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The Research & Development (R&D) Tax Credit is a U.S. federal tax incentive aimed at promoting innovation and technological advancements within the country. R&D tax credits are available to all organizations that engage in certain activities to develop new or improved products, processes, software, techniques, formulas or inventions. We receive many questions regarding the R&D Tax Credit and have compiled and answered several of them below:
How does the R&D tax credit work?
Typically, 6% to 8% of a company’s annual qualifying R&D expenses can be applied, dollar for dollar, against its federal income tax liability. Various activities may qualify for the credit, including but not limited to:
Developing processes, patents, formulas, techniques, prototypes or software
Improving or redesigning existing products
Hiring scientists, designers or engineers that are engaged in qualified activities
Devoting time and resources to creating (manufacturing or developing) new or innovative products
Developing intellectual property
Paying certain amounts for salaries, supplies, contract research and cloud hosting
Businesses can also claim an R&D tax credit of up to $500,000 per year against their payroll taxes. Eligible organizations include those that have under $5 million in gross receipts in the current year and no more than 5 years of generating gross receipts, including the current year. New businesses, meanwhile, can offset payroll taxes for up to five years, with a maximum of $2.5 million in total credits used on their quarterly federal payroll tax returns.
Can past year tax returns be modified to claim the credit?
Certainly, businesses can claim the R&D credit retroactively by filing amended returns for any open tax years, which in most cases, is three years. The time frame may be longer, however, if the organization endured losses during that period.
What is the cost for an R&D Study?
In terms of fee arrangements, we determine eligibility for tax incentives at no risk to our clients as our services are performed primarily on a contingent fee basis. Accordingly, our clients pay nothing until a tax incentive is identified.
How can I know if my business is eligible for this credit?
Qualification for the R&D tax credit mainly hinges on whether the activities align with the IRS's four-part test criteria:
1. Permitted purpose
The activity must be related to developing or improving the functionality, quality, reliability or performance of a business component (i.e. product, process, software, technique, formula or invention).
2. Technological in nature
The business component’s development must be based on a hard science, such as engineering, physics and chemistry, or the life, biological or computer sciences.
3. Elimination of uncertainty
From the outset, the organization must have faced technological uncertainty when designing or developing the business component.
4. Process of experimentation
The company must have evaluated multiple design alternatives or employed a systematic trial and error approach to overcome the technological uncertainties.
Is the R&D credit still viewed as a Tier 1 audit concern?
The R&D tax credit no longer falls under Tier 1 issues.
How do you calculate the R&D tax credit?
Generally, there are two methods for computing the QREs-based credit, regular and alternative simplified. The two methods are the same in that they both calculate the credit as a percentage of the excess of qualified spending in the year for which the credit is being calculated over a “base amount.” For this reason, these credits are sometimes called “incremental” credits. The credits are different in three ways:
1. Rates - The Regular Credit’s (RC’s) statutory rate is 20%, the Alternative Simplified Credit’s (ASC’s) is 14%.
Important note: The RC’s higher rate does not mean that a particular taxpayer’s RC will always be greater than its ASC. Its RC could be greater, but it could be much lower. This is because the RC and ASC calculate their “base amounts” differently.
2. Base Amounts – The RC’s base amount is calculated using the taxpayer’s gross receipts and QREs; the ASC’s base amount uses just QREs, hence its name, “Alternative Simplified Credit.” In some cases, the gross receipts a taxpayer needs to calculate its RC relate to tax years from as remote as the 1980s, which is part of the reason more and more taxpayers are electing the ASC.
3. Election - The ASC must be elected for a tax year either on an original return by simply completing the ASC section of the Form 6765 on which all federal R&D credits are reported, or on an amended return, whereas the RC does not have to be elected under any circumstances, just reported or claimed.
Important note: A taxpayer may elect the ASC on an amended return only if (1) the taxpayer has not previously claimed an RC on its original return or an amended return for that tax year, and (2) that tax year is not closed by the period of limitations on assessment under IRC Section 6501(a).
Is R&D tax credit taxable income?
The R&D credit reduces federal taxable income, meaning that businesses receive a dollar-for-dollar tax credit and still get to deduct expenses related to research and development.
