The R&D tax credit is a government-sponsored tax incentive offered to companies that create or improve a product, process, technique, or service to improve quality, reliability, or functionality. It is an effective way for small businesses to reduce their tax burden. However, many companies do not apply for R&D tax credits because they do not believe they qualify. We will guide you through the steps to apply for R&D tax credits.
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1. Compile and Organize Documents
A company needs to gather several documents before you begin applying for R&D tax credits. These include payroll records, receipts, invoices, research-related notes, blueprints, and designs to verify that a business engages in R&D.
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2. Check that These Documents will Allow You to Pass the IRS’ Four-Part Test
The IRS four-part test is a list of criteria that must be met to qualify for R&D tax credits. The test consists of the following sections:
New or Improved Business Component
Companies must conduct research to develop a new and improved business component. A business component can be a product, process, software, service, technique, or formula used internally or commercially.
The results do not necessarily need to be new to your industry or successful. The goal must be to improve a business component’s reliability, performance, composition, or function.
Process of Experimentation
A business must prove to the IRS that they have undergone an iterative development process. The process needs to include testing, failing, altering, and comparing the new business component to the old one.
When evaluating your business activities, you need to determine if the available information establishes the capability of improving the business component. If so, the activity would not qualify for the R&D tax credit. There need to be technical obstacles related to the business component itself. Uncertainty based on the product’s advertising or marketing would not fulfill this requirement. On the other hand, a clothing company experimenting with a different fabric to make their product more comfortable qualifies as an activity with an uncertain outcome.
To pass the technological discovery test, a company must perform activities that utilize the hard sciences, including engineering, life science, physics, and software manufacturing/design. Soft sciences and activities such as conducting surveys do not fit this criterion.
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3. Fill Out Form 6765, Credit for Increasing Research Activities
Form 6765 is the tax form used for small businesses to document R&D activities. It consists of four sections.
- Section A: For businesses claiming the regular credit. Companies need to enter the amounts they paid for R&D activities. It equals 20% of the Qualified Research Expenses (QREs) over the calculated base amount. However, claiming this credit can get complicated depending on the business.
- Section B: This section is for the Alternative Simplified Credit (ASC). Companies filing for ASC will skip Section A and vice-versa if opting for the regular credit. This credit allows a business to claim 6% of its QREs and is generally less complex than claiming regular credit.
- Section C: After calculating the current year tax credit, this section is used for additional forms and schedules that require reporting based on a company’s structure.
- Section D: The final section is only used if a business makes the payroll tax credit election. Otherwise, it is skipped.
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Filling out Form 6765 can be a heavy lift for small businesses. We save companies time and effort that can be invested back into the business. Get in touch with us for help applying for R&D tax credits and saving money!