While much of the counsel we provide clients ultimately saves them money – whether it is avoiding liability or reducing the necessity of future legal work – opportunities to capture an immediate source of cash for clients are rare. So, when they are available, we are happy to pursue them for clients. One such opportunity is the Research and Development (R&D) Tax Credit.
These Tax Credits can provide a potential, immediate source of cash (as well as a significant reduction to current and future federal/state tax liabilities). R&D Tax Credits remains one of the best opportunities for businesses to substantially reduce their tax liability. Companies from a wide-range of industries can qualify for significant federal and state tax savings. Indeed, many of our clients find themselves surprised at how much more expansive the potential application of the credit is relative to their initial expectations.
What is the R&D Tax Credit?
Originally introduced in 1981, Section 41 of Title 26 of the United States Code, the “Credit for increasing research activities” or, as it is more casually known, the “Research and Development” or “R&D” credit, was an economic stimulus incentive designed to provide a credit against income taxes paid for companies engaging in qualifying research and development activities.
Originally structured as a 2-year credit incentive, the statute was renewed every two years until 2015 when President Obama signed the Protecting Americans from Tax Hikes (PATH) Act which again renewed the statute but also made the statute a permanent fixture in the United States Code as well as providing additional benefits to small businesses. In so doing, Congress eliminated probably the biggest hurdle for small and medium-sized businesses wanting to claim the credit, utilization. The Alternative Minimum Tax bar has been “turned off” – allowing businesses with $50 million or less in gross receipts to take advantage of the incentive with less restriction related to the Alternative Minimum Tax (“AMT”). This means that for purposes of calculating the R&D tax credit, an eligible small business may presume that their tentative minimum tax is zero and may offset regular and AMT liability. Additionally, businesses less than five years old with less than five-million dollars in gross receipts may use R&D tax credits to offset up to $250,000 in payroll taxes.
As such, small businesses are claiming the credit more often, enabling them to put funds back into their business to improve products or processes that they otherwise would not have. However, we still find that many small and medium-sized business owners too often self-censor when it comes to applying for the credit. These businesses are still failing to take advantage of the credit, while big businesses, such as Amazon, continue to use the credit to its full potential, greatly reducing (or wholly eliminating) their tax bill.
Structure of the R&D Credit
26 U.S.C §41 provides for a taxable year credit equal to 20 percent of the excess of any qualified research expenses over the base amount.
The base amount is determined by multiplying a fixed-base percentage (determined based on factors such as how long your company has been in business and the extent of your company’s gross receipts and qualified activity during that time) by your company’s average annual gross receipts for the 4 taxable years preceding the year in question.
Qualified research expenses include payroll, supplies, and contractor costs incurred while conducting R&D. To determine if the expenses are qualified, a taxpayer must engage in a four-part test as outlined in detail by the IRS here but summarized as:
- Were the expenses incurred in connection with a permitted purpose?
- Was the activity related to the improvement of a product, process, formula, invention, software, or technique?
- Was there uncertainty as to the end result of the research or development conducted?
- Was there a process of experimentation to evaluate one or more alternatives?
- Was the work technological in nature?
Businesses with qualifying expenses are able to claim a credit against income taxes and, for small businesses, payroll taxes paid as a corporation. Additionally, due to changes provided by the PATH Act, small businesses may offset their alternative minimum tax obligations, a change that allows many more companies to utilize the credit than in prior years.
Who can take advantage of the Credit?
While the originally drafted legislation may have envisioned people in white lab coats crafting chemical compounds, the application has been much more universal. For a business owner, your first question should be whether or not your company makes something. Broadly defined examples include software, manufacturing, architecture, engineering, food, food processing, breweries, pharmaceuticals, etc. (here’s a bigger list of possible good candidates for the credit). Professionals like accountants and lawyers (pour one out for us) are not good candidates. However, even fields that you wouldn’t think of making something, such as financial services or warehouse services, could potentially capture the credit with software (internal use software for customer-facing functions).
If your business is making something, the next question is whether you are making the same thing the same exact way each time. This would be rare. The R&D tax credit doesn’t cover just your first iteration of a product, but also any subsequent improvements, including the production process (cleaner, greener, quicker, cheaper, automation, etc.). A special note, you don’t have to successfully get a new product to market to qualify. Trying and failing is sufficient activity to take advantage of this credit.
Qualifying expenses can include qualifying percentages of: the salary paid to a chemist developing new formulations for a multi-vitamin, the salary paid to an engineer for his time helping design and develop an energy efficient home, or even the cost of the metal it takes to develop and test a prototype trailer made by your company. As long as you are in the process of designing, developing, or testing a new product or process, this credit is available.
How does it work?
The R&D Credit is included through an IRS form 6765 filed along with your annual tax return. The credit is subject to taxation, which reduces the amount of the credit you receive by your company’s marginal tax rate but still, in most cases, results in a net positive return for your company. Depending on your need, the credits realized can then be used to offset income tax expenses or applied to your upcoming payroll tax expenses.