Everything You Need To Know About R&D Tax Credits
Business owners often consider taxes an inconvenient but necessary part of everyday operations. However, a better understanding of taxes can save you money by taking advantage of various credits, such as the R&D tax credit. How does the R&D tax credit work? Get an in-depth look into everything you need to know, including what it is, how to claim it, and how it’s calculated.
What Is the R&D Tax Credit?
The Research and Development tax credit is a federal tax liability reduction companies can take for approved domestic expenses. The rate of reduction is dollar for dollar. You also get back approximately 13 cents for every dollar spent on research that meets the eligibility requirements. Qualifying research and development expenses include the development, improvement, or design of a product, technique, process, or software.
This credit can lead to significant savings that free up cash for further R&D, hiring new employees, and more. For companies that meet the criteria of a Qualified Small Business, the R&D credit can be used to offset quarterly payroll taxes. For tax years 2016 through 2022, the maximum R&D tax credit for payroll tax was $250,000. The credit doubled to $500,000 beginning January 1, 2023. Many states have also enacted an R&D credit.
Who Qualifies for the R&D Tax Credit?
This lucrative credit is available for more than established researchers and scientists. Small businesses can also reduce tax liability for eligible expenses tied to innovation. Any company working within the United States to develop or improve a process or a product can claim the credit, no matter what industry it is in.
How Is R&D Different from R&E?
The Research and Development tax credit is also known as the Research and Experimentation (R&E) tax credit. These two terms refer to the federal benefit outlined in Section 41 of the Internal Revenue Code.
What Are the 4 Pillars of R&D?
Knowing the 4 part test R&D tax credit is a simple way to identify qualified research activities:
- Permitted purpose: Qualified activities work to improve a new or existing product or process’s functionality, reliability, quality, or performance.
- Technological nature: The activities rely on the principles of physical science, computer science, biological science, or engineering.
- Eliminate uncertainty: The activities make improvements that lead to eliminating technical uncertainties regarding a product’s capabilities, design, or method.
- Experimentation: The activities involve experimenting through processes like testing, simulating, and trial and error of hypotheses.
If your proposed activity meets the above criteria, it likely qualifies for the R&D credit.
What Are the IRS Rules for R&D Tax Credit?
What activities qualify for the credit, according to the IRS? Businesses can claim R&D credit for activities that fall into two categories:
- Qualified research activities or qualified research expenses
- Basic research payments
While many large businesses take advantage of this credit, smaller businesses often forego extensive tax savings because they aren’t aware they qualify. In fact, many small business expenses qualify under the QRA category. Work with a professional firm knowledgeable in the R&D tax credit to get advice and make sure you aren’t failing to claim eligible expenses.
How Do R&D Tax Credits Work?
The tax code for this credit works in two ways, by allowing a company to deduct R&D expenses in the first year or to get a tax credit for qualifying expenses.
Claiming the R+D tax credit requires that you submit certain documentation to prove your eligibility. Some examples are payroll records for your R&D employees and expense accounts with receipts, blueprints, prototypes, and notes from project meetings.
How Do You Fill Out Form 6765?
Form 6765 instructions on the IRS website guide you through figuring out and claiming the credit. You will find information on eligibility, qualified research, and line-by-line instructions for completing the form. Collect the following to help you work through the form more easily:
- Profit and loss statements
- Expense receipts for activities related to research and development
- Invoices
- Balance sheets
Having your information together will make it easier to get through the form more quickly and ensure accuracy.
How Are R&D Credits Calculated?
The IRS provides several formulas for businesses to calculate the correct R & D tax credit. One method called the Alternative Simplified Credit method, involves the following five steps:
- Calculate your business’s qualified research expenses going back three years.
- Calculate the average of the three totals.
- Multiply the average by 50% to get your credit base.
- Subtract your calculated credit base from the year’s total R&D expenses.
- Multiply this number by 14% to calculate your R&D credit.
New businesses that don’t have three years of expenses to calculate a credit base can multiply the year’s R&D expenses by 6%. The process is simple but requires you to understand which expenses qualify and to have documentation to submit as proof.
It’s a good idea to consult a tax specialist to ensure you take full advantage of the credit and calculate it correctly. You can also estimate your R&D credit using an online calculator.
What Is R&D Tax Credit Amortization?
In 2017, Congress created a tax bill that required amortization of R&D costs beginning January 1, 2022. This change means businesses can no longer immediately expense R&D, which may result in higher tax bills. You can find the new rules in Section 174, capitalization and amortization.
