R & D Tax Credit may not be a term many companies or individuals are familiar with. The full meaning of the word is Research and Development Tax Credit or Research and Experimentation Tax Credit.
Research and development are crucial activities for businesses and often account for a majority of expenses. With the US government's R & D tax credit initiative, businesses can continue with Research and development without worrying about added tax.
Research & Experimentation Tax Credit (R&D Tax Credit)
R&D Tax Credit is a tax provision found within S. 41 of the US Internal Revenue Code (IRC) to provide innovation incentives. Taxpaying businesses in the US which carry out any of the activities below and fulfil specific criteria may claim the tax credit:
- Development
- Design
- Improvement
Qualified Research, history and definitions
Before 1981, there were huge concerns that the United States had fallen below its economic performance potential. Discoveries made by Congress revealed that there was a severe decline in research spending within the US. This had adverse ripple effects on economic growth, competitiveness in the global marketplace and productivity gains.
To solve this problem, Congress passed a new act, "The Economic Recovery Tax Act” of 1981. The Act was designed to be the stimulus needed to encourage more investment in the US.
Initially, only activities which fit into the description of "Qualified Research" were privy to the tax credit.
The Act also described qualified Research as "commercially driven or private sector development activities envisioned to yield innovation within a technological or scientific field”. However, due to varying interpretations of the description by both taxpayers and the IRS, Qualified Research is now reduced to the "Four-Part Test."
Four-part Test
Just as the name implies, it is a combination of four tests. It seeks to reveal if a project conducts proper qualifying research activities or not.
The four tests include:
1. Permitted Purpose
In this case, the project should develop a new business component or improve an existing one from the information discovered. Examples of enhanced business components include products, software, formulas or processes. Any of these can be used internally by the company or offered commercially. Such cases will consist of new or improved functionalities, reliability, performance, operations and product quality.
2. Elimination of Uncertainty
Here, it is imperative to present activities designed to provide information useful in eliminating technical uncertainty. Such uncertainties could relate to the design, improvement of a process or product, the capacity of development or methodology.
3. Process of Experimentation
Under this test, the business should demonstrate that it used a process that evaluated different alternatives in achieving the desired result. Some examples include modelling, ongoing testing and simulation.
4. Technological in Nature
In this case, the experimentation process used in discovering information should be based on specific fields of study. They include biological or physical sciences, computer sciences and engineering. The reason for this is to ensure that the unveiled information was gotten by scientifically approved processes rather than crude unethical methods.
Although the 4-part test is meant to provide a reference for approving tax credits for businesses, the number of extensive regulations made available for supplementing aspects of Section 41 makes it difficult.
Exclusions
Certain activities will exclude a project automatically from qualification. Some of the activities not regarded as “Qualified Research” include:
- Adaptation of extant components for business
- Duplication of extant components for business
- Research following the commercial production of a component for business
- Reverse engineering
- Studies, surveys, data gathering, market research, quality control/routine testing, and other actions related to administration technique or function
- Foreign Research that is conducted beyond the borders of the US or the Commonwealth of Puerto Rico. This includes any research that is not in possession of the US
- Research funded by any contract, grant, or another individual (or governmental entity)
- Research related to arts, humanities, or social sciences
Also excluded is software designed for internal use. This doesn’t include software created by the taxpayer to facilitate sales and handle administrative and general expenses. However, it includes software that is developed to facilitate financial management functions, support service functions and handle HRM functions.
Research & Experimentation Tax Credit Calculation
There are three methods of computing R & D tax credit.
- Regular Research Credit (RRC)
- Alternative Simplified Credit (ASC)
- Start-up Credit Calculation
As a business owner, the method you should pay attention to is the R & D tax calculation for startups.
Eligible Expenses
There are four types of eligible expenses or Qualified Research Expenses (QREs). Each of the QREs is quantified based on a company’s accounting methods.
Wages
This is usually for in-house R&D activities and it constitutes a large chunk of the QREs. A startup is only eligible when an employee is paid for performing a qualified service. Some services that fall into this category include:
- Support for qualified Research
- Engagement in qualified Research
- Supervision of qualified Research directly
Supplies
According to the IRC, supplies refer to tangible properties excluding land or any land improvements along with properties that depreciate. However, for QRE, supply expenses should link to qualified research activities directly based on the taxpayer's accounting system. Examples of supplies include testing materials and prototypes.
Contract research
It is required that a third-party performs qualified research for the taxpayer. As such, the taxpayer is expected to pay the third party whether the research fails or succeeds. Usually, the contract research expenditure is 65% of the actual expense.
Basic research payments
This qualifies all the basic research payments to qualified non-profit institutions and organizations. Basic research is the fundamental research that evaluates hypotheses and theories regardless of their application. These payments are included at 75% of the actual expense.
How Does the R & D Tax Credit Work for “Startup Provision?”
A startup can access approximately $1,250,000 over five years. If you split this, it will be $250,000 every year. This amount helps the business to offset what is known as "FICA.{:target="_blank"}” The “FICA” forms part of the yearly tax on the payroll for small businesses.
What qualifies a company as a startup to benefit from the R&D Tax Credit?
- Gross receipts must not tally up to $5,000,000 for that credit year
- Gross receipts must not exceed five years
To answer the question of how tax credits work; the business must first generate expenses after which it applies for the credit. The benefit of this to the business is improved flexibility when applying the tax. It is more beneficial to small companies who don’t have sufficient income tax liability.
What You Need to Claim R & D Credits
Before claiming R & D Tax Credits, the taxpayer must evaluate and document the research activities. Documenting helps to identify the QREs for every action undertaken in the qualified research process. Even if you have to estimate certain expenses, it is essential to employ a realistic basis for your assumptions.
Here is a list of the documents you must present to claim the tax credit:
- Project lists
- General ledger expense details
- Project notes
- Payroll records
- Other documents produced during the business
Work with an Accounting Solution Specializing in Growing Businesses
Research and Experimentation Tax Credits help qualifying companies improve their savings significantly. Most companies are eligible for these credits at both State and Federal levels. However, they need the help of an accounting solution that specializes in solving these situations. This is where we come in.
Check out our R&D Tax Credit page to learn more, and see what you may qualify for.
You can reach out to Bookkeeper360 if you have any questions about R&D Tax Credits. This will save you from the risk of penalties or any other avoidable issues with the process.