Understanding the R&D Tax Credit, Eligibility, and How to Apply for the Tax Credit

By James R. Leichter

The Short Take on the R&D Tax Credit

The R&D Tax Credit is a valuable incentive designed to encourage companies to invest in innovation and technological advancements. Available to businesses across various industries, this credit can significantly reduce tax liability by rewarding activities related to research and development.

An example might include a software company that develops a B2B application and qualifies for the credit by paying programmers to create innovative software solutions.

This article explores the details of the R&D Tax Credit, including eligibility, limitations, benefits, and the claiming process, along with ten frequently asked questions to provide comprehensive insights.

Understanding the R&D Tax Credit

The Research and Development (R&D) Tax Credit, established in 1981, aims to encourage businesses to invest in innovation, improve products, and develop new technologies. It offers a substantial tax incentive for companies that engage in qualified research activities, helping to offset some of the costs associated with these endeavors.

Tax Credit versus Tax Deduction – What’s the Difference?

Remember, this is a tax credit and not mealy a tax deduction. Tax credits are worth far more because they reduce your tax burden directly. Tax credits are subtracted from your tax liability. Tax deductions reduce your taxable income.

Tax Credit

  1. A tax credit directly reduces the amount of tax you owe, dollar for dollar.
  2. For example, if you owe $5,000 in taxes and you have a $1,000 tax credit, your tax liability is reduced to $4,000.
  3. Tax credits can be either refundable or non-refundable. Refundable credits can result in a refund if they reduce your tax liability below zero, while non-refundable credits only reduce your tax liability to zero.

Tax Deduction

  1. A tax deduction reduces your taxable income, which in turn lowers the amount of tax you owe based on your tax bracket.
  2. For example, if you are in the 22% tax bracket and you have a $1,000 deduction, your taxable income is reduced by $1,000, which results in a tax saving of $220.
  3. Deductions are generally subtracted from your gross income to arrive at your adjusted gross income (AGI) and then your taxable income.

Click here to learn more about tax credits versus tax deductions.

Who Can Claim the R&D Tax Credit?

The R&D Tax Credit is available to a wide range of businesses, regardless of size or industry, provided they undertake qualified research activities. Eligible businesses include manufacturing, software development, engineering, pharmaceuticals, and more. The key requirement is that the research activities must meet the following criteria:

Qualified Research Activities (QRAs)

The activities must aim to develop or improve a product, process, formula, or software.

Technological in Nature

The research must rely on principles of physical, biological, engineering, or computer science.

Elimination of Uncertainty

The company must demonstrate that it attempted to eliminate uncertainty regarding the development or improvement of the product or process.

Process of Experimentation

The research must involve a process of experimentation, including evaluating alternatives or hypotheses.

When the R&D Tax Credit Cannot Be Used

Not all research activities qualify for the R&D Tax Credit. Exclusions include:

  1. Research conducted outside the U.S.
  2. Expenses paid to contractors outside the USA.
  3. Research in the social sciences, arts, or humanities.
  4. Surveys or studies related to management functions or efficiency surveys.
  5. Adaptation of an existing business component.
  6. Duplication of an existing product or process.
  7. Funded research, where the business does not retain substantial rights or the risk of the research.

Real-World Example

Consider a software company, Tech Innovators Inc., that specializes in developing B2B software solutions. They embarked on a project to create an advanced customer relationship management (CRM) system tailored for healthcare providers. The project required significant investment in programming, testing, and refining the software to ensure it met industry standards and addressed unique healthcare needs.

Tech Innovators Inc. paid their team of programmers to write the code, perform testing, and develop innovative features such as predictive analytics and integration with medical records. These activities qualify as QRAs because they aim to create new and improved software through a process of experimentation, addressing technological uncertainties.

How Much Is the Credit?

The R&D Tax Credit can vary depending on the specific circumstances of the business and the amount of qualified research expenses (QREs). Generally, the credit is calculated as a percentage of the QREs, including wages, supplies, and contract research expenses. The two common methods to calculate the credit are:

  1. Regular Research Credit (RRC): 20% of QREs above a base amount.
  2. Alternative Simplified Credit (ASC): 14% of QREs exceeding 50% of the average QREs over the previous three years.