The backlash for R&D section 174 is widespread, with businesses facing problems, confusion, and high costs under the new law. A bipartisan group of members of Congress have recognized this as a problem and have introduced legislation to repeal amortization. No decision has yet been made, but support for repeal is growing.
What Types of Expenses Qualify for the Credit?
A variety of expenses qualify for the tax credit:
- Wages to research and development employees
- Third-party costs, such as expenses paid out to contractors you hire to perform qualified activities that contribute to the research
- Research payments to a qualified scientific organization or educational institution
- Supplies required for the research and development of new products and technologies
The R&D tax credit is flexible and can include quite a few expenses. However, some are excluded:
- Research started after the commercial production process began
- Costs associated with fixed assets that keep your business operational
- Duplication of an existing product
- Market research, such as surveys
- Research done outside of the United States
- Research regarding software used for internal purposes
- Research already funded by a person, grant, organization, or the government
- Research into any discipline involving the arts, humanities, or social sciences
Sometimes, an expense may qualify for more than one tax credit. If this happens, you need to understand the benefits of each so you can make an informed decision on which credit to take.
What Are Examples of R&D Tax Credits?
There are nearly endless ways for a business to qualify for the credit. Here are a few examples:
- Designing cloud-based software solutions
- Developing new products
- Improving or enhancing an existing product
- Developing or improving an existing process
- Testing a product or process
- Beta testing
- Conducting research and documenting the results
Is R&D Tax Offset Taxable Income?
The R and D tax credit reduces your federal taxable income by giving you a dollar-for-dollar credit on qualified expenses. You can also still deduct certain R&D expenses on your tax return.
What Happens to Unused R&D Credits?
If your business lacks tax liability, you first must carry the credits back one year (if there was tax liability). Then any remaining credits can carry forward for a maximum of 20 years. The extended time frame was put into effect by 2015’s Protecting Americans from Tax Hikes (PATH) Act.
How Far Back Can You Claim R&D Tax Credits?
One of the great things about R&D credit is that you can claim it for any open tax years by filing an amended return. Typically, this is about three years, although it may be longer if you sustain losses.
If Our Company Has Had Losses but Incurred Qualified Research Expenses, Can We Utilize the R&D Credit Benefit?
One of the most common questions is, “Can you take R&D credit if you have a loss?” The simple answer is yes, you can. Your company mustn’t be profitable to take advantage of the R&D tax credit. Companies that have a loss also benefit. As a loss-making company, you could potentially claim back a more significant percentage of your R&D expenditure than those that make a profit. Also, you could receive a cash credit instead of reducing your tax bill.
What Is the Timeline To Complete an R&D Study?
Knowing how and when to claim the R&D tax credit for an ongoing research and development project is essential. Understand that you can only claim the stages that involve technological uncertainty, such as product research, development, and testing. It’s crucial to keep detailed records to claim the appropriate expenses for work done during each tax period.
If you have not yet made a claim for prior years of an ongoing project, you may claim expenses for two years after the end of an accounting period.
If I Claim the R&D Credit, Will I Be Audited?
Claiming the R&D tax credit on an original return filed on time does not trigger an audit automatically, and R&D clients do not have a higher rate of audits than standard income tax returns for those claiming the credit on an original return. However, there is always the possibility of an audit, so you should have supporting documents available to prove your claim.
How Does KBKG Work With CPAs?
KBKG has offices across the U.S., so you can get help with R&D tax credits in Los Angeles or the East Coast. We offer various services and software to CPAs and other businesses to help them understand which tax programs benefit clients most. Our services complement traditional tax and accounting teams by offering knowledge and expertise alongside your existing team as we work together to achieve more excellent value and savings.
How Will KBKG Help Me Stay Compliant as Laws and Regulations Are Changing?
Tax laws and regulations frequently change on a federal or state-by-state basis. It’s important to work with a company that understands how the R&D tax credit in southern California differs from that in other states.
KBKG helps you stay compliant by educating you on the newest regulations while providing valuable services that get you the most savings under the current laws. We continuously monitor changing laws and maintain federal, state, and local government relationships to provide you with the latest insights and support.
Final Thoughts: Can I Claim the R&D Tax Credit?
The R&D tax credit has many benefits, like creating a dollar-for-dollar tax liability reduction and improving cash flow. However, it can be a challenge to understand the complex tax system well enough to get the most value for your business. Taking advantage of available money-saving opportunities often requires help from professionals. To discover which tax programs can best benefit your business, contact KBKG to learn more about the valuable solutions available to save you money. Our experts are knowledgeable, experienced, and ready to work with you to identify the tax credits and deductions for which your business qualifies.