The Complete Guide To Understanding & Receiving The Research & Development Tax Credit
What is the R&D tax credit and does your business qualify? Our complete R&D tax credit guide answers these questions and more.
Businesses that create or improve new or improved processes and products may be able to cash in on the research and development tax credit. This tax credit provides significant money-saving benefits to eligible businesses, including lowering income tax liability, reducing alternative minimum tax, and even providing savings for payroll taxes.
If your business engages in research and development, this post is for you.
We’ll explore the research and development tax credit, breaking down what it is, what qualifies, how to calculate the R&D credit, and how to claim the R&D tax credit on your next tax return. Keep reading to learn more about the research and development tax credit.
Table of Contents
- What Is The Research & Development Tax Credit?
- Who Qualifies For The R&D Credit?
- Who Doesn’t Qualify For The R&D Credit?
- How Does The R&D Tax Credit Work?
- What Is The Deadline For Claiming The R&D Tax Credit?
- How To Calculate The R&D Credit
- How To Claim The R&D Credit
- Is The R&D Tax Credit Taxable Income?
- The Bottom Line On The Research & Development Credit
- FAQs About The Research & Development Tax Credit
What Is The Research & Development Tax Credit?
The research and development tax credit (R&D) credit is a general business federal tax credit used to incentivize businesses to develop a new product or process or improve an existing product or process. This tax credit is available to qualified businesses of all sizes, including startups, small businesses, and corporations.
The R&D tax credit was introduced in the Economic Recovery Tax Act of 1981. Although the original tax credit expired in 1985, it was extended 15 times through the end of 2014. In 2015, the tax credit was made permanent through the Protecting Americans from Tax Hikes (PATH) Act. At this time, the tax credit’s application was expanded to allow small- to medium-size businesses to also benefit.
In order to be eligible to claim this credit, a business must prove that it invested in qualified research and development activities to develop or improve a product or process.
The R&D tax credit reduces a business’s federal income tax liability. However, some businesses may be eligible to use the tax credit to offset alternative minimum taxes or the employer’s share of payroll taxes.
There are also R&D tax credits available at the state level, and most states have R&D credits available for eligible businesses to reduce state income tax liability. The rates and requirements for these credits vary by state.
For the purpose of this post, we’re going to focus exclusively on the federal R&D credit. Consult with a CPA or tax professional to learn more about state R&D credits available to your business or reach out to one of these trusted R&D service providers for claiming the R&D tax credit.
Who Qualifies For The R&D Credit?
Businesses with qualifying expenses associated with research and development may qualify for the R&D credit.
This credit can be applied to a business’s income tax liability. Qualifying expenses include things like:
- Creating patents, techniques, software, formulas, or prototypes
- Improvements or redesigns of products
- Creating, developing, or manufacturing innovative or new products
- Developing intellectual property
- Hiring engineers, researchers, developers, and other third parties that engage in eligible R&D activities
- Paying salaries or purchasing supplies used for eligible R&D activities
To qualify for the R&D credit, projects must meet all requirements of the four-part test outlined in Section 41 of the Internal Revenue Code.
Here’s what you need to know about the four-part test:
- Business Component: The information gathered during the R&D process should be used to create or improve a business component. This includes processes, techniques, formulas, products, and software. This component can be used internally or distributed commercially. Components that aren’t new to the industry but are new to the company qualify.
- Elimination Of Uncertainty: The business must demonstrate it went through a process to eliminate uncertainty in developing or improving the business component. This process may include simulation, modeling, and/or trial and error.
- Process Of Experimentation: Businesses must show that they used an iterative process to develop or improve the business component. This process must show that the business evaluated alternatives. The process of experimentation may include simulation, modeling, and/or trial and error.
- Technological In Nature: To be technological, the research must rely on the principles of hard science. Hard science relies on experimentation and hypotheses and includes physics, biology, chemistry, engineering, or computer sciences.
Who Qualifies For R&D Credit To Offset Alternative Minimum Tax?
The R&D credit is applied to a business’s income tax liability. However, there are some instances where the credit can be used to offset alternative minimum tax (AMT).
In addition to meeting the other requirements for the R&D credit, businesses must also:
- Be a corporation (including S-corporations) or a partnership
- Have gross receipts of less than $5 million for the tax year
- Have no gross receipts for any tax year prior to the 5-tax-year period ending with the current tax year
- Not be a tax-exempt organization as defined under Section 501 of the Internal Revenue Code
Who Qualifies For Payroll Tax Election?
Some businesses may qualify to apply up to $250,000 of the research and development tax credit toward the employer’s portion of Social Security taxes. New businesses can take the payroll tax election for up to five years for a maximum total of $1.25 million that can be applied toward payroll taxes on quarterly tax returns.
Qualifying businesses must meet the four-part test, as well as the following requirements:
- Must have less than $5 million in gross receipts for the current year
- Must not have made payroll tax elections for five or more preceding tax years
Who Doesn’t Qualify For The R&D Credit?
There are certain activities that typically do not qualify for the R&D credit.
- Duplicating a process or product that already exists
- Surveys & studies
- Research conducted after commercial production begins
- Research to adapt a product or process to a specific customer’s needs
- Research for certain internal-use software
- Research that is conducted outside of the U.S., Puerto Rico, or U.S. territories
- Research funded by another person or government entity
- Research conducted in the areas of arts, humanities, and social sciences
Any research and development process that does not meet the four-part test also does not qualify for the R&D credit.