How to Claim the R&D Tax Credit

To claim the R&D Tax Credit, businesses must follow these steps:

  1. Identify Qualified Research Activities (QRAs). Document those activities in detail.
  2. Document QREs: Maintain detailed records of wages, supplies, and contract research expenses related to the QRAs.
  3. Calculate the Credit: Choose between the RRC or ASC method to calculate the credit amount.
  4. File IRS Form 6765: Include this form with the business’s tax return to claim the credit.
  5. State Credits: Check if your state offers an R&D credit and follow the respective procedures.

10 Frequently Asked Questions (FAQs)

Q: Does it matter if the software program was offered for sale? Does the credit apply to a programmer that developed a software program that was offered for sale?

A: Yes, it does matter if the software program was offered for sale. The eligibility for the R&D Tax Credit for software development depends on several factors, including whether the software is intended for internal use or for sale to customers. If the software program is developed for sale, lease, or license to customers, it generally qualifies for the R&D Tax Credit, provided it meets the other requirements for qualified research activities (QRAs). Software developed primarily for internal use (e.g., internal business operations) has more stringent qualification criteria.

Q: What qualifies as a Qualified Research Activity (QRA)?

A: Activities that aim to develop or improve a product, process, formula, or software using principles of science or engineering.

Q: Does the R&D Tax Credit apply to companies that fully expensed their payroll expenses and did not capitalize payroll expenses over time?

A: Yes, the R&D Tax Credit applies to companies that fully expensed their payroll expenses. Qualified research expenses (QREs) include wages paid to employees who perform qualified research activities. Whether these wages are expensed or capitalized does not affect their eligibility for the credit.

Q: Is the R&D Tax Credit offered by the IRS or my State or both?

A: The R&D Tax Credit is offered by both the IRS at the federal level and by many states. The federal R&D Tax Credit can be claimed through the IRS, and many states offer their own R&D tax credits with varying requirements and benefits.

Q: Which states do not offer the R&D Tax Credit?

A: As of now, a few states do not offer their own R&D Tax Credit. These states include:

  1. Alabama
  2. Alaska
  3. Delaware
  4. Florida
  5. New Hampshire
  6. South Dakota
  7. Wyoming

However, this list may change, and it’s advisable to check with state tax authorities or a tax professional for the most current information.

Q: Are employee payroll taxes and benefits such as health insurance a qualified expense?

A: Yes, employee payroll taxes and benefits, such as health insurance, can be included as qualified research expenses (QREs) under the R&D Tax Credit. These expenses must be related to employees who are directly engaged in qualified research activities.

Q: Can I amend my tax return to claim the R&D Credit?

A: Yes, you can amend your tax return to claim the R&D Credit. Generally, you have up to three years from the date you filed your original return or two years from the date you paid the tax, whichever is later, to file an amended return and claim the R&D Tax Credit.

Q: Can startups claim the R&D Tax Credit?

A: Yes, startups can claim the credit and even offset payroll taxes in certain situations.

Q: Are there any limits on the R&D Tax Credit?

A: The credit amount is subject to limitations based on the company’s tax liability and other tax credits claimed.

Q: Can the R&D Tax Credit be carried forward?

A: Yes, if the credit exceeds the tax liability, it can be carried forward up to 20 years.

Q: Is there a deadline to claim the R&D Tax Credit?

A: The credit must be claimed on a timely filed tax return, including extensions.

Q: Can expenses for failed projects be included?

A: Yes, expenses for unsuccessful research projects can be included if they meet the criteria for QRAs.

Q: What documentation is required to support the claim?

A: Detailed records of research activities, expenses, project notes, and time tracking for employees involved in QRAs.

Q: Do all states offer an R&D Tax Credit?

A: No, not all states offer an R&D Tax Credit. Businesses should check their state’s specific regulations.

Q: Can software development qualify for the R&D Tax Credit?

A: Yes, software development often qualifies, especially if it involves new or improved software through experimentation.

Q: How does the credit affect financial statements?

A: The R&D Tax Credit can enhance cash flow and improve financial statements by reducing tax liability and increasing after-tax profits.

Final Points

The R&D Tax Credit is a powerful incentive for businesses to invest in innovation and technological advancements. By understanding the eligibility criteria, documenting research activities, and properly calculating and claiming the credit, businesses can significantly reduce their tax burden and fuel further growth and development. Whether you’re a startup or an established company, exploring the benefits of the R&D Tax Credit can lead to substantial financial savings and encourage ongoing innovation.

Your Comments and Suggestions are Welcome

I hope this helps you better understand the R&D Tax Credit and how it may apply to your company.

Please leave your comments or questions and I will try to answer them.

Thank you!

James R. Leichter (about me)
RA Tax and Accounting, Inc.