Answers to our most common questions
What is the R&D Tax Credit?
The Credit for Increasing Research Activities (the “R&D Tax Credit”) is a government-sponsored tax incentive that rewards companies who conduct research and development in the United States and its territories. The R&D Tax Credit is a federal and state (most states) tax credit that can result in dollar-for-dollar reduction of taxes owed at year end. For startups that meet qualifying criteria, the R&D Tax Credit can be used to offset payroll taxes. Originally enacted in 1981 under the Economic Recovery Tax Act, the credit expired eight times and was extended 15 times until it was made permanent in 2015 under the Protecting Americans from Tax Hikes Act (PATH Act). Primarily a labor-based incentive, the R&D Tax Credit aims to promote U.S. innovation by creating positive cash flows and reducing taxes.
Typically, “Research and Development” implies laboratories, test tubes, and white lab coats. However, the IRS’s definition of R&D is rather broad, and can be applied to many industries including manufacturing, engineering, architecture, food & beverage, and software development. Any business of any size can claim the R&D Tax Credit if their R&D activities satisfy the 4-part test and the associated expenditures qualify under IRC Section 41.
Does my company qualify for the R&D Tax Credit?
R&D Tax Credits can be claimed by businesses in a number of industries, including software development, manufacturing, life sciences, engineering, architecture, food & beverage, aerospace & defense, and agriculture. Any company can claim R&D Tax Credits as long as they are undertaking activities that meet the requirements of the 4-part test:
- Permitted Purpose: In simple terms, the purpose of the activity or project must be to create something new, or improve upon a product, process, software, invention, patent, or formula (referred to as a business component). The permitted purpose falls under a broad umbrella that includes improving functionality, performance, reliability, or quality of the business component.
- Elimination of Uncertainty: The activities and project in question must attempt to eliminate uncertainty related to the optimal design, development methodology, or component’s capability to achieve the permitted purpose.
- Process of Experimentation: Substantially all of the activities constitute elements of a process of experimentation. The activities must include a systematic evaluation of alternative solutions to eliminate the technical uncertainty through, for example, trial and error or a Product Development Lifecycle (“PDLC”).
- Technological in Nature: The activities and process of experimentation must rely on the fundamental principles of the hard sciences, including biology, computer science, engineering, physics, or chemistry.
How do I know if I am a good candidate?
The R&D tax credit offsets expenses for the development of qualifying business components. The first step is, you need to own the entity with the expenses.
As a clinic or lab owner, it is likely that you engage in the process of streamlining or improving your practice through the addition of new equipment, techniques, or materials. If the development of these business components or trade processes satisfies the 4-part test, odds are that there is some qualifying R&D credit available.
To get a better idea of your company's potential R&D Tax Credit, contact one of our R&D Tax Credit experts.
Do I have to invent or discover something brand new to qualify?
The R&D tax credit is not just for inventing something or getting a patent. It is also available (and most typically used by) companies that are improving or modifying an existing product or improving a process---that is, improving outcomes, reducing uncertainties, etc.
What expenses qualify for the R&D Tax Credit?
There are three main categories of expenses that can be claimed for the R&D Tax Credit:
- Wages – Wages paid to employees who conduct qualified R&D activities, and the wages of the employees who directly supervise and support the research.
- Supplies – Supplies and raw materials used or consumed in the R&D process, including prototyping and testing of a new or improved product, process, formulation, or patentable business component. This also includes expenses related to rental of cloud computing assets used in software development.
- Contract Research – Payments made to third-party contractors, 1099 employees, or universities for technical activities conducted on the company’s behalf. These can include technical analysis or testing, design services, and other development activities for a qualified business component.
The more research expenses a company incurs year over year, the greater the tax credit will be. For all research costs in a given year, a company can expect anywhere from 7-10% in federal credits in addition to state credits (percentage varies), where applicable.
What can the R&D Tax Credit be used for?
The R&D Tax Credit is a dollar-for-dollar reduction of federal income or payroll tax liabilities. R&D credits can be claimed on amended tax returns (going back three years), which can generate cash refunds due to overpayments in those years. Additionally, federal R&D Tax Credits roll forward for up to 20 years.
For qualified small businesses (i.e. startups), these credits can be used to offset payroll tax owed to the IRS. Therefore, startups no longer need to be profitable to take advantage of the R&D Tax Credit.
In addition, most states also have an R&D Tax Credit available to offset various income, franchise, or sales and use tax liabilities.
How much can I expect to get in R&D Tax Credits every year?
The R&D Tax Credit is a comparative credit, which means that it will depend on the difference between current year qualified research expenses (QREs) and the base amount (calculated using prior year gross receipts and/or expenses). The more research expenses a company incurs year over year, the greater the tax credit will be. Typically, a company can expect a benefit of 7-10% of the federal QREs and another 2-12% in state credits (depending on the state).
To get a better idea of your company's potential R&D Tax Credit, contact one of our R&D Tax Credit experts.
Which states offer R&D Tax Credits?
