How To Calculate The R&D Tax Credit

Calculating the Research & Development (R&D) Tax Credit can be complex, but understanding the available calculation methods can help you estimate your potential tax savings and determine which approach may provide the larger credit.

In this guide, we’ll explain the two methods used to calculate the R&D tax credit, walk through each calculation step by step, and discuss when it makes sense to work with a tax professional.

What Is The R&D Tax Credit? The Quick Answer

The Research & Development (R&D) Tax Credit is a federal tax credit available to businesses that create or improve products, processes, or software. To qualify, businesses must have participated in qualified research activities under Section 41 of the Internal Revenue Code.

The credit is calculated using qualified research expenses and can reduce your federal income tax liability. Some eligible businesses may also be able to apply the credit toward payroll taxes or Alternative Minimum Tax (AMT). Unused credits can generally be carried forward for up to 20 years.

What Expenses Are Used To Calculate The R&D Tax Credit?

To qualify for the R&D tax credit, businesses must incur expenses while performing qualified research activities. To be considered qualified research, the project must meet the IRS’s four-part test:

• Business component
• Elimination of uncertainty
• Process of experimentation
• Technological in nature

If all four requirements are met, certain expenses related to the project may be used to calculate the R&D tax credit.

• Employee Wages: Wages paid to employees who conduct, supervise, or directly support qualified research activities may be included when calculating the R&D tax credit.
• Contract Expenses: Expenses paid to third-party contractors for qualified research activities may also qualify. To be eligible, your business must retain substantial rights to the research and bear the economic risk of the project.
• Supply Expenses: Supplies that were used during research activities also qualify. Supplies must be tangible and can’t be capitalized or depreciated.

The Two Methods For Calculating The R&D Tax Credit

There are two methods for calculating the R&D tax credit: the Regular Research Credit (RRC) method and the Alternative Simplified Credit (ASC) method.

The RRC method allows businesses to claim 20% of qualified research expenses (QREs) above a calculated base amount. While this method may produce a larger credit, it’s also more complex because it requires historical gross receipts and research expense data to calculate the base amount.

The ASC method uses qualified research expenses from the previous three years to calculate the credit instead of relying on historical gross receipts. It’s generally easier to calculate, making it the more common choice for many businesses.

The IRS allows businesses to calculate the credit using either method. Because the results can differ, many businesses calculate both and claim whichever provides the larger credit.

How To Calculate The R&D Credit Using The Regular Research Credit Method

The RRC method requires more information and involves more in-depth calculations. However, many businesses may find that the extra work is worth the effort when claiming the R&D tax credit. Here’s how to calculate the R&D credit using the RRC method.

Step 1: Gather Your Documentation

To calculate the R&D credit using the RRC method, you’ll need to know your current year QREs. Gathering documentation to support these expenses is important for accurate calculations. Some documentation that you may need includes:

• W-2s
• Payroll records
• 1099s
• Service contracts
• Receipts for supplies
• Invoices

You’ll also need to determine your average QREs for the previous four years, so make sure you have documentation that helps you calculate this average.

Step 2: Average Your QREs

As mentioned in step one, you will need the average of your QREs from the previous four years. Make sure to keep this number handy because you’ll need it later.

Let’s look at an example.

You’ve calculated your QREs, and you have the following amounts:

• Current Tax Year: $80,000
• Previous Year: $50,000
• Two Years Ago: $100,000
• Three Years Ago: $30,000
• Four Years Ago: $20,000

To get the average, add together the QREs and divide the total by four.

($50,000 + $100,000 + $30,000 + $20,000) / 4 = Average QREs

$200,000 / 4 = $50,000

In this example, the average QRE for the previous four years is $50,000.

Step 3: Determine Your Fixed Base Percentage

The fixed base percentage is determined by whether you have an existing business or startup. According to the IRS, a startup company for the purposes of claiming the R&D tax credit either:

• Has gross receipts and QREs in a tax year beginning after 1983 OR
• Has gross receipts and QREs for fewer than three years beginning after 1983 and before 1989

More details about the fixed base percentage can be found in the IRS Instructions for Form 6765. The fixed base percentage can never exceed 16%.

For this example, we’ll use a fixed-base percentage of 3%, which applies to certain qualifying startup companies under the IRS rules. Your fixed-base percentage may be different depending on your business’s circumstances. See the IRS Instructions for Form 6765 for details.

Step 4: Calculate Your Base Amount

To calculate your base amount, multiply the fixed base percentage determined in step three by the average QREs from the previous four years. This is the amount that we calculated in the second step.

