The truth is the Research & Development (“R&D”) Tax Credit is one of the most overlooked tax incentives in our current tax code system. A major reason for that is the swarm of misconceptions surrounding the credit, with the most common misunderstanding being who can actually qualify. One of the most enticing aspects of the credit is that you do not have to be a major corporation with research labs and teams of scientists in order to claim the credit.
In fact, the credit is available to companies and businesses of all sizes and in a wide range of categories operating both within and outside of the technological and scientific realms. If you perform any type of R&D efforts to develop or enhance a new product, process or technology, you may be eligible for a critical tax credit.
As a result of recent tax code legislation, your business has more reason than ever to take advantage of one of the most misunderstood and overlooked tax benefits.
What’s in this article?
- What is the R&D Tax Credit?
- How has the R&D Tax Credit evolved over time?
- Who qualifies for the R&D Tax Credit?
- How does the R&D Tax Credit work?
- Are any activities excluded from the credit?
- How do I claim the R&D Tax Credit?
- How do you calculate the credit?
- What are the terms of the California R&D Tax Credit?
- How can Squar Milner help you?
What is the R&D Tax Credit?
The Research & Development Tax Credit was implemented in 1981 as an incentive for U.S. companies to invest in innovation and technological and scientific advancements. Ideally, the credit would encourage American businesses to hire new employees, develop or improve new products, service lines or techniques, and facilitate the growth of operations.
The Federal Research and Development Tax Credit is a dollar-for-dollar credit against a company’s federal income tax based upon a percentage of qualified research expenditures. It is subject to the limitations of a general business credit. More exactly, if the taxpayer cannot utilize the full amount of the research credit in the current year or the immediate year prior, they can carry it forward for 20 years.
There is a permanent Federal R&D Tax Credit, listed as Internal Revenue Code (IRC) 41, as well as specific state Research and Development Tax Credits. You are able to concurrently claim both the Federal and state tax credits. However, not all states offer this tax incentive.
As of 2019, the states that do not have a state R&D Tax Credit are: Alabama, Washington D.C., Michigan, Mississippi, Missouri, Montana, Nevada, North Carolina, Oklahoma, Oregon, South Dakota, Tennessee, Washington, West Virginia and Wyoming.
*NOTE: Even if your particular state does not offer the credit, you are still eligible for the Federal Research and Development Credit.
How has the Research and Development Tax Credit evolved over time?
Since the inception of the credit in the 1980s, legislation, regulation and judicial precedent have expanded the number of companies able to utilize the R&D Credit.
First, in 2003, lawmakers removed the Discovery Rule from the credit qualifications. With this move, the required research activities no longer had to be “new to the world,” but simply “new to the taxpayer.” This meant that the product, process, technique or service developed through R&D activities no longer had to be an entirely new, never before seen, concept in order to qualify for the credit. Instead, only the taxpayer had to be new to the process, design, technique or service.
More recently, in 2015 President Barack Obama signed the Protecting Americans from Tax Hikes (PATH) Act. The legislation effectively removed the uncertain yearly status of the R&D Tax Credit by solidifying it as permanent tax code. In addition, the PATH Act modified the credit to better benefit small and mid-size businesses and make it accessible to start-ups. More exactly, PATH allows “small eligible businesses,” which are defined as businesses with an average of $50 million or less in gross receipts over the prior three years, to claim the Federal Research and Development Tax Credit against their Alternative Minimum Tax (AMT) liability.
Since then, the 2017 Tax Cuts and Job Act (TCJA) further improved the R&D Credit through indirect means. For example, the TCJA lowered the federal corporate tax rate from 35% to 21%. As a result, the rate reduction increases the value of the credit. Furthermore, the TCJA increased availability of the tax credit for certain taxpayers by eliminating the Sec. 55 AMT and amended Sec. 38(c)(6) to treat corporations as having zero tentative tax minimum. These specific amendments to the tax code effectively eliminated an obstacle that prevented certain corporate taxpayers from utilizing the credits due to the tentative minimum tax limitation.
Find additional amendments to the code in recent years HERE.
Who qualifies for the R&D Tax Credit?
In the most basic terms, the Federal R&D Tax Credit is available to any individual, organization or corporation that performs significant R&D activities. The company itself does not have to be technological, scientific or medical in nature – although it certainly can be. Rather, the most important requirement is the performance of activities that meet the criteria for qualified research expenditures.
Taxpayers may utilize the credit if their R&D activities meet each of the following:
- Activities are related to the development or improvement of products, processes or techniques;
- Activities involve the application of principles of the physical or biological sciences, engineering or computer sciences;
- Activities involve an evaluation of alternatives used to eliminate technological uncertainties faced during the development process.
Again, any company from any industry can take advantage of the credit if they meet the above criteria. For example, a business in the financial services industry may qualify for the credit if they develop an in-house software to improve their operational efficiencies. In fact, our past and current clients range from seafood companies to wineries to cosmetic manufacturers. We have helped clients who developed new exercise equipment, designed customized HVAC systems and improved projector technologies for digital files. The point is this – if you are taking risks and spending money to develop or improve a product, technique or process, there is chance you qualify for the R&D Tax Credit.
How does the Research and Development Tax Credit work?
The Federal Research and Development Tax Credit applies to any taxpayer that incurs expenses for performing Qualified Research Activities (QRA) in the United States.
