The Research and Development (R&D) tax credit can provide substantial tax savings to business owners. However, due to the complexity of the credit, many businesses are not taking deductions they are rightfully entitled to.
This article will make it easy for you to determine whether you qualify for the credit and what steps you need to take to claim this credit.
Table of Contents
What is the R&D Tax Credit?
The R&D tax credit provides a tax break for companies developing the functionality, performance, reliability, or quality of a new or existing business component. Eligible business components include:
- Products
- Processes
- Computer Software
- Techniques
- Formulas
- Inventions
The United States created this tax credit to reward businesses for investing in innovation. Additionally, 30 states offer an R&D tax credit to reduce your state tax liability.
Is My Company Eligible for the R&D Tax Credit?
Eligibility for the R&D credit is much broader than most business owners realize. The credit applies not only to products but also to manufacturing processes, software development, and quality enhancements. Additionally, start-ups are eligible to use the R&D tax credit to offset their payroll tax for up to five years.
In general, your company will be eligible for the R&D tax credit if it:
- Devotes time and resources to creating new or innovative products
- Improves existing products
- Develops processes, patents, prototypes, or software
- Hires designers, engineers, or scientists
Do not be disappointed if you have qualified for the R&D tax credit in previous years but did not use it. You can file amended tax returns for three prior years to take advantage of the R&D tax credit.
How Will My Company Benefit from the R&D Tax Credit?
Tax credits are the most advantageous form of relief provided by the IRS. Tax credits work by directly reducing your tax liability. For example, if you owe $20K on your taxes but received an R&D tax credit of $5K, you will only owe $15K instead.
Typically, the R&D credit saves companies up to 10% of annual R&D costs. So, if you spent $1M on research and development in 2022, you can expect to receive a tax credit of around $100k.
Start-up companies can use the R&D tax credit to offset up to $250K of payroll taxes in five separate years.
Non-public companies with less than $50 million in revenue can use the R&D credit to offset the alternative minimum tax.
Common Misconceptions About the R&D Credit
There are three common misconceptions that lead businesses to not taking the R&D credit when they are rightfully entitled to it.
Your Company Isn’t Paying Federal Income Tax
Just because you do not owe federal income tax does not mean you cannot use the R&D credit. Instead of offsetting your federal income tax, you can use the R&D credit to decrease your payroll taxes. Start-ups and small businesses can deduct up to 250K each year for five years from their payroll taxes.
To qualify to offset your payroll taxes, your company must meet both of these requirements:
- Have less than $5 million in gross receipts for the credit year
- Have no gross receipts or interest income dating back more than five years
Your Company Isn’t Focused on R&D
You don’t have to be a high-tech and innovative company to qualify for the R&D credit. If your company invests time and resources into developing or improving processes or products, you may be eligible for the R&D credit.
Your Company Isn’t Developing Anything New
Even if your company isn’t developing anything new, you can still be eligible for the R&D credit. The tax credit is also available to companies that are improving products, processes, techniques, formulas, or software.
Additionally, the research and development does not have to be groundbreaking and new. The research only has to be new to the company performing it.
How to Determine R&D Eligibility: The Four-Part Test
The Internal Revenue Code (IRC) and Treasury Regulations established a four-part test to determine whether your expenditures qualify for the R&D credit or not.
1. Qualified Purpose
The research must be intended to develop a new or improved business component. The improvements should be related to function, performance, quality, or reliability.
2. Elimination of Uncertainty
The research must be intended to eliminate the technical uncertainty of the capability of the product, process or improvement. Uncertainty remains if the company does not establish an optimal methodology or appropriate design to determine the capability of the product or process.
3. Process of Experimentation
The company must show a systematic approach to identifying and evaluating one or more alternatives for achieving the desired result. Experimentation can be done through trial and error, modeling, simulation, or some other methodology.
4. Technological in Nature
The process of experimentation must apply the principles of hard sciences such as engineering, physics, chemistry, and computer science.
How Can My Company Claim the Credit
To claim the R&D tax credit, you must file Form 6765 with the IRS. The calculation can seem complex and convoluted at times, so make sure you or your CPA has a firm grasp of the instructions before filling out the form.
If you forgot to claim the R&D credit in a previous tax year, you can still file amended tax returns to take advantage of the credit and receive a refund from the IRS. Generally, you will be able to amend the three previous year’s tax returns.
What Documentation Is Necessary to Claim the Credit?
Having good documentation is the backbone of taking this credit. It would help if you documented all of your research activities so you can establish how much expenses you actually paid for qualified research and development. Remember that, although you are allowed to estimate some research expenses, those estimates must have a factual basis underpinning the assumptions.
Some examples of documentation that will help you claim the R&D credit:
- Payroll Records
- Project lists and notes
- Lab results
- Expense reports
- Emails and other communications produced in the business
Does the R&D Credit Bring Increased IRS Scrutiny?
Yes, claiming the R&D credit can bring increased IRS scrutiny. That is why it is crucial to be thorough when calculating and documenting all of your qualified research and development activities. The courts will often disallow deductions that do not have sufficient documentation or follow the four-part test outlined above.
Improper Reporting Example
In the case of Siemer Milling Company v. Commissioner of Internal Revenue, the court disallowed over $235,000 in R&D credits claimed by Siemer Milling Company in 2010 and 2011.
In 2010 and 2011, Siemer Milling developed new flour products and improved its production line. Siemer Milling thought developing a new product and engaging in technical activities were enough to qualify for the R&D credit. However, Siemer Milling never demonstrated how these expenses met all four tests to qualify for the credit.
The court found that just stating that you are undergoing research and development is not enough to qualify for the credit. Furthermore, the court ruled that listing the steps taken in the development is insufficient to constitute scientific research. You must undertake a methodical plan involving a series of trials that test a hypothesis to qualify for the credit.
Amortization of R&D Expenses Starting in Tax Year 2022
Starting in 2022, companies will no longer be able to immediately deduct expenses that qualify for the R&D credit. Instead, they will have to capitalize the costs and amortize them over a period of 5 years. Research and development costs that occur outside the U.S. will be amortized over a 15-year period.
Conclusion
Suppose your company has been developing new or improving existing products or processes. In that case, there is a good chance that your company qualifies for the R&D credit. However, it is important to remember that you must have robust documentation to calculate your credit accurately.
At Windstone Financial, we have helped numerous business owners take advantage of the R&D credit. If you think that your business might qualify for the R&D credit, click the button below to speak with a CPA today!