Can I offset state taxes as well as federal?
Yes. Most states offer a credit for expenditures to attempt to develop or improve a product, process, or software, and most adopt or follow rules similar to those of the federal R&D credit. Some states require taxpayers to file an application other than just the tax return on which the credit is claimed to be eligible for their credits. Some also limit their credit to certain industries or the amount of credits that will be allowed each year. In many cases, though, state credits are even more generous than the federal credit. For example, some states have higher credits rates; or they allow taxpayers to sell or to transfer their credits to other taxpayers; or they pay taxpayers the value of their state credits even if the taxpayers aren’t currently paying taxes; i.e., their credits are “refundable.”
Do R&D tax credits expire?
The Protecting Americans from Tax Hikes (PATH) Act of 2015 permanently extended the R&D credits available under Section 41 of the Internal Revenue Code. If there is a lack of tax liability, business may carry unused credits forward for up to 20 years.
When do I claim the R&D credit?
The credit is claimed on a timely-filed (including extension) federal income tax return for the year in which the qualified expenses were incurred. The credit may also be claimed by amending a previously-filed return on or before the statute of limitations date to report credits related to expenses incurred during that period. The statute of limitations generally grants three years after the original deadline or filing date (whichever is earlier) to amend returns.
What are the risks of claiming the R&D credit?
IRS exam. Like any other tax position, it is possible that the IRS will examine an R&D credit position. Original tax returns that include R&D credit positions have not been more likely to be examined than those that do not include R&D credit positions. Amended tax returns claiming R&D credits that are used in the years under examination have been more likely to be examined. If examined, R&D credits may be allowed or disallowed, in whole or in part. If credits are allowed, the IRS may consider the taxpayer’s other tax positions to identify additional tax liability, but only to the extent of offsetting the credit. This has been uncommon.
Disallowed credits. It is possible the IRS would examine and disallow some or all the R&D credits. Credits that have been appropriately identified and supported are generally allowed. Credits related to vague or undocumented activities often are not.
IRS penalty and interest. If the IRS disallows a credit it may assess a penalty if it finds that the credit was either claimed through negligence or the disregard of rules or regulations, or results in a substantial understatement of income tax. Generally, this penalty equals 20% of the credit disallowed, i.e., of the tax the IRS believes was underpaid. The IRS may also assess interest due on that 20% from the date that the tax should have been paid, but this has not been our experience.
How can Saba Tax Advisory help me maintain tax credit compliance as laws and requirements change?
We provide an unparalleled combination of experience, technology and resources to help make the entire process of claiming tax credits as simple, streamlined and predictable as possible. We maintain relationships with federal, state and local government agencies and continuously monitor for changes in applicable legislation and compliance requirements. As a result, we’re able to provide proactive information and insights, as well as ongoing audit support.
What if my company is already claiming the R&D credit?
Based on experience, the majority of companies that have claimed R&D benefits have not taken full advantage of them, even if an “R&D Study” has been done. Saba Tax Advisory offers the following complimentary services to help companies determine whether they are leaving cash on the table or could more efficiently and effectively claim their R&D credits:
Cost & Calculation Review: Like a tax examiner, we look for errors and red flags, including those caused by use of outdated files and regulations. We also look for understated, missed, and non-qualified costs to enhance both your credit’s materiality as well as its credibility.
Documentation Review: R&D benefits are often only as valuable as the documentation available to support them. As part of a documentation review, we assess whether and how tax examiners will accept—or disallow—your credit in light of the nature and extent of your documentation and make recommendations to improve it, for both current and future tax years.
Systems & Technology Review: We help companies develop and implement procedures and technologies to identify, document, and calculate future credits, more efficiently and more effectively.
The R&D Tax Credit serves as a testament to the U.S. government's commitment to fostering innovation and technological progress. By providing financial incentives to companies pushing the boundaries of their respective fields, the credit ensures that the nation remains at the forefront of global technological advancements. If you have any additional questions regarding the R&D Tax Credit or would like to find out if your company qualifies, please visit our website, email us at info@sabataxadvisory.com or call us today at (916)276-1952.
The information provided in this blog is intended for general information only, and is not meant to constitute tax advice.