R&D Tax Credit: What is it?

The R&D Tax Credit, also known as the Research and Experimentation (R&E) Tax Credit, provides a valuable tax incentive for U.S. businesses to invest their savings in research and development activities. This includes efforts aimed at improving processes, inventions, formulas, products, or software.

As a reliable tool for reducing income tax liabilities, the R&D Tax Credit offers significant opportunities for businesses.

Startups that meet specific requirements can apply the credit to their federal tax liability and claim up to $500,000 in FICA payroll tax savings. To qualify for payroll tax savings, your business must meet the following criteria:

• Less than 5 years of gross receipts: The company must have no more than 5 years of gross receipts, including the current year.
• Gross receipts under $5 million: Your company’s gross receipts for the current year must be under $5 million.

Meeting these requirements can open up opportunities for your business to claim R&D tax credits and enjoy payroll tax savings, which can be valuable for supporting your research and development efforts while reducing your tax burden.

What’s the Catch?

To qualify for the R&D Tax Credit, only activities that meet specific criteria are eligible. These activities must pass the IRS’s 4-part test:

Permitted Purpose

New or Improved Business Component (product, process, formula, technique, invention, software).

Elimination of Uncertainty

Uncertainty related to business component

Process of Experimentation

Evaluate one or more alternatives, attempting to resolve uncertainty

Technological in Nature

Activities must rely on a hard science:

• Physical Sciences
• Biological Sciences
• Engineering
• Computer Science

The History and Evolution of the R&D Tax Credit

The R&D Tax Credit has existed as a temporary year-to-year measure since 1981, requiring congressional approval every few years. When enacted, its sole purpose was to encourage investment and innovation in the U.S.

In 2015, with the passage of the “Protecting Americans from Tax Hikes Act” (PATH), the R&D Tax Credit became permanent. In addition, the credit can now be used to offset payroll taxes (as well as income taxes), which allows even companies with net losses to receive the credit immediately.

A major shift occurred in 2022 when the Tax Cuts and Jobs Act (TCJA) introduced changes to how R&D expenses are handled. Companies are no longer allowed to deduct R&D costs in the same taxable year. Instead, they must now amortize Section 174 deductions over five years for domestic expenses and fifteen years for expenses incurred outside the U.S. This change applies to costs incurred after 2021.

The IRS has released Revenue Procedure 2023-111 to provide taxpayers with a method to obtain consent under Section 446 to change methods of accounting for specified research expenditures.

Furthermore, the Inflation Reduction Act of 2022, signed by President Biden, brought another key update. Starting in 2023, the Act doubles the maximum R&D tax credit qualified startups can apply against their payroll tax liability—from $250,000 to $500,000 per year.

What Should You Do Next?

To claim the R&D Tax Credit you must file IRS Form 6765 with your income tax return. This will require gathering all the necessary documentation needed to support the claim.

Since determining which expenses qualify can be complex, it’s highly recommended to consult with a professional who specializes in R&D tax credits. They can help identify eligible activities and expenses to ensure you maximize your claim.

At Finvisor, we offer a free consultation to help assess your eligibility and provide an estimate of your potential R&D credit.

On average, companies receive about 10% of their qualifying R&D expenses back through the credit. For example, if your company spent $1 million on wages for technical employees working on a new or improved business component during the year, your R&D credit could amount to around $100,000!

Let us help you navigate the process and potentially unlock substantial savings for your business.

How to Calculate the R&D Tax Credit

Once you have determined whether your business qualifies for the credit, there are two methods commonly used to calculate the R&D tax credit:

• The traditional regular research credit (RRC) method
• The alternative simplified credit (ASC) method

The Regular Research Credit (RRC) Method

Under the RRC method, the credit equals 20% of a company’s current year qualified research expenses (QREs) that exceed a base amount.

The base amount is determined by applying the taxpayer’s fixed-base percentage of gross receipts spent on QREs to the prior four years’ average gross receipts of the company.

Entities must have the data necessary to determine their QREs to use this method with ease.

The Alternative Simplified Credit (ASC) Method

The ASC is calculated by multiplying the amount of QREs for the taxable year that exceed 50% of the average QREs for the prior three tax years by 14%.

If the taxpayer has no QREs in the prior three tax years, the credit equals 6% of the QREs for the current credit year.

This is the most commonly used method due to its ease and more accessible prior record requirements.

Conclusion

In conclusion, the R&D Tax Credit is a valuable incentive for businesses that invest in research and development activities. It offers a significant financial benefit that can help companies offset their innovation-related expenses, promote growth, and stay competitive in their respective industries.

Understanding the eligibility criteria and the application process is crucial for businesses looking to take advantage of this tax credit. By doing so, not only can they reduce their tax liabilities, but they can also foster a culture of innovation, driving progress and innovation forward.

So, whether you’re a small startup or a large corporation, exploring the R&D Tax Credit might just be the financial boost your business needs to fuel its innovation engine and secure a brighter future.