Established in 1981, the research and development (R&D) tax credit aims to provide working capital to businesses in various industries across the country. Although the R&D benefit was first introduced as an income tax credit, the new changes in the last few years now make it possible for small businesses and pre-revenue companies to take advantage of these programs.
Even with these changes, businesses continue to miss out on the R&D tax credits each year. Companies often don’t know enough about R&D tax credits or they’re aware of the program but don’t feel that the qualifying hoops are worth jumping through.
Below we look at the most common reasons why some companies fail to take advantage of the Federal R&D tax credit program.
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Why Most Companies Don’t Take Advantage of R&D Tax Credits
The benefits of R&D tax incentives are substantial but underutilized. If you take a closer look at how R&D tax credits work, it’s clear that the benefits of the program far exceed the effort to apply. If your company is in the dark about these benefits, read on. We’ll dispel some common R&D tax credit myths, as well as how to make the most of these benefits.
Myth 1: “We haven’t earned any revenue yet”
Your business doesn’t need to turn a profit to benefit from the research and development tax credit. As long as your small business meets the other requirements (detailed below), you can take the credit as a payroll offset of up to $250,000 per year.
You must have less than $5 million in gross revenue in the previous credit year and have no gross receipts five years before the credit year. In addition, you must have done your company’s payroll taxes in an income tax form field on time.
Myth 2: “We’re not a large enough company”
R&D tax credits differ from other R&D government incentives in that they benefit firms of all sizes. Per the U.S tax code, any firm that develops new or improved products, processes or software qualifies for the program. In addition, this benefit is available across virtually any industry, so long as your company’s R&D meets the parameters of the IRS’s four-part test.
Myth 3: “We don’t have any employees”
You can still apply for R&D tax credits even if you’re a party of one. Although wages contribute a fair amount to your final credit calculation, it’s likely that you incur other costs such as contractor payments and supply expenses.
Whether you have employees or not, you can use the R&D tax credit to offset your alternative minimum tax. The most important thing is to ensure that you document your R&D activities, project notes, process diagrams, and lab results. After all, if you take the tax credit as a payroll offset without an actual payroll, you can carry the credit forward up to 20 years.
Myth 4: “We are not a qualified small business”
Qualified startups and small businesses can claim their R&D tax credit against payroll tax. However, you can still apply if you are involved in any of the following activities:
- Developing a new business or manufacturing process
- Developing new prototypes or models
- Improving quality control testing
- Developing proprietary products and seeking patents for them
- Improving existing businesses or efficiency of existing processes
- Environmental testing or certification
If you fall under any of these categories, you can likely deduct 10% of your R&D costs from your taxes.
Myth 5: “R&D credits don’t apply to our industry”
If your startup is not involved in research and development activities but has technical-like employees, you can apply for R&D tax credits. Such employees include developers, engineers, technicians, researchers, and scientists. To qualify, these employees must be creating new or improved products, processes, techniques, or software.
As mentioned above, there’s no limit to the industries that can claim the R&D tax credits, so long as they meet the requirements. Companies in virtually any industry can claim R&D credits if they are involved in new product development or improvement of existing ones, whether the products are viable or not.
Myth 6: “We didn’t invent something new”
You don’t need to reinvent the wheel to qualify. While the R&D tax credit is for small businesses and startups involved in designing, developing, and improving products, processes, software, and techniques, it doesn’t necessarily need them to be new. As long as your company pursues innovation intended to increase investment, then you can apply and qualify for the R&D tax credit.
Myth 7: “Our R&D was unsuccessful”
The R&D tax program doesn’t specify success as a precursor to qualifying for the tax credit. Most great ideas are the product of a series of failures. You shouldn’t have to shy away from riskier initiatives just because you’re afraid of failing and losing out on your ROI. You likely spent substantial money developing those initiatives, regardless of the outcome.
The federal government recognizes these efforts by availing R&D tax credits to lessen the burden even if your invention failed. When approving these taxes, they acknowledge the effort and not the success.
Myth 8: “We already filed our taxes”
If you have already filed your annual tax returns, it might be too late to claim your payroll tax credit. Luckily, this program gives you up to three years to amend your earlier tax returns. By doing so, you can retroactively take advantage of the benefit offered by the research and development tax credit.
It’s also a good idea to familiarize yourself with the rules and regulations of your state that allow amendments on company tax returns. If you have already filed your yearly tax returns, it may not be too late to claim your R&D tax credit.
Alternatively, if your business didn’t benefit from the income tax offset for the previous tax year, it can still be eligible for a payroll tax credit claim by the R&D program. The credit claim allows qualifying small businesses to reduce their employer FICA payroll tax liability in the current year.
Myth 9: “We can’t justify the cost of an R&D study”
When claiming R&D credit on an original return, you must retain sufficient records to substantiate the eligibility of the expenditure claims. However, the IRS may require you to provide documentation such as a list of each business component and research activity related to your R&D claims.
In this case, you can hire a professional tax expert to help determine to what extent your records meet the IRS requirements. Services like this can also help you gather more evidence to support your credits.
Myth 10: “We aren’t a ‘scientific’ company”
You don’t have to run a traditional scientific company to benefit from R&D tax credits. In general, any company of any size can benefit as long as they invest in research, development, design, and improvement of new or existing products. The most important requirements to qualify for the credit program include that the business paid, pays, or expects to pay:
- Regular federal income tax
- Federal payroll tax
- Similar state tax in one or more than 40 states in the country that provide R&D or similar incentives
- Similar taxes in one or more 35 non-US countries that provide similar incentives
Although manufacturing industries claim most R&D credits, there’s no limit on which sector can claim as long as you meet the mandatory requirements.
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Determining R&D Credit Eligibility
Any company involved in resolving technological challenges is eligible for R&D incentives. However, eligibility mostly depends on whether the company meets the required criteria or not. You can test your eligibility by using the IRS’s four-part test:
- Qualified purpose – Your research must be aimed at creating or improving a business component to achieve improved functionality, reliability, or performance.
- Elimination of uncertainty – You must demonstrate that you have tried to remove uncertainty about the development or improvement of your business component.
- Experimentation: Through systematic trial and error, simulation, or modeling, you must prove that you have tried other alternatives to achieve the desired results.
- Technological in nature: The process of experimentation for your research and development must rely on hard sciences. However, you are not obliged to expand, exceed, or refine existing scientific processes.
Before you claim your R&D credits, you must review your startup’s operations to see if they are eligible. In addition, be ready to provide proof of any R&D activities with thorough documentation.
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Taking Advantage of R&D Tax Credits
Claiming R&D tax credits doesn’t have to be intimidating or difficult. There are a few ways you can go about filing your claim. You can book a series of appointments with your accountant to evaluate your eligibility and get your documents in order. You can attempt to gather the right document and fill out the tax forms on your own. Or you can partner with MainStreet.
Every year, the government sets aside billions in tax credits that most accountants never think to claim. With MainStreet, you can plug your payroll and accounting software directly into our dashboard. We search through 200+ credits, finding the ones that best suit your business. Once you qualify, we do all the heavy-lifting to claim your credits and pass the savings onto you.