What Are Research and Development (R&D) Tax Credits?
When most people think Research and Development (R&D), they think of white labs coats and test tubes. However, the IRS defines it a bit differently here in the U.S. In hopes of incentivizing U.S. businesses to keep highly technical jobs here in the U.S., the R&D tax credit applies to any business creating or improving a new product, process, formula, patent, or new technologies.
Originally enacted in 1981, under The Economic Recovery Tax Act (ERTA), the tax credit has since expired 8 times and has been extended 15 times, until 2015 when the tax credit became permanent, under the Protecting Americans from Tax Hikes Act (PATH).
As the tax credit became permanent, this opened the door for many businesses to take advantage of the tax credit for the first time. Before the provision to legislation, the R&D tax credit could only be used to offset federal and state year-end tax liabilities. However, now, the tax credit applies to companies of all sizes regardless of their tax position. Additionally, the the provisions also now allow businesses to go back as far as their statute of limitations are open, 3 years for federal (most states follow), and amend prior year tax returns to claim all development costs and unclaimed tax credits. Find out if your business qualifies today!
Qualified Small Businesses (QSB) – Payroll Tax Credit Offset
Qualified Small Businesses (QSB) may now use the tax credits generated to offset the employer portion of payroll tax owed to the IRS, up to $250,000 for each qualified year. Under definition, a QSB is a business with less than $5 million in gross receipts in the eligible year and not having gross receipts for more than 5 years. This is HUGE for startups or businesses in losses during their first couple years!
Eligible Small Businesses (ESB) – AMT Offset
Effective January 1st, 2016, Eligible Small Businesses (ESB) can now use the tax credits generated against their alternative minimum tax (AMT). An ESB is defined as a business with less than $50 million in average gross receipts for the three preceding years.
How Do You Know If A Business Qualifies?
To qualify for R&D tax credits, a business of any size must meet all four parts of the, 4-Part Test:
- Permitted Purpose: Intended purpose of the activity or project must be to create or improve functionality, performance, reliability, or quality of a business component. The business component is defined as any product, process, software/technology, formula, patent, or invention.
- Elimination of Uncertainty: The activities and projects in question must attempt to eliminate uncertainty related to design, development methods, or components capabilities.
- Process of Experimentation: The activities must include process of experimentation of the unknown that would include testing, evaluating alternative, or systematic trial and errors.
- Technological in Nature: The activities and process of experimentation must rely on hard sciences, such as computer science, engineering, chemistry, biology, or physics.
If you can answer yes to all of these (No to #2) the qualified research expenses (QREs) associated with that project or business component are considered qualified and captured towards the tax credit.
What Expenses Qualify?
After identifying which projects or business components of a business qualify, the next step is determining which expenses qualify towards the credit.
- Wages – Taxable Wages (W2 Box-1) paid to employees directly engaged in qualified activities or those employees directly supervising/supporting those performing the direct research.
- Supplies –All supplies expensed for prototypes or for testing materials can be captured, as well as leased equipment or computers.
- Contract Research – Payments made to a third party (contractor, subcontractor, vendor) to perform qualified research or testing on behalf of the taxpayer or business.
How Big Will The Tax Credits Be?
There are two different methods when calculating the federal tax credit, the Regular Research Credit (RRC), and the Alternative Simplified Method (ASC), as each state either follows one of the two federal methods or has their own set of rules. On average, 10-15% of the QREs for each year will generate federal/state tax credits. The R&D tax credit is actually the “Credit for Increasing Research Activities” and as such, the more QREs that are spent year over year, the bigger the credits will be year over year.
What Does This All Mean?
Whether a business has taken the R&D tax credit before or if this is the first time you have ever heard of the tax credit, Visionary Tax is here to help. We are on a mission to educate CPAs and small to medium-size businesses that have never taken the tax credit about this lucrative and game changing tax credit that can make a difference.
Word From The Author
Thank you for taking the time to read this article. More dynamic content is on its way! To see if you qualify for the R&D tax credit and meet the requirements above click here:
We will assess the status of your project and conduct a free preliminary credit analysis for all open years, including advising your CPA on how to put your project in position to utilize this credit.
Feel free to email us at [email protected] or call at 714-251-6126 if you have any questions regarding if a business qualifies. Feel free to connect with me on LinkedIn.
You can find more emerging tech insight here: