What is the R&D Tax Credit?

The R&D tax credit (or research and development) applies to all companies that are engaged in building new or improving upon business-operations such as methods, computer software, materials, and procedures. This type of tax credit can benefit small businesses and large corporations alike. The availability ranges from the state to federal, and more than thirty states are currently giving credits that can help offset the tax liabilities from the state level.

How can your business qualify for R&D tax credits?

This particular tax credit will apply to many companies that may not even realize they can qualify. This type of credit ranges from activities including but not limited to manufacturing methods and procedures, enhancements to quality and development of new software. Companies that are considered start-ups will be able to apply this particular credit against taxes for payroll for a time period ranging up to five years.

Businesses and institutions that can apply for eligibility may do so if they meet the following criteria: 

  • Involved in active hiring of high-level employees such as engineers, designers and scientists;
  • Improvement of products already on the market;
  • Devoting employees and materials to the development of new or improved products;
  • Evolving procedures, software, and patents for the next generation.

How does the R&D tax credit work?

The R&D tax credit works based on both prior and current years for tax statements and the documentation of activities related to research and development. As an organization prepares and accurately reports the activities related to R&D, their disposition and stature for the amount of credits received may increase. While an estimation may be made with respect to expenses of R&D components, the final documentation must be supported by accurate facts and figures. 

The information pertaining to final documentation can include but is not limited to testing results, email threads and internal reports, program notes and agendas, detailed expense reports and records of payroll with respect to employees involved in the R&D activities. 

Which expenses can qualify for the tax credit?

There are many expenses associated with business activities, and at times it may be challenging to break up specific categories in order to accurately track and report expenses with regards to research and development. The report which explains why a company should receive this particular credit should include related expenses such as wages paid to employees with the R&D department, materials bought and purchased for the purpose of developing new and innovative products, computers and related technologies that improve the process of research.

Does the tax credit only apply to companies with a focus on R&D?

To answer this question, a business owner or interested party must understand the application of the R&D credits. In the section below about the four-part test, you will read more about the nature of the tax credit and gain a better understanding behind the laws associated with this particular tax credit

What is the four-part test by the IRS?

This test implemented by the IRS helps businesses understand if they can apply. The first part determines if expenses are related to the active development and experimentation of new processes and products. Second part is to divide if the information or processes that are discovered have a technological nature, something related to the hard sciences such as computer and bio-sciences. The third part means that the research is done with the intention to produce useful business components including products or software. Finally, the fourth part determines if the research completed in the business activities includes elements of experimentation. 

Which components of business are disallowed from the R&D tax credit?

Activities that are not applicable to the tax credits include:

  • Research that takes place outside of the United States and its territories
  • Research completed following main-stream introduction of the particular component
  • Any activity that is related to reverse engineering of another product or process
  • Studies of processes or markets, data collection from clients, customers or employees
  • Software that is developed with the sole purpose of benefiting the company from an internal perspective without intention of selling that software
  • Any research which is already funded by grants, contracts and government entities
  • The active adaptation of an existing business activity

Conclusion

Based on the current tax code, many large and small  businesses can potentially qualify for the R&D tax credit. The tax benefits are available at both the federal and state level. Be proactive and talk to a small business accountant who can help you with the details of this tax credit and create a plan to take advantage of its benefits.