Request an R&D Tax Credit Assessment of Your Business Click Here

R&D Tax Credit

The Federal R&D Tax Credit

The Credit for Increasing Research Activities, more commonly referred to as the Research and Development (R&D) Tax Credit, was enacted in 1981 and made permanent in 2015 with the passing of the Protecting Americans from Tax Hikes (PATH) Act. The credit was enacted to encourage businesses to keep innovation in the United States and is available to nearly all industries – it is not just for companies that wear lab coats and develop patents.

The calculation requires an analysis of the current year expenses, as well as an analysis of at least the three prior year expenses (if available). The credit can be claimed for the current year and can be claimed retrospectively for any open tax years. Unused credits can be carried back one year and can be carried forward up to 20 years.

State R&D Tax Credits

Following the passing of the R&D Tax Credit at the federal level, several states also developed their own R&D Tax Credit. The qualification and calculation methodology varies based on each state, and can be claimed in addition to or independently from the Federal R&D Tax Credit.

Qualification Requirements and Eligible Expenses

Qualification Requirements

The definition of research and development is fairly broad and encourages companies from a variety of industries to claim the credit.

To claim the R&D Credit, a company’s activities must meet the four-part test requirements set forth in Internal Revenue Code (IRC) Section 41, as detailed below.

  • New or improved business component includes a product, process, formula, software, invention, or technique. A design is considered a product for R&D credit purposes.
  • There must be an uncertainty to eliminate, including an appropriate design, methodology, or capability. This translates to evaluating whether a company was uncertain as to any of the following: can we do it?, how are we going to do it?,” or “what is the appropriate design for what we’re we are trying to do?”
  • The uncertainty must be eliminated through a process of experimentation. This process of experimentation cannot be merely plug and play – there must be a systematic trial and error process used to overcome the uncertainty.
  • The process of experimentation must be technological in nature, including the principals of physical or biological sciences, engineering, or computer science. Social sciences, including arts or humanities, are specifically excluded.

Eligible Expenses

  • Wages paid or incurred to an employee for qualified services. Qualified services include activities of individuals directly engaged in R&D, as well as activities of individuals directly supporting or directly supervising R&D.
  • Supplies used in the conduct of qualified research for tangible property other than land or improvements to land and property subject to the allowance of depreciation.
  • Rental or Lease of Computers/Cloud hosting expenses tied to qualified research activities.
  • Contract research expenses paid or incurred by a taxpayer to any person (other than an employee) for qualified research.

The R&D Credit allows four types of expenses to be included in the credit calculation.

Using the R&D Tax Credit

Generally, most companies use the R&D Credit to offset income tax of the company and/or the shareholders or partners.

However, with the passing of the PATH Act, start-up companies can now use the R&D Credit to offset the employer portion of the taxpayer’s Social Security tax liability.

*Each situation must be evaluated on a case by case basis to determine the most appropriate utilization strategy

Offsetting income tax

  • R&D credits can be used to offset current income tax
  • R&D credits can also be generated for several years and carried forward to offset income tax related to the sale of a business*
  • C-Corporation R&D Credits can be considered an asset on a company’s balance sheet*

Offsetting Social Security Tax Liability

  • The R&D Credit can be used to offset the employer portion of Social Security tax liability
  • To be eligible:
    • Company has to be 5 years old or less
    • Company has to have less than $5 million in gross receipts/sales
  • Nuances
    • Maximum of $250k per year
    • Can be used for expenses for all employees, not just employees engaged in R&D
    • Any unused credit can be carried forward to offset future payroll tax or income tax, depending on the financial situation of the company
    • We will work with CPA and payroll provider to ensure the correct information is filed on the necessary forms
  • Net Operating Losses
    • Depending on the tax paying position of the company, it may be possible to go back more than 3 years to generate an R&D credit to be carried forward
    • This is very specific to each entity and would need to be evaluated on a company by company basis