The R&D tax credit is a government tax incentive for U.S.-based businesses that design, develop, or improve products, software, processes, or formulas. The government calculates the stimulus based on increased research activities and expenses. You can, therefore, benefit from the relief if your company pursues innovation with increasing investment.
Almost any company can benefit from R&D tax credit regardless of industry. The key metric by which the government qualifies R&D depends on a four-part test.
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The Four-Part Test
The Internal Revenue Code and the Treasury Regulations use the Four-Part Test to determine R&D tax credit eligibility. Most people associate R&D with companies that encounter and resolve technological challenges. However, “R&D” is much broader that most expect. You may find that your business qualifies for the tax relief incentive if you meet this test:
- Process of experimentation – you must prove that you have tried other alternatives for achieving the desired results through simulation, modeling, and systematic trial and error.
- Research purpose – your research must create a new, or improve an existing, business component to achieve improved function, performance, reliability, or quality.
- Elimination of uncertainty – while presenting your research and development, you must prove that you have eliminated uncertainty about the development or improvement of the business component.
- Technological in nature – your process of experimentation must rely on hard sciences such as computer science, biology, physics, or chemistry. However, you should refrain from refining, exceeding, or expanding existing scientific principles.
If you plan to apply for the R&D tax credit, be ready to identify, document, and support your R&D activities. If your development is related to internal-use software (IUS), you must satisfy these three additional tests:
- The software development must involve a significant economic risk that requires you to commit substantial resources.
- The software must be innovative and result in speed improvement and substantial cost reduction worth the investment.
- The software shouldn’t be commercially available to taxpayers without making significant changes to satisfy the above two requirements.
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Types of R&D Tax Credits
To benefit from R&D tax credits, you need to understand the two types available and which category your business falls into.
The R&D tax credit is calculated in two ways: the regular research credit (RRC) and the alternative simplified credit (ASC).
The RRC is an incremental credit that takes 20% of a taxpayer’s current-year qualified research expenses (QREs) that exceed the base amount determined by applying the taxpayer’s historical percentage of gross receipts spent on QREs to the average of the last four years’ gross receipts.
The ASC takes 14% of the QREs for the taxable year that exceeds 50% of the average QREs for the three years prior to the credit determination year. If the taxpayer has no QREs in any one of the three preceding tax years, the ASC rate equals 6% of the QREs for the credit determination year.
Companies that have not previously claimed the R&D credit or that don’t have the historical QRE data should use the ASC.
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Benefits of R&D Tax Credits
Taking advantage of R&D tax credits offers numerous benefits, including:
Improving Cash Flow
The R&D tax credit has been associated with scientists and experimental lab work for a long time. However, businesses across a wide range of sectors can take advantage of the tax incentive that helps reduce federal income tax liabilities.
You should claim your R&D tax credit through your annual tax return. The IRS calculates the credit annually based on the amount your business pays or incurs on qualified research expenditures (QRE). The credit amount represents 7-10% of the incurred or paid QRE during the year. Claiming this amount can be a significant boost to your growing business.
While outlining your QREs, you can include costs such as:
- Internal wages paid to employees participating in R&D activities
- Supplies used in the R&D activities
- Amount paid to third parties hired to assist in R&D activities on behalf of your business
But before you calculate and capture your R&D tax credit, you need to assess the eligibility of your project(s) relating to the design, development, and construction of new or existing business processes.
If your project passes the four-part test, then you likely qualify for R&D tax credit relief. That said, there’s one important caveat that you must consider before concluding eligibility. Any project you’re conducting under a contractual agreement with a third party is regarded as funded research, hence disqualifying the R&D tax credit.
Therefore, you need to review contractual agreements carefully to determine if the contractor bears any financial risks of failure and retains the rights to the results of the R&D work. You still qualify for an R&D tax credit if you have signed a fixed-fee contract agreement. On the other hand, work performed under cost-plus or times and material agreement automatically disqualifies the tax credit.
Offsetting Your Payroll Taxes
If you are a new business or a startup, you can apply for an R&D tax credit against your payroll for up to five years. Under the PATH Act of 2015, you can get a maximum benefit of up to $250,000. The payroll-tax offset caters to qualified expenses incurred during the previous tax year. You can still receive benefits for research activities even if they are not profitable.
When preparing your federal income tax returns, make sure you calculate and show the R&D credit and the portion applied to offset your payroll taxes. After applying, the offset will be available quarterly from the first calendar quarter. But to be eligible, you must meet the following requirements:
- Prove that you have a payroll-tax liability
- Have gross receipts for five years or fewer, as interest income counts towards those receipts
- Carryout qualifying research activities and expenditures
- Your gross receipts for the applied year accumulate to less than $5 million USD
According to the IRS, gross receipts include:
- Income from investments
- Total sales, which include net returns and allowances
- All amount received for services
If you want to start benefiting from this tax relief, start planning early to determine your eligibility for the offset tax payroll. Planning early helps you understand all the information you need to gather by the end of the year and makes for more accurate record-keeping.
Using the R&D Tax Credit Carryforward
You can make use of the R&D tax credit carry forward to take unused R&D tax credits generated over the year since you qualified for QREs and apply them for future tax liabilities. But you can only use this if you invested in research and development but didn’t turn a profit, or if you were eligible for a larger tax credit than what you paid in income taxes.
If you have unused tax credits, you must file amended tax returns for the years you failed to claim. Then you can carry forward the unused tax credits for up to 20 years after bringing them back for one year. When claiming your tax credit, you need to move your credits to an open and amenable tax return. In addition, make sure you reduce your carry forward tax credits by any amounts that you could have utilized in the closed taxable years.
Things to Consider Before Applying for Payroll Tax Relief
The type of scrutiny you receive from the IRS after applying for this tax relief depends on how you deposit your payroll taxes. For example, if you deposit your payroll taxes to the federal government monthly or semiweekly, you will need to file a payroll tax return at the end of each quarter using Form 941.
Regardless of the size of your business, the IRS technical specialists will get involved in your R&D credit examination. In addition, if your business is in the tech industry, you will face complex rules even if you are eligible for the R&D tax credit.
Most CPAs don’t suggest applying for these tax credits due to their complexity. Fortunately, that’s where MainStreet comes in. At MainStreet, we help startups and small businesses by taking the guesswork out of government tax credits and passing the savings onto you. We handle all of the qualification, questions, and paperwork on the backend, so you can focus on running your business. If you qualify, we’ll pass along the final paperwork to you for your CPA to file along with your annual tax return. It’s that simple.