The R&D Tax Credit, also known as the Research and Experimentation (R&E) tax credit, provides a tax incentive to U.S. companies so that they can invest the savings by spending on research and development activities related to the improvement of processes, inventions, formulas, products, or software. This development tax credit remains a reliable way for companies to reduce income tax liabilities.
The R&D Tax Credit allows startups who meet certain requirements to use the credit against their federal tax bill and claim up to $250,000 towards FICA for payroll tax savings. The requirements for payroll tax savings include:
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 US. 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.
Each company is eligible for up to 250% of their average monthly payroll expense, with a salary cap of $100,000 per employee, with a maximum of $10 million.
Once you have determined whether your business qualifies for the credit, there are two methods commonly used to calculate the R&D tax credit:
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 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.