Published June 27, 2023
What is the R&D Tax Credit?
The R&D tax credit, also known as the research and development tax credit, applies to all companies engaged in the creation or improvement of various business operations, such as methods, computer software, materials, and procedures. This tax credit is beneficial for both small businesses and large corporations. It is available at both state and federal levels, with over thirty states currently providing credits that can help offset state-level tax liabilities.
How can your business qualify for R&D tax credits?
Numerous companies may qualify for this tax credit without even realizing it. Eligibility extends to activities such as manufacturing methods and procedures, quality enhancements, and the development of new software. Start-up companies can apply this credit against payroll taxes for a period of up to five years.
To qualify for this tax credit, businesses and institutions must meet the following criteria:
- Actively hiring high-level employees, including engineers, designers, and scientists.
- Improving existing products in the market.
- Devoting resources to the development of new or enhanced products.
- Evolving procedures, software, and patents for future generations.
How does the R&D tax credit work?
The R&D tax credit is based on both prior and current years’ tax statements, as well as documentation of research and development activities. By accurately reporting these activities, an organization can increase its chances of receiving a higher amount of credits. Although estimations can be made regarding R&D expenses, final documentation must be supported by accurate facts and figures.
Final documentation may include testing results, email correspondence, internal reports, program notes and agendas, detailed expense reports, and payroll records of employees involved in R&D activities.
Which expenses can qualify for the tax credit?
Tracking and reporting expenses related to research and development can sometimes be challenging, given the variety of business activities. However, it is crucial to accurately identify and categorize these expenses. The documentation supporting the claim for this tax credit should include the following related expenses:
- Wages paid to employees within the R&D department.
- Materials purchased for the purpose of developing innovative products.
- Computers and technologies that enhance the research process.
Does the tax credit only apply to companies with a focus on R&D?
The applicability of the R&D tax credit extends beyond companies with a specific focus on research and development. To understand the scope of this tax credit, one must familiarize themselves with the four-part test outlined by the IRS.
What is the four-part test by the IRS?
The four-part test established by the IRS helps businesses determine if they are eligible for the R&D tax credit. Let’s explore each part:
- Active Development and Experimentation: The expenses must be related to the active development and experimentation of new processes and products.
- Technological Nature: The information or processes discovered should have a technological nature, particularly in the hard sciences like computers and bio-sciences.
- Business Component: The research must aim to produce useful business components, including products or software.
- Experimentation: The research conducted in business activities should include elements of experimentation.
Which components of the business are disallowed from the R&D tax credit?
Certain activities are not eligible for the R&D tax credit. These include:
- Research conducted outside of the United States and its territories.
- Research conducted after the mainstream introduction of a particular component.
- Reverse engineering of existing products or processes.
- Studies focused on processes or markets, as well as data collection from clients, customers, or employees.
- Development of software solely for internal use without the intention of selling.
- Research is already funded by grants, contracts, or government entities.
- Active adaptation of existing business activities.
The current tax code provides the opportunity for both large and small businesses to potentially qualify for the R&D tax credit. These tax benefits are available at both the federal and state levels. To make the most of this tax credit, it is recommended to be proactive and consult a small business accountant who can provide guidance on the details and help create a plan to leverage the benefits of the R&D tax credit.