible research expenses over a base amount under the regular credit method.
The base quantity is difficult to calculate. It’s calculated using a fixed-base percentage and the company’s average yearly gross receipts over the previous four tax years.
Companies that have never claimed the R&D credit before or don’t have the data needed to assess their eligible historical research expenses will likely find the second technique to be more straightforward.
Alternative Simplified Credit Method
Calculating the R&D tax credit using the Alternative Simplified Credit (ASC) approach consists of four steps:
- Average the company’s qualified research expenses (QREs) over the past three years.
- Multiply the average QREs by 50%.
- Subtract that result from the QREs of the current year.
- Finally, calculate the R&D tax credit by multiplying that number by 14%.
Who Is Eligible For the R&D Tax Credit?
Any business that incurs expenses while attempting to create new or improved goods or processes while on US land is eligible for the R&D credit.
A simple four-part test can help you figure out if your company is eligible for the federal tax credit.
- Elimination of uncertainty. You must have performed research to eliminate any uncertainty about the development or improvement of your company’s products or processes. Changes for aesthetic purposes are not enough to qualify.
- Experimentation processes. You must experiment to remove uncertainties by using modeling simulation, trial and error, or other R&D methods.
- Research must be technological. Engineering, physics, chemistry, biology, and computer science are all examples of hard sciences that you can use in research to qualify.
- Qualified purpose. The research’s goal must be to develop a new or improved product or method that improves functionality, dependability, performance, or quality.
Some activities are specifically excluded from the R&D tax credit by the tax code.
According to the Instructions for Form 6765 by the IRS, excluded activities are:
- Research conducted after the start of production
- Research to adapt a product for a specific customer’s needs
- Duplicating an existing process or product
- Studies or surveys
- Research about certain software for internal use
- Research performed outside of the United States or a US territory
- Research in arts, social sciences, or humanities
- Research funded by other people or government programs
A few states also have their own R&D tax credit programs. These states have their own set of regulations and limitations, so it’s best to talk to a tax professional in your state to see if you qualify for both a federal and state credit.
Calculating R&D Tax Credits: Expenses
Documenting your company’s QREs is required to calculate the R&D credit, including:
- Wages paid to anyone working on, supervising, or supporting the R&D process
- Supplies used during the R&D process
- Research expenses paid to third parties for performing research on behalf of the company
- The cost of renting hardware and cloud services for R&D purposes
For the expenses to be considered, the study does not have to result in a successful product or procedure. You can claim the credit even if the initiative or research was a failure.
Special Rules For New Businesses & Startups
The federal R&D tax credit is not refundable, but you can carry it forward for up to 20 years if your available credit is more than your tax payment. New enterprises with a lot of research costs but little or no income tax liability have an option that can assist them in decreasing their tax burden right now.
New and small firms can utilize the R&D tax credit against their payroll tax (FICA) for up to five years, because of the Protecting Americans from Tax Hikes (PATH) Act of 2015. This permits businesses to gain from their research initiatives regardless of whether they are successful. To be eligible for the payroll tax credit, a corporation must meet the following criteria:
To qualify for this payroll tax offset, the business must have:
- Less than five years of gross receipt
- Under $5 million in gross receipts this year
Each year, a qualifying business can deduct up to $250,000 from its R&D credit from its payroll tax liability. However, you must choose this option on an originally filed tax return, so if you forgot to apply the R&D credit to payroll taxes in a previous year, you wouldn’t be able to make up for it by filing an amended return.
The PATH Act also permits small enterprises to use the research tax credit to reduce their alternative minimum tax liability (AMT). To be eligible, the company must:
- Not be listed on a public exchange
- Have gross receipts of $50 million or less, on average, from the previous three tax years
Do You Qualify For the R&D Tax Credit?
Major corporations aren’t the only ones who can benefit from the R&D tax credit; in fact, they’re the ones who usually claim it because they have a staff of lawyers and accountants on hand to assist them through the restrictions.
If you’re still unsure whether your company’s R&D operations qualify for the credit, consider the following:
- Do you create anything? You may be qualified for the credit if your company works in software, manufacturing, architecture, engineering, food, or construction.
- Are you enhancing an existing item? Your new product or method doesn’t have to be industry-first; it only has to be company-first. Year after year, businesses rarely create their products in the same manner. You may be eligible for the credit if your company does research to improve its goods or processes cleaner, greener, faster, or less expensive.
If you replied “yes” to both of the above questions, contact Parachor Consulting—Your R&D tax credit experts.