What is the Research and Development (R&D) Tax Credit?
The R&D tax credit is a general business credit that was created for taxpayers that design, develop, or improve products, processes, techniques, formulas, or software. The R&D tax credit was first introduced in 1981 under Internal Revenue Code (IRC) §41 as a strategic tool to stimulate R&D and job growth in the United States. The Protecting Americans from Tax Hikes (PATH) Act of 2015 permanently extended the R&D tax credit and expanded several provisions. The R&D tax credit can be applied as a dollar-for-dollar offset of federal income tax liability and, in certain circumstances, payroll tax liability. Most states provide a similar credit. A credit of $.04 cents – $0.65 cents is generated for each dollar of qualified research expenditures (QREs). For example, approximately $40,000 – $65,000 of Federal R&D credits is generated from $1 million dollars of QREs.
What type of industries can benefit from the R&D credit?
A common misconception surrounding the R&D tax credit is that you must be a large corporation, or that only scientific and technological industries qualify. Industry and company size generally does not matter. With the recent changes to the R&D tax credit, start-ups, and small and medium-sized companies from a variety of different industries can qualify for this lucrative credit, such as: Aerospace & Defense, Architectural Firms, Breweries & Vineyards, Construction, Engineering, Financial Services, Food & Beverage, Health, Life Sciences and Pharmaceuticals, Technology & Hardware, Transportation, and Software Companies.
Qualified Small Business Payroll Tax Credit for Increasing Research Activities
Under a provision of the PATH Act, a qualified small business (QSB) can elect to claim a certain amount – up to $250,000 of its research credit annually as a payroll tax credit election against its employer portion of social security tax, as imposed by IRC §3111(a), rather than against income tax liability.
To qualify as a small business, a corporation (including an S corporation) or partnership, must meet the two requirements listed below:
i. The gross receipts for the tax year the entity is claiming the credit for must be less than $5,000,000.
ii. The entity must have zero gross receipts for any taxable year preceding the five-tax-year period ending with the year the entity is claiming the credit for. For example, for the 2020 credit, the entity must have zero gross receipts for tax year 2015 and prior.
The payroll tax credit election is an annual election made by a qualified small business specifying the amount of research credit that may be used against the employer portion of social security liability. The credit is claimed on Form 941, Employer’s Quarterly Federal Tax Return. In addition to Form 941, Form 8974, Qualified Small Business Payroll Tax Credit for Increasing Research Activities, will also need to be completed and attached.
Internal Revenue Code (IRC) §41 Four-Part Test
In order for activities to qualify for the research credit, a taxpayer must show that the activities meet all the requirements of the Four-Part Test as described under IRC §41.
1. Permitted Purpose – To satisfy this test, you must demonstrate that the activities performed were intended to create or improve a product, process, formula, or software with respect to one of the following:
2. Technological in Nature – To satisfy this test, you must demonstrate that the activities performed fundamentally relied on the principles of one of following hard sciences:
i. Biological sciences
ii. Computer science
iv. Physical Sciences
3. Technical Uncertainty – To satisfy this test, you must demonstrate that some level of technical uncertainty existed during the performance of the activities related to one of the following areas:
i. The capability or method for developing or improving the product, process, formula, or software.
ii. The method for developing or improving the product, process, formula, or software.
iii. The appropriate design for the product, process, formula, or software.
4. Process of Experimentation – To satisfy this test, you must demonstrate that in order to eliminate your technical uncertainty, there was a process involved that included an evaluation of alternatives or iteration. For example, you could have been performing:
iii. Systematic trial and error
It is important to note that your activities are not contingent upon success. In fact, failure is a good indicator of the technical uncertainty test, so your activities would still qualify even if you failed to reach your desired outcome.
Types of Expenses that Qualify for the R&D Tax Credit
- Wages: Taxable wages on Form W-2, Box 1 paid or incurred to an employee for directly performing, supporting, or supervising “qualified research”.
- Supplies: any amount paid or incurred for “supplies” used in the conduct of “qualified research”.
- Contract Research: 65 percent of any amount paid or incurred by the Company to any person (other than an employee of the Company) for “qualified research”.
- Cloud Computing: Payments to cloud service providers for the cost of renting server space if the hosting space was used for the conduct of development or testing.
How and when do I claim the credit?
The R&D tax credit is claimed annually in the Federal tax return. Specifically, the tax credit is reported on Form 6765, Credit for Increasing Research Activities. Each state has its own R&D tax credit form. Certain elections (e.g. 280c) must be made on an originally filed tax return.
Can I claim the Federal and State credit for prior years?
Federal and State taxpayers can claim the R&D tax credit retroactively for tax years that are open to amendment under relevant statutes of limitations. For Federal, taxpayers can generally file amended returns for the past three years. The statutes vary for each state. For example, for California the statute is open for four years.
How long can the credit be carried-forward for?
If your company does not have taxable income and does not qualify for the payroll tax credit, the credit can still be carried forward and used to offset future taxable income. The Federal R&D tax credit can be carried forward up to 20 years. The statutes vary by each state. For example, for California the credit can be carried forward indefinitely.
What type of supporting documentation is needed to claim the R&D tax credit?
To claim the R&D tax credit, a company must retain records in sufficiently usable form and detail to substantiate that the expenditures claimed are eligible for the credit. A company must first identify and document qualified R&D employees, activities, and vendor expenses. Next, the company must document how the credit was calculated and how their research activities meet the requirements to qualify for the credit. Some examples of this are collection of Form W-2’s, GL details, vendor invoices, master contract agreements, completion of R&D Survey by Subject Matter Experts (SMEs) and collection of contemporaneous supporting documentation.
We at Dana R. Borys, An Accountancy Corporation can help maximize and support your tax credits by providing an audit-ready deliverable to ensure that the claim and records exceed the Internal Revenue Service standards.