The Four Part Test
In general, research activities must meet the “four part test” in order to qualify for the R&D Tax Credit. Per IRC § 41, the taxpayer must demonstrate that the activities satisfied the following four requirements:
- Permitted/Qualified Purpose – The principal objective of the activity is to improve the functionality, performance, reliability, or quality of a product, process, software, technique, invention or formula that the taxpayer intends to use in their business or hold for sale, lease or license.
- Technological Uncertainty – The taxpayer faces uncertainty regarding the feasibility, design or methods to develop the component.
- Process of Experimentation – The taxpayer conducts activities evaluating alternatives through modeling, simulation, systematic trial and error, or other methods.
- Technological in Nature – The success or failure of the project is determined by the principles of engineering, physics, chemistry, biology, computer science, or similar natural or “hard” sciences, as opposed to other principles such as economics, consumer preferences, aesthetics, or more.
Qualified Research Expenditures
The following types of Qualified Research Expenses (QRE) determine the Research and Development Tax Credit amount:
Taxable wages paid to employees who conduct or directly supervise or support qualified activities;
Cost of supplies used and consumed during R&D activities;
- Supplies include extraordinary utilities and exclude capital items or administrative items.
Contract research expenses paid to a third party to perform qualified activities on behalf of the taxpayer, regardless of the success of the research;
- IRC § 41 regulations allow contract research expenses at 65% of the total cost incurred.
- The taxpayer must retain substantial rights to the results of the activity.
Are any activities excluded from the Research and Development Tax Credit?
While a number of activities do qualify for the credit, there are also certain activities that do not fall under the definition of qualified research and development activities. Primary examples of these excluded activities are:
- Research activities conducted outside of the United States;
- Research after beginning commercial production of the business component;
- Research related to customizing the business component for a particular customer;
- Activities that rely extensively on the social sciences, arts or humanities;
- Activities intended to collect routine data or perform standard, ordinary testing for quality control of existing components;
- Activities performed for market research, such as consumer preference testing;
- Activities that adapt or duplicate an existing business component based on plans, blueprints, detailed specifications, or other publicly available information;
- Activities funded by an unrelated third party;
- For example, if the taxpayer does not retain the rights or intellectual property resulting from the activities, or
- The taxpayer does not carry a financial risk as the third party is contractually obligated to pay for the project regardless of success or failure.
How do I claim the R&D Tax Credit?
Claiming the research and development credit requires a number of factors. However, the potential savings are too significant to not explore the possibility, especially because credits are eligible for both current and prior tax years.
Most importantly, taxpayers must contemporaneously evaluate and document their research activities. This establishes the amount of QRE for each qualified research activity or project.
Examples of adequate documentation includes:
- Payroll records
- General ledger expense detail
- Project lists
- Project notes
- Other documents produced through the normal course of business
Combining this documentation along with credible employee testimony (i.e. a project supervisor offering detailed information related to a qualified research project) form the basis of the R&D Tax Credit.
How do you calculate the Research and Development Tax Credit?
Your total QRE used to perform specified qualified activities drives the total amount of the tax credit. As of 2019, there are two methods for calculating a company’s research and development tax credit: regular and alternative simplified.
Under the regular method, the research credit for the taxable year is equal to the sum of 20% of the excess of the qualified research expenses over the base amount.
The base amount is the sum of the fixed-base percentage and the average annual gross receipts of the taxpayer for the four years prior to the credit year.
A fixed-base percentage is the “percentage which the aggregate qualified research expenses of the taxpayer for taxable years beginning December 31, 1983, and before January 1, 1989, is of the aggregate gross receipts of the taxpayer for such taxable years.”
Alternative Simplified Credit Method
Another option is the alternative simplified credit (ASC) method. Per the ASC method, a business can claim 14% of the amount of qualified research expenses for the credit year as long as it exceeds 50% of the average qualified research expenses for the three prior taxable years.
Additionally, a company that did not have qualified research expenses in any one of the three preceding tax years can claim a credit equal to 6% of its qualified expenses during the current tax year.
Once the ASC method is used, you are unable to implement the regular method for any succeeding years.
What are the terms of the California R&D Tax Credit?
The California R&D Tax Credit is very similar to the Federal Tax Credit, including the definition of qualified research activities. However there are some notable differences:
- When using the regular method, California applies a 15% credit rate as opposed to the federal rate of 20%
- California does not have an ASC method
- California allows the Alternative Incremental Research Credit
- California furnishes a different definition of gross receipts for companies that provide services
- The taxpayer must conduct qualified research activities within California
- For example, you cannot include the wages of a qualified employee working in another state
When applying for the California R&D Tax Credit, attach Form 3523 to your California tax return.
How can Squar Milner help you?
Squar Milner has a dedicated R&D Tax Credit practice led by Partner-in-Charge of Research Credit Services Doron Bass and Tax Partner Brian Shin. The team works exclusively on R&D Studies to help clients take full advantage of the opportunities the credit presents. From the outset, we conduct a no-cost assessment phase to determine the estimated benefits and costs of performing a complete implementation. Based on the results of the initial assessment, as well as the prospect’s desire to work with us, we initiate a full blown R&D Study.
We have worked with clients of all sizes, ranging from start-ups to multi-billion dollar high profile international corporations. Our team has extensive experience conducting research and development studies for all entity types, as well as a wide range of industries. Some of the specific industries include manufacturing, cannabis, technology, semiconductor, software, construction and pharmaceuticals.
Disclaimer: This material has been prepared for informational purposes only, and is not intended to substitute for obtaining accounting, tax, or financial advice from a professional tax planner or financial planner. All information is provided “as is,” with no guarantee of completeness, accuracy, timeliness or of the results obtained from the use of this information.