The R&D tax credit incentive was introduced in 1981, reducing state and federal taxes for qualified expenditures. The move came as a response to a recession and pushed innovative companies to remain competitive. To this day, the incentive allows eligible businesses in the public and private sectors to claim tax credits for qualified research.
The R&D tax credit has four components, but most businesses claim only two: the Alternative Simplified Credit (ASC) and Regular Research Credit (RRC). The Alternative Simplified Credit offers companies a 14% tax break on spending on qualified research activities, while the Regular Research Credit offers 20% tax relief. These credits can provide considerable relief to startups and small businesses looking for alternative ways to maximize their cash flow.
The qualification and claim process for tax credits tends to deter businesses from taking advantage of these awesome benefits. Let’s explore some common questions we hear from founders and small business owners on tax credits, how they work, and how you can use them to extend your runway.
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1. “What is the R&D tax credit and who is it for?”
As we mentioned above, the R&D tax credit is a federal incentive designed to reward taxpayers who invest in US-based research activities. The tax credit is available to businesses developing or modifying new or existing products, processes, software, processes, and techniques.
For instance, you’ll likely qualify for R&D credits if you invest time, money, and other resources in improving your products and processes. But to benefit from the incentive, you need to properly document and correctly calculate all your possible R&D tax credits.
Furthermore, your research activities must pass the following four-part test:
1. Permitted Purpose
Your research activities must relate to developing new or improving existing business components’ functionality, performance, reliability, or quality. The product doesn’t have to be an innovation to your industry, but it must be unique to you, your company processes, or your products.
2. Technological In Nature
The qualified activity must rely on hard sciences, like biotechnology, chemistry, computer sciences, or engineering principles.
3. Process of Experimentation
You must undergo a process of experimentation that involves simulation, evaluation of alternatives, and trial and error methodology to confirm your hypothesis. Essentially, you should be employing the scientific method in some form.
4. Elimination of Uncertainties
All qualified activities must contain information that would eliminate uncertainty concerning the development or improvement of the business component. Consider the answers to questions, like:
- What uncertainties did you intend to overcome with your business process that could not be eliminated using standard practices?
- What activities did you perform in the tax year that eliminated uncertainties?
- Did you achieve any advancements as a result of the work described?
Beyond the pillars defined by the four-part test above, you can determine whether your activities qualify for the R&D tax credit by answering the following questions:
- Have you created, improved, or added new features to an existing product?
- Have you integrated multiple processes that were not initially designed to interact?
- Has your research improved the response time of your software application?
- Have you improved a product to reduce cost or improve its manufacturing capabilities?
- Have you incurred costs on the project or incomplete prototype due to unresolved technical problems?
- Are you modifying an existing product or process to improve performance?
If your answer to the above questions is yes, your research and development activities will likely deem you eligible for the tax credit.
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2. “What activities qualify for R&D tax credits?”
Technically referred to as “Qualified Research Activities”, these activities refer to expenses related to the research and development of new or improved products or processes. These include:
- Internal wages paid to employees involved in the research activities, like providing scientific services and those directly supervising and supporting them. Around 70% of the federal tax credit goes to paying wages to employees involved in R&D activities.
- Supplies and equipment used in the research and development processes.
- Contractual research expenses, regardless of whether the research was successful or not.
- Essential research payments made to various scientific research organizations and educational institutions.
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3. “What are the benefits of R&D tax credits?”
Although there are several differences between federal and state R&D tax credits, both avenues offer invaluable benefits to companies that deal with innovation and technical advancement across a variety of industries.
- Tax credits help reduce your current and future tax liabilities, on both the federal and state levels.
- Tax credits can be a source of almost immediate cash if you are a small business or a startup company.
- Tax credits offer a dollar-for-dollar credit against the taxes paid or owed.
- Tax credits are available to companies and businesses in virtually any industry as long as you meet the requirements set forth by the four-part test.
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4. “What types of companies typically apply for R&D tax credits?”
It’s common for companies to disqualify themselves from tax credits. Whether they assume that they’re not a large enough company or they simply don’t have the resources to properly research them, more than 90% of tax credits go unused every year.
However, recent tax reforms have taken steps that make the R&D tax credit incentive favorable to businesses of all sizes across virtually any industry. Some examples of pre-profit and pre-revenue startups that can qualify for the tax incentive include:
If your company deals with polymers, metals, ceramic, glasses, and composites, you can qualify for the R&D tax credit when engaging in any of the following activities:
- Reprocessing of waste materials
- Miniaturization of electronic components
- Development or improvement of new nanomaterials
- Development of new materials and modification of new ones to achieve one or more superior features
Aerospace and Defense
If you are in the aerospace and defense sector and involved in any of the activities listed below, you can apply for the tax credit.
- Use of automated processes and robotics
- Production of innovative products and methods as a cost-cutting measure
- Design and production of unmanned aerial devices
- Innovative designs that improve distinct customer requirements
Information and Technology companies involved in any of the following activities may qualify for the R&D tax credit:
- Creation and testing of prototypes
- Designing of improved data management methods
- Cybersecurity and information assurance
- Improved information management techniques
- Innovation of large-scale networks
- Development of high-end computing infrastructure and applications
Architecture and Engineering
If you are in the architecture and engineering sector, you may qualify for an R&D tax credit if you are involved in any of the following activities:
- Designing of energy-efficient buildings
- Development of plans that use groundbreaking methods to overcome challenging site conditions
- CAD design
- Improvement or development of new designs that optimize the use of resources such as water, energy, and materials
- Design of unique drainage systems and flare stations
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5. “When would you not apply for tax credits?”
For an activity to qualify for R&D credits, you must prove that it meets all the requirements. However, there are certain times that the IRS might raise objections to your claim. Some of the most common reasons that the revenue service may deny your claim include:
- Your systematic trial and error, which involves simple trial and error, is insufficient. Simple trial and error find a solution by relying on hunches and guesses and learning from the mistakes until you find a viable solution. On the other hand, systematic trial and error rely on an organized product development process and hypothesis formation before experimentation and testing.
- Failure for the internal use software to meet the economic risk test. If you are developing an internal-use software, it must meet a high threshold innovation test in addition to the four-part test. In this case, you must prove that the software development involved significant economic risk.
- Lack of substantial records that prove that the expenses you claim are eligible for the credit.
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6. “How do I claim the R&D tax credit?”
To claim your R&D tax credit, you need to file IRS Form 6765 when filing your annual income tax return. If you are not sure whether your research activities qualify for the tax credit, inform your CPA ahead of time that you wish to take an R&D tax credit. Most accountants do not specialize in R&D tax credits due to their complexity, so give your CPA plenty of time to review your claim or consider consulting a third-party provider.
If you plan to claim the R&D tax credit, start planning now. It’s important that you keep detailed records of your activities and expenses well ahead of your annual tax filing. Waiting until tax season may be too late to fix things and gather all the necessary documents required to prove eligibility.
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7. “What proof should I provide to support my claim?”
When claiming your R&D tax credit, the IRS requires you to submit documentation supporting your claim. Therefore, you need to rigorously document all the activities you wish to claim and how much you spent on research activities. Important documents of proof include:
- Payroll records for employees involved in R&D activities
- Contract and invoices paid to third parties involved in the R&D activities
- Receipts showing expenses incurred in sourcing material and equipment used in the research and development
- Blueprints, designs, patents, and prototypes related to the research
- Project and meeting notes related to the research
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Claiming R&D tax credits doesn’t have to be intimidating or difficult. With the right documents, you may even be eligible to claim credits from current and prior tax years.
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.