Posted by Shivali Anand
April 19, 2022 | 6-minute read (1209 words)
Many of America's 30 million-plus small businesses engage in research and development on a regular basis. Nevertheless, most small- to medium-sized enterprise owners are unaware that they qualify for the federal R&D tax credit. Further, business founders may be unaware that this tax credit applies to procedures they are already engaged in.
Despite popular misconceptions, the R&D tax credit is not confined to huge enterprises in specialized areas or businesses with a dedicated R&D department. It's open to any company that produces or improves a product or process in the course of doing business, regardless of size, revenue or industry.
In brief, enterprises in a wide range of industries may be eligible for the R&D credit, allowing them to lower their tax burden by carrying out their regular operations. The R&D tax credit regulations, on the other hand, are complicated and intricate.
To assist you in determining your startup's eligibility, we've broken down the R&D tax credit's complexities.
What is the R&D tax credit?
The R&D tax credit, commonly known as the Credit for Increasing Research Activities, encourages firms in the U.S. to create new or better goods or processes. It provides a tax credit to businesses that raise their investment in research and development, which decreases the amount of tax payable or enhances a tax refund.
Background: The R&D tax credit was created in 1981 as a two-year temporary incentive to encourage innovation, but it has become a permanent feature of the IRS tax system. Many small firms and startups were initially excluded due to the program's stringent qualification requirements.
The R&D tax credit became a permanent element of IRS tax law when the Protecting Americans from Tax Hikes Act was presented in 2015, with updated criteria that significantly expanded eligibility to include both startups and established businesses. However, many small firms are uninformed of the change and continue to believe they are disqualified.
How it functions: The R&D tax credit offsets firms' federal income taxes and, in some cases, payroll taxes, dollar for dollar, based on the amount of eligible research and development investment.
The credit stipulates that R&D expenses be capitalized and amortized over a five-year period. Qualified startups can get up to $250,000 in R&D tax credits every year for the next five years if they expect to use the credits to offset payroll taxes and more than $250,000 if they plan to use the credits to offset income taxes.
One quick point to remember is that payroll tax offsets are not available to qualified businesses collecting revenue for over five years and/or have more than $5 million in revenue during the tax year.
Test for eligibility
To evaluate whether a company's activities qualify for the R&D tax credit, Section 41 (d) of the IRS tax code employs a four-part test. To be eligible for the R&D credit, your startup's activities must fulfill the criteria below.
1. The Section 174 test: The company must show that the costs were made in the course of its trade or business and that they are research and development expenses in the experimental or laboratory sense.
2. Technological information test: The company must show that its research method is based on concepts from hard sciences such as engineering, physics, chemistry, computer science and other fields.
3. Business component test: The company must be able to connect the tax credit research to the relevant/specific business component. Any product, method, computer software, technique, formula or idea to be kept for sale, lease, license or further utilized in the company's trade or business is considered a business component.
4. Experimentation test: The company must show that it has identified the source of uncertainty in developing or enhancing a particular business component. It must also demonstrate that it arrived at the new or enhanced product or method by process of elimination, simulation, systematic trial and error or other types of review.
A note on failed R&D efforts: To be eligible, the R&D endeavor does not have to be successful. An unsuccessful attempt may highlight the importance of trying new things. Furthermore, the new or enhanced product, capability or method does not have to be industry-first. It is simply necessary for the company performing the research to be creative.
What expenditures do you have the right to claim?
When calculating qualified R&D credit savings, the IRS typically relies on three expense buckets. The chart below shows research costs that are eligible for the R&D tax credit and those that are not.
The formula for calculating the R&D tax credit
The R&D tax credit computation begins when you've decided that the activity fulfills the four-part eligibility criteria and identified qualifying research costs.
These five steps will help you calculate your R&D tax credit:
Step 1: Compute your eligible research costs for the three years prior.
Step 2: Using these data, calculate the average QRE.
Step 3: Take the average QRE and double it by 50%. Your credit base is this number.
Step 4: Subtract the credit base from your current year's total R&D costs.
Step 5: To calculate your R&D tax credit, multiply the figure by 14%.
For example, during the last three years, a startup has spent $100,000 on qualified R&D. Its credit base is now $50,000 (50% of $100,000). This year, the company spent $120,000 on R&D, which is $70,000 more than last year. The R&D tax credit is 14% of $70,000 or $9,800.
Startups with less than three years of R&D experience: Companies with less than three years of R&D experience can compute the R&D tax credit as a flat 6% of total R&D costs for the year. In the scenario above, the startup would receive a $7,200 R&D tax credit (6% of $120,000).
Documentation required to support your claim for R&D tax credits
You must send substantiating papers with your R&D tax claim to the IRS. Your supporting materials should include the following:
• Be relevant to the time period in which the research was conducted.
• Emphasize the technological difficulties faced to demonstrate that the research was completed and that people were involved.
• Emails, technical papers, whiteboard or product roadmaps, timesheets, invoices/receipts, contractors agreements, development/engineering notes and so on may all be used as proof.
What is the R&D tax credit and how can I apply for it?
By completing IRS Form 6765 with your income tax return, you can claim the R&D tax credit.
|R&D tax credit eligible/ineligible expenses
|Qualified research expenses
||Expenses not covered
• Contract research expenses.
• Cloud computing expenses.
• Payments made for the right to use computers for research.
• Routine data collection.
• Consumer preference testing.
• Market research.
• Research paid by an unrelated third party.
• Duplication of existing product/process.
• Research conducted outside the U.S.