Regardless of how much we earn, which politicians we support, or what type of music we like to listen to, one thing that unites pretty much all Americans is the desire for a lower tax bill. For businesses, large and small, it’s no different. As for tax credits? They make this possible.
However, for entrepreneurs, it is nearly impossible to keep up with the latest changes to the tax code. In this post, we take a deep dive into the Research and Development (R&D) Tax Credit, outlining how small businesses can take advantage of this beneficial tax break.
What is the Research and Development Tax Credit (R&D Tax Credit)?
The Research and Development Tax Credit, or R&D Tax Credit, is a federal and state tax credit under the Internal Revenue Code section 41 to incentivize companies to perform research and development activities within the United States. The credit has expired and been extended several times since first introduced in the Economic Recovery Tax Act of 1981.
Under the Obama administration, the 2015 extension made the credit permanent, allowing the United States to become more internationally competitive with research and development opportunities.
The R&D Tax Credit provides major benefits — think in billions of dollars for companies each year — making it the most significant U.S. tax incentive, in terms of the sheer dollar amount. However, tax credits don’t always come easily to the little guy, and the R&D Tax Credit definitely has some hoops to jump through. Yet, one of the most significant issues isn’t the programs themselves, but it’s the equal access, or lack thereof, that taxpayers have to them. While big corporations have historically had the upper hand over small businesses in receiving their benefits, the legislative changes in recent years have made this credit more accessible.
What exactly qualifies as research and development?
It’s more inclusive than most would assume — many businesses perform activities for the R&D Tax Credit without even realizing it. Examples of industries that often qualify include biotech, software development, and agriculture. (Most companies that have an engineer or developer on staff would meet the requirements.)
To help determine if you qualify, the IRS has outlined a straightforward 4-part test:
- Permitted purpose: Are you developing or improving a product, process, formula or software?
- Technological in nature: Is your work within physical or biological sciences, engineering, or computer sciences?
- Elimination of uncertainty: Are you asking questions like, “Can we develop it?” Or “How do we develop it?”
- Process of experimentation: Are you systematically evaluating one or more alternatives?
What expenses can be claimed?
Three types of expenses can be included in the credit calculation for your qualified project: wages, contract expenses, and supplies.
Wages are very often the largest component. Salaries paid to U.S.-based engineers, designers, and direct supervisors are all qualified expenses. A portion of payments made to U.S.-based contractors are also eligible. Lastly, supplies are non-capital/non-depreciable materials used or consumed in the development process, such as prototype materials.
8 Reasons Startups Miss the Research and Development Tax Credit
1. It sounds too good to be true.
Entrepreneurs expect to work hard for funding, so they can initially be skeptical about this benefit they’ve already earned. The R&D Tax Credit is a legitimate government program that rewards investments in innovation.
2. I’m not earning any revenue, so I didn’t think I qualified for the R&D Tax Credit.
Companies don’t need revenue to claim the credit and don’t need to be paying income tax. The credit can be taken as a payroll tax offset, up to $250K per year, by qualified small businesses. You are considered a qualified small business if you have less than $5 million in revenue and are within five years of your first gross receipt.
3. I don’t have any employees so I didn’t think I could take the R&D Tax Credit.
Although wages are typically the biggest component of the credit calculation, contracted costs and supplies are also eligible. If you take the R&D Tax Credit as a payroll tax offset but have no payroll, the credit can be carried forward to the next quarterly return. The credit doesn’t expire and continues to be available until it can be fully used against payroll tax.
4. I’m not a qualified small business, so I didn’t think I could claim the R&D Tax Credit.
While only qualified startups can take the R&D Tax Credit against payroll tax, other companies can take it against income tax. This benefit can then be carried forward for a period of 20 years. Credits generated in net loss years can be recorded as Deferred Tax Assets, enhancing your balance sheet and making your company more attractive to potential acquirers.
5. I might not do R&D work.
Many different industries and products qualify for this credit where development activities pass a four-part test. Most technology startups, including software companies, qualify.
6. My work wasn’t incorporated into my end product, so I didn’t think it qualified.
The work does not need to be successful to qualify. If you spent time and money working in a certain direction then needed to change, that effort still qualifies.
7. I already filed my taxes, so I thought it was too late to claim the R&D Tax Credit.
The R&D Tax Credit must be submitted with your annual business tax return. Some companies can amend their returns to monetize it as an income tax credit — and can even consider performing a ‘look back’ (up to 3 years) to capture unclaimed tax credits.