The definition of qualifying research activities in each state is based on the federal tax credit regulations; however, the calculation methodology varies significantly from state to state. For example:
- Some states provide a refund or exchange of unused R&D Tax Credits, so that even if a taxpayer has no tax liability it can still derive a cash benefit.
- The R&D Tax Credits in some states have not been permanently adopted, and may expire in the future.
- Most states require that the research activities must be conducted within their borders to qualify.
- Some states do not offer the alternative simplified credit calculation.
- In some states, basic research payments made to universities and certain non-profit organizations can be included in the calculations.
There are 38 states that currently allow taxpayers to claim the R&D Tax Credit. Below is the list of states that DO NOT offer the R&D Tax Credit:
- District of Columbia
- South Dakota
- West Virginia
How does Dr. Tax Credit calculate the federal and state R&D Tax Credits?
Dr. Tax Credit uses a four-step process:
- Preliminary Analysis (includes discovery and credit estimation)
- Credit Calculation
a. Qualitative Analysis: an activities-based analysis to gather and review supporting project documentation; and
b. Quantitative Analysis: analysis of financial documents to aggregate qualified research expenses (“QREs”) using various methods, including interviews, surveys, questionnaires, and proprietary tools.
3. Documentation and Substantiation of the Credits (includes delivery of an audit-ready package containing details of our methods, calculation, and applicable forms)
4.Audit Support (if the credits are ever challenged by the IRS or state, we stand by your side).
Depending on whether a company has previously claimed the R&D Tax Credit, our methods could vary. Also, since every R&D engagement is unique and has different levels of complexity, some steps can be eliminated or adjusted as necessary.
Can startups that are/were in losses benefit from the credit?
In addition, prior-year federal R&D Tax Credits can be carried back one year and forward up to 20 years. Once the company reaches profitability, those credits will be available for use. Each state is different when it comes to carryforward and carryback rules, but most follow the general federal guidelines.
To be considered a QSB, a company must meet these requirements:
- Less than $5 million in current-year gross receipts;
- Five or fewer years of gross receipts; and,
- Have qualified research expenses.
Can my company’s chances of audit increase by claiming R&D Tax Credits?
This is a common misconception among small and medium businesses. Taking the R&D Tax Credit on a timely-filed return, including extension, does not increase your company’s audit risk. According to the IRS, only 0.9% of corporate tax returns and 0.2% of small businesses (S corps and partnerships) are randomly selected for audit.
According to IRS guidelines, a return can be selected for audit based on a myriad of reasons. There is no directive that specifically targets companies who claimed R&D Tax Credits.
My company does not have a dedicated research center or laboratory. Can I still claim R&D Tax Credits for my expenses?
Contrary to general belief, businesses do not have to have employees in white coats working in a laboratory to claim R&D Tax Credits. Many activities across a wide range of industries are considered qualified research expenses (QREs). Investments your company makes in developing innovative solutions, creating novel products and formulations, or even making process improvements are claimable expenses as long as the project satisfies the 4-part test.
Tax Credit 4-part test requirements are as follows:
Permitted Purpose: In simple terms, the purpose of the activity or project must be to create a new or improved product, process, software, invention, patent, or formula (referred to as a business component). The permitted purpose falls under a broad umbrella that includes improving functionality, performance, reliability, or quality of the business component.
Elimination of Uncertainty: The activities and project in question must attempt to eliminate uncertainty related to the optimal design, development methodology, or component’s capability to achieve the permitted purpose.
Process of Experimentation: Substantially all of the activities constitute elements of a process of experimentation. The activities must include a systematic evaluation of alternative solutions to eliminate the technical uncertainty through, for example, trial and error or a Product Development Lifecycle (“PDLC”).
Technological in Nature: The activities and process of experimentation must rely on the fundamental principles of hard science, including biological sciences, computer science, engineering, physics, or chemistry.
Click here to read more about industry-specific qualified research expenses (QREs).
Can the R&D Tax Credit be claimed for a prior year?
Yes, the R&D Tax Credit can be claimed if the federal and state statute of limitations have not lapsed. For the federal credit, an amended return can be filed up to three years from the original filing date. Most states follow the same three-year statute of limitations; however, there could be state-specific regulations for the state in which your business operates.
Which activities are excluded?
The following activities are excluded from R&D Tax Credits:
- Research related to arts, social sciences, or humanities are not considered qualified research activities.
- Research conducted outside the U.S. or its territories is not eligible.
- Projects solely aimed at adapting or duplicating existing business components and reverse engineering existing products, processes or software.
- Surveys, studies, activity relating to management function/technique, market research, routine data collection, or routine testing/quality control
- Some software developed for internal use, but there are exceptions for this exclusion
- Research funded by any grant, contract, or another person, conglomerate, or government entity
How much is this going to cost me?
Because Dr. Tax Credit operates on a success-based fee structure, our clients incur only a small base fee to start the process. We invoice the balance when our clients reduce tax liabilities on a current year tax return or when they receive refunds from amended prior year returns.
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