$50,000 X 0.03 = $1,500

The base amount is $1,500.

Step 5: Multiply Current QREs By 50%

In this step, you’ll multiply your current tax year’s QREs by 50%. In step two, our example shows that the current year’s QREs are $80,000.

$80,000 X 0.50 = $40,000

This calculation gives you a total of $40,000.

Step 6: Compare Base Amount With Current QREs To Determine Minimum Base Amount

For this step, compare the base amount from Step 4 ($1,500) with 50% of your current-year QREs from Step 5 ($40,000). Use the larger of the two amounts as your minimum base amount. In this example, the minimum base amount is $40,000.

Step 7: Calculate The Excess Of Current QREs Over The Minimum Base Amount

Now, we will subtract the minimum base amount found in step six from the current year’s QREs. The minimum base amount from the previous step was $40,000, while the current QREs are $80,000.

$80,000 – $40,000 = $40,000

After performing this calculation, your total is $40,000.

Step 8: Multiply Your Total By 20%

Take the figure from the previous step and multiply it by 20%. This will give you the total amount of your R&D credit.

$40,000 X 0.20 = $8,000

In this example, your R&D credit would be $8,000.

How To Calculate The R&D Credit Using The Alternative Simplified Credit Method

The ASC method is slightly easier and requires less information than the RRC method. Here’s what you need to know about calculating the R&D credit using the ASC method.

Step 1: Gather Your Documentation

To calculate the R&D credit using the ASC method, you’ll need to know your qualifying research expenses for the current year, as well as the previous three years. Gather documentation that supports your qualified research expenses. You’ll need these records to accurately calculate your credit and should keep them in case the IRS requests supporting documentation. Your documentation may include things like:

• Payroll records
• W-2s
• Employee timesheets
• Invoices
• Purchase orders
• 1099s

Once you’ve gathered your documentation, calculate the QREs for each year.

If your business had no qualified research expenses during any of the previous three tax years, your credit is generally equal to 6% of your current year’s QREs.

Step 2: Calculate The Average QREs For The Previous Three Years

The next step is to calculate the average QREs for the previous three years. Let’s look at an example.

In the first step, you gathered your documentation and determined that your QREs for each year are as follows:

• Current Tax Year: $50,000
• Previous Year: $50,000
• Two Years Ago: $100,000
• Three Years Ago: $30,000

To calculate the average, add together the QREs for each year, then divide the total by three.

($50,000 + $100,000 + $30,000) / 3 = Average QREs

$180,000 / 3 = $60,000

In this example, the three-year average is $60,000.

Step 3: Multiply The Average By 50%

The next step is simple. Take the average from Step 2 and multiply it by 50%.

$60,000 X 0.50 = $30,000

In this example, our total is now $30,000.

Step 4: Subtract The Total From Step 3 From The Current Year’s QREs

Subtract the amount calculated in Step 3 from your current year’s QREs.

$50,000 – $30,000 = $20,000

The remaining $20,000 is the amount you’ll use in the final calculation.

Step 5: Multiply The Total From Step 4 By 14%

Multiply the amount from Step 4 by 14% to calculate your R&D tax credit.

$20,000 X 0.014 = $2,800

Based on this example, your R&D tax credit is $2,800 using the ASC method.

Should I Use RRC Or ASC When Calculating The R&D Tax Credit?

As the examples above show, the RRC method is more complex than the ASC method. In our example, it also produced a larger tax credit. However, the best method depends on your business’s circumstances.

The RRC method can produce a larger credit for some businesses, but it also requires more historical information and more complex calculations. The ASC method is generally easier to calculate and is often preferred by businesses with limited historical records. Because every business is different, it’s a good idea to calculate the credit using both methods to see which provides the greater tax benefit.

When To Hire A Professional To Claim Your R&D Credit

Determining eligibility, calculating the credit, and filing the necessary tax forms can be complicated, especially if you’re claiming the R&D credit for the first time.

There are some situations where calculating and claiming the credit can become even more confusing. This includes filing an amended return for claiming prior years’ credits, carrying forward credits from previous years, or applying a portion of the credit to payroll or AMT taxes. Mistakes can lead to delays, additional IRS scrutiny, or penalties, which is why many business owners choose to work with a tax professional.

If you’re unsure whether your business qualifies or how to calculate and claim the credit, consider consulting a tax professional. A qualified tax professional may also be able to identify other tax credits your business qualifies for and provide support if the IRS questions your claim or conducts an audit.