As a business owner, you certainly do not want to overpay on your taxes. However, this is usually what happens when an eligible institution doesn’t use its Research and Development (R&D) Tax Credit. Most businesses overlook or are often unaware of such a significant tax-saving opportunity. For this reason, the GOAT Tax was created.
It all boils down to the fact that R&D tax credits can be a rather confusing topic to dive into. Businesses may find it difficult to determine their eligibility for the credit or calculate the size of expected benefits if they do not have any technical knowledge on the matter. This is why the GOAT Tax was established: to help and educate businesses on the R&D tax credit and assist companies that qualify for it.
In this article, we have come up with a guide addressing the issues business face with R&D Tax credits. We will be explaining in simple language what the R&D tax credit is, how it is calculated, how you can qualify for it or claim it, and so much more.
What is the R&D Tax Credit?
The R&D tax credit is a tax incentive that is meant to encourage research activities related to improving or developing products, software or processes. This tax incentive was first introduced in 1981 by the federal government. It was later made permanent by Congress in 2015 through the PATH Act.
The rules pertaining to the R&D tax credit are explained in Section 41 of the Internal Revenue Code. The credit is available for allowed expenses incurred on certain types of research, known as Qualifying Research Activities. All types of businesses that attempt to use scientific methods to innovate or make improvements could qualify—so the rewards are definitely not exclusive to large corporations with huge R&D departments.
How Do Companies Benefit from R&D Tax Credits?
Benefits from the R&D tax incentives vary depending on the type of business that applies for it.
When it comes to for-profit organizations, R&D credits mean dollar-for-dollar reduction in federal income tax liability. Eligible Small Businesses (ESBs) can also use them against Alternative Minimum Tax (AMT) liability. ESBs are defined as businesses that earns an average of $50 million or less in gross receipts in the last three years.
Qualifying Small Businesses (QSBs), on the other hand, are able to use part or all of its credits to even out payroll tax obligations, for a maximum of $250,000. QSBs are usually startups that are under five years old and earn current year gross receipts of under $5 million. The payroll tax offset helps lower staff costs without decreasing headcount or salaries. It also means you don’t need to generate profit in order to use tax credits.
Unused credits can be carried over for 20 years and applied against taxes in the future years. This carry-forward feature is important for keeping cash flow at times when there aren’t a lot of funds available.
R&D credits release resources for other purposes too. In reality, companies usually get back around 5-10 cents for every dollar spent in qualified expenses.
How Do You Calculate R&D Tax Credit?
It’s not always easy to calculate one’s R&D tax credit entitlement because there are two methods to choose from—the Regular Research Credit or the Alternative Simplified Credit.
Form 6765 (Credit for Increasing Research Activities) explains in a series of steps how businesses can calculate their potential tax credits using either methods. You can calculate your credits using both methods and then apply that one that gives you better results.
The Regular Research Credit makes up 20% of all qualifying expenditures for the current year that goes beyond a specified base amount. This base amount may include complicated and comprehensive calculations, depending on whether you’re a start-up or an established business.
The Alternative Simplified Credit, on the other hand, is usually 14% of the difference between the current year’s qualifying expenditures, and 50% of the average qualifying expenditures for the past three years.
Businesses can opt for a reduced credit regardless of the method they use. This lowers their R&D tax credits but saves them from making an unfavorable adjustment to their taxable income. It also makes the preparation of state tax returns a lot simpler.
What Activities and Expenses are Qualified for R&D Tax Credits?
R&D Tax Credits are available only for eligible expenses related to Qualifying Research Activities (QRAs). QRAs are those that satisfy the four-part test laid out by the Internal Revenue Service (IRS).
Basically, this means:
- The activity is done for the purpose of developing or improving a product or system. Your business/company is trying to improve on its reliability, quality, speed, cost-efficiency, or another factor related to performance.
- The activity is intended to fix or solve technical uncertainties related to improving or developing a product or system.
- It involves a process of experimentation to decide the best way forward, and the progress can be traced back to trial and error, prototyping, modelling, simulation, or some other experiment.
- The activity’s experimentation process relies on hard sciences or scientific principles such as chemistry, computer science, and engineering.
It should be noted that there is no need for the experiment to be a success. Failed or abandoned research can still qualify for a tax offset.
If your activity meets the four part-test, then you can claim Qualifying Research Expenses (QREs) related to them.
There are three major types of eligible expenses which are salaries, supplies and contracted research. Keep in mind that qualified expenses may be less than your cash outlay. For instance, if your employees 50% of their time on a qualifying project, only 50% of their salaries would be considered as a qualifying expense.
The IRS has also provided a list of activities that DO NOT qualify for R&D tax credits. Examples of these would be projects related to management functions and social sciences, as well as activities done outside the USA.
So how do you start identifying potential qualifying expenses? Start by looking into the R&D costs in your financial accounting system. You might also find it more convenient to work with professionals or use a platform like GOAT Tax to determine the eligibility of your activities and expenses.