No company, big or small, wants to pay more than what their taxes require them to. But this is what happens when a qualified entity doesn’t make use of the Research and Development (R&D) Tax Credit. Many businesses missing out on such a huge opportunity to save on taxes? The reality is not many businesses know about some tax incentives or they lack the knowledge of using R&D tax credits software.
R&D tax credits can be a confusing topic to navigate. If you don’t have technical knowledge in this matter, you might find it difficult for your business to determine eligibility for the credit, or to estimate how much benefits you are entitled to. There are also companies that are simply unaware of R&D tax credits and how to use an R&D tax credit software to calculate their expected benefits.
In this article, we will discuss the different issues concerning R&D tax credits and outline the essentials in way that’s easy for everyone to understand.
What is the R&D Tax Credit?
The R&D tax credit is a tax incentive that was created as a means to encourage research activities related to creating or improving new products, systems, or software. This tax incentive was first introduced in 1981 by the federal government. Later on, Congress made it permanent through the PATH Act in 2015.
The rules for the R&D credit are summarized in Section 41 of the Internal Revenue Code. The credit is basically available for qualified expenses incurred on specific types of research, which are referred to as Qualifying Research Activities. Businesses from different industries that try to use scientific principles to create or improve products, processes, and software can qualify—so the rewards are clearly not only limited to large corporations with sizeable R&D departments.
How Can Companies Benefit from R&D Tax Credits?
Benefits may vary depending on the kind of business involved.
For example, when it comes to profit-making entities, R&D credits refer to dollar-for-dollar reduction in federal income tax liability. Eligible Small Businesses or ESBs can use them against the Alternative Minimum Tax (AMT) liability too. In other words, ESBs refer to businesses that has an average of $50 million or less in gross receipts in past three years.
A Qualifying Small Business or QSB, on the other hand, can use a part or all of its credits to offset payroll tax obligations, up to a maximum of $250,000. QSBs are usually startups that are less than five years old and have under $5 million in gross receipts for the current year. The payroll tax offset significantly lowers staff costs without reducing staff or salaries. This also means that there’s no need for you to make profits in order to use tax credits.
It’s possible to carry forward unused credits for up to 20 years and apply them against future year’s taxes. This carry-forward ability is necessary for keeping cash flow at times when you don’t have enough available funds.
R&D credits free up resources for other uses as well. Realistically speaking, companies get back around 5-10 cents for every dollar they spend in qualified expenses.
How Do You Calculate R&D Tax Credits?
Calculating how much R&D tax credit you are entitled to is not always easy because there are two methods to choose from—the Regular Research Credit Method and the Alternative Simplified Credit Method. However, you can also use an R&D tax credits software to calculate your potential credits.
Form 6765 or Credit for Increasing Research Activities enumerates the steps needed to calculate how much credit you should receive using either of the two approaches. You can determine your credits using both methods and then apply the one that gives you better result.
The Regular Research Credit is 20% of all qualifying expenses for the current year that exceeds a specific base amount. This base amount involves complicated and detailed calculations, depending on what kind of business you have (startup or established one).
The Alternative Simplified Credit is usually 14% of the difference between the amount of current year qualifying expenditures, and 50% of the average qualifying expenditures for the last three years.
You can choose to take a reduced credit regardless of the method you use. This lowers your R&D tax credits, but you won’t end up making any unnecessary adjustments to your taxable income. It can also simplify your tax returns preparations as well.
What Are Considered Qualified R&D Activities and Expenses?
R&D tax credits are only granted for qualified expenses related to Qualifying Research Activities or QRAs. QRAs are those that meet the IRS’s four-part test.
This basically means that:
.The activity is performed for the purpose of creating or improving a product or process. You want to improve its quality, reliability, speed, cost-efficiency and more.
.The activity seeks to find a solution to technical uncertainties related with improving or developing your product or process
.The activity involves a process of experimentation to decide which is the best way forward. Progress is also tracked back to trial and error, prototyping, modelling, simulation, or some other experiment.
.The process of experimentation is based on hard sciences or scientific principles, such as chemistry, physics, engineering, or computer science.
Remember that there is no need for the experiment to succeed. Even failed experiments and/or abandoned research qualifies for a tax offset.
If your R&D activity satisfies the four-part test, you can claim Qualifying Research Expenses (QREs) related to them.
How Do You Claim The R&D Tax Credit?
After you’re done calculating your R&D credits through either of the two methods or with an R&D Tax Credits Software, your next move should be to start claiming it.
One common misconception that keeps businesses from claiming R&D tax credits is that the claims process is very complicated and requires a lot of work. Although some intentional planning is necessary, the secret is to have the right documentation, which usually includes records that businesses already have on hand.
These records usually include:
.Tax and payroll records
.Testing documents, such as lab notes, project records, design drawings, prototypes, patent applications
.Reports that record/track time, expenses, and other project accounting information
