The Research & Development (R&D) tax credit is a federal tax credit available to businesses of all sizes that conduct Research & Development activities domestically in the United States. The definition of R&D is broad and applies to nearly every industry, not just your typical science labs. The R&D tax credit was first introduced in 1981 as a way of rewarding businesses that were investing in American innovation to boost the economy. When first introduced it was only intended to be a two-year credit, but due to its success, it has been extended every year since. Over the years there have been many changes to the R&D Credit, but most notably in 2015 as part of the PATH Act, it was overhauled and established as a permanently available tax credit. This has allowed more businesses to fully utilize the credit without fear that it will be unavailable in the future.
What Activities Qualify for the R&D Tax Credit?
The Internal Revenue Code (IRC) Section 41 and the related regulations help define what types of activities qualify for the R&D tax credit. Next, we are going to break it into two sections, what activities qualify as R&D and what expenses of the R&D activity qualify for the R&D tax credit.
To qualify as R&D according to IRC section 41, the taxpayer must show that the activities:
- Are intended to discover information to remove technological uncertainty that exists at the outset of the project or initiative related to the capability or methodology for developing or improving the business component or the appropriate design of the business component.
- Rely on hard science, such as physical science, biological science, computer science, or engineering.
- Relate to the development of a new or improved business component, defined as new or improved products, processes, internal-use computer software, techniques, formulas, or inventions to be sold or used in the taxpayer’s trade or business.
- Substantially all R&D activities must contain elements of a process of experimentation.
Once we determine what activities qualify for R&D, next we need to determine what expenses are considered Qualified Research Expenses (QRE). As a reminder, only expenses incurred domestically in the U.S are eligible QREs.
- Wages paid to employees for qualified services.
- Supplies used and consumed in the R&D process.
- Contract research expenses paid to a third party for performing Qualified Research Activities on behalf of the taxpayer, regardless of the success of the research, allowed at 65% of the actual cost incurred.
- Basic research payments made to qualified educational institutions and various scientific research organizations, allowed at 75% of the actual cost incurred.
How is the R&D Tax Credit Calculated?
There are two distinct ways to calculate the R&D tax credit. The first of which is the Regular Method and the second is the Alternative Simplified Method. Both methods are similar in that the credit is determined by comparing your current year QREs to the base amount. The difference in the methods come into the details of how the base amount is determined and the percentage of the credit. When using the Regular Credit, the base amount is determined by calculating the QREs as compared to gross receipts from 1984 to 1988 (the original years the credit was available) or by applying the start-up company rules that create a formula based on the years that R&D activities began with a limit based on 50% of the current year QREs. The Alternative Simplified Credit takes an average of the past three years and is adjusted each year. The Regular Credit yields a credit of 20% whereas the Alternative Simplified Credit yields a 14% credit.
In determining which method is the most beneficial there are several factors to consider as this decision is permanent. Some of these factors include the amount of R&D activity that will be completed in the initial years compared to the lifetime of the company, the availability of historic information needed to determine the base periods under the Regular Method, when the business or owners be able to utilize the credits, and the cost of having a formal study completed.
With both methods, there is also another election to consider, which is commonly referred to as the 280C Election. This election is required and permanently based on the first filing containing the R&D tax credit. Without this election, the business must remove the gross amount of the credit from their deductions when determining taxable income. With the 280C election, the credit is further reduced by the tax impact of the credit to simplify the reporting requirements.
As an added incentive for start-up companies to take advantage of the credit, the IRS has granted the ability to use the credit to offset payroll taxes. The credit is still nonrefundable in the event it exceeds payroll tax liability, but any excess can be carried forward. To qualify as a start-up, the company must be within the first five years of operations, have current year gross receipts of less than $5 million, and not be included in a controlled group that does not meet either of the first two requirements.
The R&D tax credit is a vital tool in generating cash flow while investing in a growing business that is overlooked by many businesses. The R&D credit often yields a cash return on investment of approximately 5-7% of the QREs. In addition to a federal tax credit, many states offer a modified version of the credit that can be easily calculated alongside the federal calculation.
If you have any questions or would like to discuss further, please contact your HBK Advisor.