8. I thought the cost of an R&D study wouldn’t be worth the benefit.
The concept of an R&D Tax Credit is simple. The government wants to reward you for investing in innovation. While the concept is simple, a traditional R&D tax study is notoriously complex. The challenge is getting it done right for a reasonable effort and cost.
Research & Development Tax Credit FAQs:
Q: Why is the R&D Tax Credit so important to businesses?
A lot of companies don’t know about this credit. And even if they do know, they don’t think they can qualify. People assume that R&D implies cutting-edge innovation and white lab coats, but that’s not the case from the tax perspective. The definition is so broad.
It’s a great time to update your understanding about business R&D efforts and realize the potential tax credits your business could leverage. If you’re spending money to develop new products or processes, you should look into taking advantage of this credit opportunity.
Q: How do you calculate the R&D Tax Credit?
There are two separate calculations on a federal level. Most states have their own calculation methodology. Regardless of calculation, all states consistently follow the federal R&D qualification guidelines. The federal credit can roughly be estimated at 6.5% of qualified research expenses. In Georgia, it can be up to to 10%, another example of Georgia being a tax-friendly state. The credit can be used to offset payroll taxes, income taxes, or AMT, depending on specific characteristics of the company claiming the credit.
For more details, including an example calculation, download the Intro to R&D Tax Credits or estimate your company’s credit with this quick calculator from one of Acuity’s partners, Clarus R+D. You can also check out one of our webinars with Clarus R+D for further guidance on getting your R&D Tax Credit.
Q: How can you claim the R&D Tax Credit and what are the main challenges for companies trying to do so?
Thinking they can do it on their own. We notice that when a client has tried to prepare everything on their own, they’re typically doing so from a calculation perspective. This opens them up to a larger IRS audit risk because they’re not putting substantiation around the credit they are claiming. That really is the key to it all and companies typically struggle with that internally.
We also see companies attempting to do their own calculations, which we don’t advise. This is a situation where utilizing a subject matter expert will allow the best possibility to maximize the credit’s potential. It can also become a challenge around substantiating the credit because there is no real standardization or outline for potentially qualifying businesses to follow.
We have guidance on what the IRS wants to see, but there’s no specific requirements. That’s why it’s so beneficial to leverage an expert – they know what documentation is needed, understand how things should be set up and have the experience to help companies take full advantage of the R&D Tax Credit.
Q: Why DON’T companies qualify for the R&D Tax Credit?
Using contractors who aren’t located in the United States is a big one. Research and development must be US-based to qualify for the tax credit . We also sometimes see companies who have received some type of government grant to do the research and development who do not qualify for the credit.
Q: What are the benefits of the R&D Tax Credit becoming permanent?
In late 2015, the PATH Act (providing over $620 billion in tax reductions for families and businesses) was passed by the House of Representatives. This is what made the R&D Tax Credit permanent. It also gave two additional benefits to help smaller companies thrive. First, startups that have less than $5 million in gross receipt and are in their first five years of business can now use the federal credit to offset federal payroll tax withholding. Second, companies that have an average gross receipt of $50 million or less over the past 3 years can now use the R&D tax credit to offset the alternative minimum tax (AMT).
Q: What is the takeaway – next steps?
The R&D Tax Credit can be incredibly impactful for a business. This credit can enable companies to take on additional headcount or provide capital back to the business. More companies qualify than they would think. It’s worth initiating a conversation with an expert to see if this is an option.
Quick Tips from Us to Move Forward
Talk to the CPA that prepares your taxes. We recommend having a planning session in June/July each year with your tax CPA to establish some strategies. Your CPA is technically not allowed to charge you a contingent fee if they are the person signing your tax return. Some tax CPAs really push the envelope on this, but most lock in your cost up front.
Talk to someone who specializes in the R&D Tax Credit. The benefit of using a specialist is that they don’t get paid unless you get paid, so your interests are aligned. Plus, they aren’t limited to the same rules as your tax CPA because they don’t sign your tax return. Their usual fee on a contingency basis is 25-30% of the amount of the credit.
Look into other tax credits and deductions that you might be eligible for. Check out this list of small business tax deductions & credits to see if you qualify for any.
Keep up with all important tax deadlines, and file an extension if needed. Use our small business tax prep checklist to stay on schedule, or check out this information about how and why to file a tax extension.
Reach out for help if you need it! Business taxes are complicated, and it can be stressful to try to keep up, stay compliant, and ensure that you’re not leaving money on the table. We are here to help! If you’re already an Acuity bookkeeping customer and would like to learn more about our tax practice, click here. If you’re interested in learning more about our services and how we can get your financial engine up and running, send us a message! We’ll be happy to answer your questions while connecting you with our trusted partners.