How Does The R&D Tax Credit Work?
The R&D tax credit is a federal tax credit available to businesses with qualified research and development expenses.
Businesses that qualify for this credit can apply it to their federal income tax liability. Businesses that meet certain requirements can use the R&D tax credit to offset alternative minimum tax, while some may also be able to apply the tax credit to Social Security taxes for up to five years.
For most businesses, the amount of the credit will equal approximately 7% to 10% of qualified research expenses. However, the actual credit amount varies based on a number of factors. Learn more about how to calculate the R&D tax credit for your business.
The R&D credit is claimed through federal income tax returns. Businesses that qualified for the R&D tax credit but didn’t claim the credit on their tax returns may be able to retroactively claim the credits by filing an amended return.
One thing to note about the R&D tax credit is that there are stringent requirements for qualifying — simply engaging in research and development activities doesn’t automatically qualify a business. It’s also worth noting that all businesses claiming the credit must be able to prove that their R&D expenses meet all criteria set forth by the IRS. The rules for calculating the credit are also quite complex. Businesses unsure if they qualify or need help calculating the R&D credit should reach out to a CPA, tax preparer, or other third-party business specializing in general tax credits.
The best R&D tax credit software providers can help you through the whole process.
What Is The Deadline For Claiming The R&D Tax Credit?
The R&D tax credit is an ongoing, permanent tax credit, so there isn’t an expiration date.
However, businesses must claim the credit on their annual federal income tax returns. Credits can also be claimed retroactively by filing an amended tax return. An amended return to claim the R&D can be filed for open tax years, typically three years. However, there may be exceptions for businesses that recorded losses during this period. Get the full scoop in our guide to claiming the R&D tax credit.
Do R&D Tax Credits Expire?
There’s good news if a business doesn’t have tax liability when claiming the R&D tax credit. These businesses can carry forward the R&D tax credit for up to 20 years to reduce future tax liability.
How To Calculate The R&D Credit
There are two methods for calculating the R&D tax credit: calculating the regular credit or using the Alternative Simplified Credit.
If you calculate using the regular method, you can receive a credit of 20% of your qualified research expenses over a fixed-base percentage. This method of calculation is a little tricky, as the fixed-base percentage is based on:
- Whether your business is a start-up or an existing company
- The gross receipts and aggregate qualified research expenses of your business for up to 10 previous tax years
The Alternative Simplified Credit (ASC) is an easier way to calculate the R&D credit. Using this method, the R&D credit is calculated by:
- Averaging qualified research expenses over the last three years
- Multiplying the average by 50%
- Subtracting half of the average from the current qualified research expenses
- Multiplying the number from the previous step by 14%
This method is simpler but requires you to have previous years’ records to accurately calculate your credit.
The IRS recommends that businesses calculate their credit using both methods to find the method that yields a higher credit amount.
Both methods for calculating the R&D credit can get confusing and require you to have your records in order. Many small businesses opt to hire a tax preparer, CPA, or R&D tax credit software company to assist in calculating the amount of the credit and to properly complete and file tax forms.
How To Claim The R&D Credit
The R&D tax credit is claimed when filing a federal income tax return. Qualifying businesses will file IRS Form 6765, Credit for Increasing Research Activities to claim the R&D credit.
On this form, the business will identify qualifying expenses, as well as documentation that proves the costs meet the requirements as outlined in Section 41 of the Internal Revenue Code.
If you used the regular method for calculating your credit, you will use Section A of Form 6765 to claim the credit. If you used the ASC, you will fill out Section B of the form. Businesses that are taking the payroll tax election will need to fill out Section D.
The R&D credit can also be claimed retroactively for up to three years by filing an amended tax return. There may be exceptions for businesses that experienced a loss during the period they are claiming a credit. If this is the case, consult with an accountant to learn more.
Because the process is so complex, it’s important to have an understanding of what’s required to claim the tax credit.
This includes understanding the four-part test to qualify, knowing which R&D expenses are allowable, and having the records and documentation to verify these expenses. Fortunately, you can consult with your accountant, tax preparer, or other financial expert to help you navigate the process.
Even reputable third-party companies specialize in helping small businesses claim the R&D credit for a fee. Make sure to do your research and choose the option that’s best for your business.
Is The R&D Tax Credit Taxable Income?
The R&D tax credit is not taxable income. Instead, it is a dollar-for-dollar tax credit that reduces federal income tax liability. Additionally, businesses that claim the credit will still be able to deduct research and development expenses when filing their income tax returns.
The Bottom Line On The Research & Development Credit
Businesses that engage in research and development through in-house processes or hiring a third party may be eligible to receive a tax credit if all requirements of the IRS are met.
While navigating through the requirements, calculating the tax credit, and actually filing the tax forms can be a bit of a headache, the tax break can be significant for many taxpayers, allowing business owners to keep more of their money to put back into their businesses.
And while many small business owners may not meet the requirements for the R&D credit, other business tax credits are easier to qualify for.
One such tax break is the employee retention tax credit, established in response to the COVID-19 pandemic. Although this credit could only be claimed in 2020 and 2021, eligible small business owners impacted by COVID can retroactively claim the credit to receive a refund check from the IRS. Do your research and take the time to find out about these money-saving credits that can help your business succeed.