The Research and Development (R&D) tax credit is a commonly underutilized, yet powerful, tax incentive available for companies to substantially reduce their tax liability, improve their bottom-line, and reinvest back into their business. Daily activities performed by companies in a wide range of industries may qualify for federal and state R&D tax savings.
Unfortunately, R&D tax credits are also one of the most misunderstood methods of tax relief because there are many false assumptions about what is needed to qualify. In the following overview we’ll provide a brief description of the R&D tax rules, qualification criteria, and useful tips to maximize potential benefits. This article focuses specifically on federal R&D tax credits but there are also 40 states that provide R&D tax credits, each with its own set of rules and qualification criteria.
You don’t have to be scientists in white lab coats to qualify
For more than 40 years, companies have taken advantage of the R&D tax credit, claiming roughly $10 billion per year in tax savings. This powerful tax credit is not just available to large companies or companies employing hundreds of scientists. Companies of all sizes, in many different industries, may qualify for R&D tax credits including those working in software, manufacturing, aerospace and defense, agriculture, food and beverage, and life sciences. Even startups that have not yet generated taxable income may be able to monetize the R&D tax credit by claiming these R&D credits against their payroll tax liability.
There are many rules to claim an R&D tax credit but simply stated, if your company is involved in the technical development of new or improved products, or processes that require the undertaking of a systematic evaluation of multiple alternatives, to achieve the desired result, you may qualify. This applies to new product development, product enhancements, software development, manufacturing process improvements, and the list goes on…
Benefits of R&D tax credits for startups and small businesses
Unfortunately, many small businesses do not take advantage of this tax benefit because they self-censor, believing that their business will not qualify.
The Protecting Americans from Tax Hikes Act of 2015 opened the door for companies with little to no income tax liability to monetize the R&D tax credit. Eligible small businesses are now able to take the R&D credit against their alternative minimum tax liability. Eligible small businesses are defined as corporations that are not publicly traded, and are corporations, partnerships, or a sole proprietorship with average annual gross receipts not exceeding $50 million for the three taxable years preceding the current taxable year.
Startups with no more than five years of gross receipts and less than $5 million in gross receipts can also take advantage of the R&D tax credit incentive to offset up to $1,250,000 (over a five year period) of their Federal Insurance Contributions Act payroll taxes.
Benefits of timely capture of R&D tax credits
Even though a company may not be paying tax and may not be able to utilize the R&D tax credit currently, there are still good reasons to claim the credit. One of these reasons is that it is always easier to identify and document these credits while the supporting information is available and “fresh” in everyone’s minds. Waiting too long or until the company is profitable may be too late to capture the credits effectively, efficiently, and completely.
Another reason to choose to capture these credits in a timely fashion is because these credits can become extremely valuable in a sale transaction. Accumulated research and development credits can impact purchase price in an M&A or other deal, as a buyer may be inclined to pay more for the company if it has accumulated research credits (subject to IRC Sec. 383 limitations) and also if it has infrastructure in place to capture these credits on a “real time” basis.
Additionally, the accumulated credits may also be able to be used to offset the tax as result of a sale transaction. These credits may be able to offset the tax at the corporate level in the event of a C corporation sale or at the shareholder level in the event of pass-through entity sale.
The four-part R&D tax credit test
The criteria established by the following R&D four-part test will help to determine if your business qualifies for the R&D tax credit.
1. Technological in Nature - The activity performed must fundamentally rely on principles of engineering, computer science, physical or biological science.
2. Process of Experimentation - The company must demonstrate that they have undertaken an iterative development process, evaluating alternatives to eliminate uncertainty.
3. Elimination of Uncertainty - The activity must be aimed at eliminating uncertainty with respect to the development of a product or process.
4. Permitted Purpose - The activity must be intended to develop a new or improved business component.
Reviewing the tax code requirements and the company’s eligible activities should be the first step in the process of identifying potential R&D tax credits. Due diligence is required when adhering to the R&D tax credit rules and calculating and documenting the company’s qualified research activities. On the surface the rules may not seem complicated but there are many steps to claiming R&D credits – and many complicated tax court cases and a lot of misinformation that can make R&D claims confusing.
Importance of R&D tax credit documentation
To meet the requirements for the R&D tax credit, a history of the business’ qualifying activities must be documented. Documentation of R&D efforts can be challenging because employees may work on several projects at once and perform different types of duties. To address this, it is important to segment qualified R&D activities from all other work performed. Thankfully, today’s payroll systems can be programmed to track qualified research wages to qualified research projects.
The R&D tax credits may be claimed for both current and prior tax years, so it is recommended that companies document their R&D activities, so they’re well positioned to claim the credit for both situations.
The types of documentation that can be used to substantiate R&D labor expenses include:
• Time tracking data
• Employee W-2 forms
• Project lists
• Payroll registers
• Time questionnaires
• Job descriptions
• Meeting minutes
• Lab results
• Interview notes provided for oral testimony
Common misconceptions about R&D tax credits
Today, more companies than ever are qualified to take advantage of the R&D tax credit. However, many businesses still have reservations and don’t believe they will qualify based on misconceptions about how the tax credit may apply to their business. Some of these misconceptions include:
• They don’t believe they do R&D work - The definition of R&D work is broad. If the business is attempting to develop or improve a new product or process it may qualify for the R&D tax credit.
• They don’t believe they are inventing anything – There is no requirement that product or processes be successful or new to the world.
• They believe the risk of an audit will increase - The R&D tax credit is a permanent incentive intended to promote innovation in the U.S. Claiming R&D credits on timely filed tax returns, whenever possible, is encouraged and in most cases does not trigger an audit. However it is imperative that the taxpayer collect and retain proper documentation to support any R&D tax credit claim.
Claiming the R&D credit
A taxpayer shouldn’t feel intimidated by preconceived notions of what R&D is or what companies can qualify. Across industries, the possibilities for qualifying activities exist, and vital tax savings may be uncovered to be used for future projects.
At MGO, our professionals bring more than 30 years of R&D tax experience to help you file and defend your R&D tax credit claim. We welcome the opportunity to provide your company with a complimentary R&D tax credit eligibility analysis to determine if this tax incentive can help fuel your company’s growth.