By: Alex Bray, JD, LLM, MBA, Aldrich Advisors
For companies looking to reduce their tax burden, research and development (R+D) tax credits are a valuable yet underutilized tax planning strategy. Not only is this a generous incentive at both the federal and state levels, but the standards to qualify are much more accessible than many people realize. If your company is taking risks to innovate, here’s what you should know about how to qualify for the R+D tax credit.
What is the R+D tax credit?
The government created the R+D tax credit to encourage businesses to invest more in domestic research and innovation. This includes designing, developing, or improving products, processes, techniques, software, and other inventions. It’s a federal tax credit, and more than 30 states offer their own version of an R+D credit, as well.
Through this credit, your business can use its eligible research costs to reduce tax liability. Some possible expenses that qualify are:
The wages of employees conducting research
The cost of supplies used during R+D
The cost of hiring contractors or consultants for research-related activities
Payments made to educational institutions and scientific research organizations for conducting your research
Certain cloud computing expense
How can businesses use the tax credit?
You can potentially claim approximately 10% of your annual R+D costs for the federal credit, and there is no limit on the total amount you can claim. Remember, this is a tax credit, not a deduction. It gives your business a dollar-per-dollar reduction in your tax bill, which is more generous than a deduction.
Even though the credit is non-refundable, if you don’t owe enough taxes to use the entire earned credit, you can carry it forward for up to 20 years to offset future taxes.
New small businesses and startups with gross revenues below $5 million and no gross receipts dating back more than five years can also use the research and development tax credits to offset their payroll (FICA) taxes, up to $250k.
Finally, eligible small businesses (ESBs) can use this credit against any owed Alternative Minimum Tax (the IRS defines an ESB as one that is not publicly traded and has averaged less than $50 million a year in revenue over the past three years).
How do I qualify for the R+D tax credit?
Business owners usually imagine scientists in a lab when they think about research. While scientific research is one way to qualify for the R+D tax credit, it’s far from the only option. Companies in a wide range of industries use this credit, including construction, architecture, engineering, manufacturing, agriculture, and finance.
The government also uses a broad definition for the activities that count as innovation. Inventing new products is a common way to use this credit, but anyone can be the innovator, not just degree-holding scientists or state certified engineers. Companies also qualify by designing new software, creating more efficient manufacturing processes, or enhancing product quality.
The research doesn’t have to be brand new for the entire world. It just must be new for your organization, and something you had to experiment with to figure out. For example, you develop a manufacturing process that other companies might be using, but the technique is not publicly available, so you had to discover it yourself.
Even if your research doesn’t lead to a successful innovation, you may still be eligible to claim the credit for trying. Besides these general standards, ultimately your research must pass a four-part test developed by the IRS and federal legislature.
How does the four-part test work?
For your research to qualify for the R+D tax credit, it must pass all four of the following
components:
1. Business component/qualified purpose: The research must have the goal of developing
or improving products or processes connected to your trade or business, to add
new/better functions, performance, reliability, or quality. Eligible business components
include products, processes, techniques, formulas, and software. You must identify the
specific business component that you're trying to improve and how you would use the
innovation as part of your operations.
2. Elimination of uncertainty: The second test looks at whether you researched to
eliminate uncertainty regarding the development/improvement of a business
component. In other words, you spent resources to learn something new and necessary
for a possible innovation. The information available to you beforehand must have been
insufficient to solve this problem, so your business had to invest in research and
development.
3. Technological in nature: Expenses that qualify for the R+D credit must also be based in
the hard sciences. The IRS states that the research must be based on principles of
physical or biological sciences, engineering, or computer sciences. Non-technological
expenses like consumer surveys, cosmetic or aesthetic improvements, or management
studies do not meet this requirement.
4. Process of experimentation: The last of the four-part test checks that you used a
process of experimentation to evaluate one or more alternatives where the final results
were uncertain at the beginning of your research. This could be a system of trial and
error, modeling, simulations, and other forms of experimenting to develop an improved
process or product.
How do I maximize the credit?
If you think your business might be eligible for the R+D credit, these steps can help you get the most out of the tax break:
1. Properly document research expenses: be sure to track ledger expenses, payroll, lab
results, project notes, design drawings, and emails showing the costs, timelines, and
research results. While you can submit cost estimates, clear records help you avoid
forgetting about any expenses you might claim. Accurate technical records also can
defend against a possible audit.
2. Remember the four-part test: If you are considering a project for this credit, ask
yourself how and why it passes all components of the four-part test. Make sure you can
easily answer those questions.
3. Review state credits as well: Many states offer their own R+D tax credit, with different
standards than the federal version. Check to see how you can qualify in all the states
you operate.
4. Keep an open mind for what qualifies: The R+D tax credit is broad and encompasses
many activities of discovery and innovation. If you think your business might be
innovating or risking resources to try new things, it is worth investigating.
Managing Your Tax Liability with Aldrich
If you're unsure whether your work qualifies for the R+D tax credit, reach out to your Aldrich
Advisor. Our team of tax experts can help you determine whether you qualify and what steps
your business should take to maximize its tax savings.
Alex Bray, JD, LLM, MBA, is the Research and Development Tax Director at Aldrich CPAs + Advisors LLP in Lake Oswego, Oregon and can be reached at 503-716-9389 or abray@aldrichadvisors.com for more information.