FAQ: R&D Tax Credits for Large and Small Businesses
The federal R&D tax credit benefits large and small companies across nearly every industry. Common questions and answers related to the R&D tax credit are outlined below.
The R&D tax credit is a dollar-for-dollar offset of federal income tax liability and, in certain circumstances, payroll tax liability. Most states provide a similar credit, making the average potential benefit of the federal and state credit in the range of 10-20% of qualified spending.
The R&D credit equals the sum of amounts calculated using two different kinds of expenses: (1) qualified research expenses (QREs) and (2) basic research payments (BRPs).
Generally, both types of expenses relate to activities performed in the U.S. to advance U.S. technologies.
If you or your company made or is making QREs or BRPs, you may be eligible for R&D credits, whether your activities succeed or not.
- Increased cash flow
- Increased earnings per share
- Increased return on investment
- Reduced federal and state tax liability
- Reduced effective tax rate
In general, activities qualify if they meet each element of a “four-part test” and aren’t excluded.
- Qualified purpose. The purpose of the activity is to improve the functionality, performance, reliability, or quality of a product, process, software, technique, invention or formula that is intended to be used in the taxpayer’s business or held for sale, lease or license (component).
- Technological uncertainty. The taxpayer encounters uncertainty regarding whether it can or how it should develop the component, or regarding the component’s appropriate design.
- Process of experimentation. To eliminate the uncertainty, the taxpayer evaluates alternatives through modeling, simulation, systematic trial and error, or other methods.
- Technological in nature. The success or failure of the evaluative process is determined by the principles of engineering, physics, chemistry, biology, computer science, or similar natural or “hard” science, as opposed to principles of, e.g., economics, social sciences generally.
Q: Don’t you have to achieve a major scientific breakthrough or do revolutionary of pioneering research to qualify?
No. This misconception has at times been encouraged by poorly conceived administrative guidance. Fortunately, after a few years, the agency responsible for the guidance became aware that the guidance was misleading and unfounded.
Activities don’t have to succeed to qualify. Generally, they have only to attempt to discover technological information lacking to a taxpayer who is trying to develop or improve a business component’s functionality, performance, reliability, or quality by systematically evaluating whether or how it could do so, or the component’s appropriate design.
Some activities are excluded because they weren’t judged to incentivize an increase in the kind of R&D in the U.S. the credit was designed to stimulate.
Excluded activities include:
- Research conducted outside the U.S.
- Routine data collection or ordinary testing for quality control of existing components
- Market research
- Consumer preference testing
- Research “funded” by an unrelated third party, i.e., for which the taxpayer either doesn’t retain rights to the results of the activity or necessarily have to pay for the activity because an unrelated third party is contractually obligated to pay for it, even if the activity fails to produce the desired result.
Other activities that don’t qualify because, generally, they don’t meet the four-part test:
- Repairs and maintenance
- Preproduction planning for a finished component
- Tooling-up for production
- Trial production runs
- Trouble shooting
- Accumulating data relating to production processes
- Activities relying on the social sciences, arts, or humanities
- Research after commercialization
- Adapting existing components to a particular customer’s need
- Duplicating an existing component via reverse engineering
Important note: If an activity above meets the four-part test, it likely qualifies. If the IRS examines the activity, it may subject it to greater scrutiny, but the key question is whether the activity meets the four-part test.
Yes. Activities to develop software to be held for sale, lease, or license that meet the 4-part test above and that are not statutorily excluded can qualify.
Activities to develop software intended “primarily for internal use” must meet additional requirements but can also qualify.
- Taxable wages for employees who perform or directly supervise or support qualified activities.
- Cost of supplies used in qualified activities, including extraordinary utilities, excluding capital items or general administrative supplies.
- 65%-100% of contract research expenses for qualified activities, provided the taxpayer retain substantial rights to the activity’s results and must pay the contractor whether it succeeds or fails.
- Rental or lease costs of computers used in qualified activities, e.g., payments to cloud service providers (CSPs) for the cost of renting server space to develop or improve a component.
In general, any company — in any industry and of any size — that invests in activities of the kind outlined in this FAQ can benefit if in the course of carrying on a U.S. trade or business the company paid, pays or expects to pay:
- Regular federal income tax;
- A similar state tax in one of the more than 40 U.S. states that provide for incentives for R&D and R&D-related investments; or
- In certain circumstances outlined below, federal payroll tax; or
- Similar taxes in one of the more than 35 non-U.S. countries that also provide for such incentives.
Industry generally doesn’t matter: Although most R&D credits are claimed by companies in manufacturing (usually 60-70% of total credits claimed), information (15-20%), professional, scientific, and technical services (10-15%), wholesale and retail (5-10%), and financial and insurance (5%), millions of credits are claimed each year by companies in other industries, including natural resources, like mining and oil-and-gas; services, e.g., health, entertainment, administrative, and hospitality; architecture and construction; real estate, rental, and leasing; transportation and warehousing; agriculture; forestry; fishing and hunting.
And size never matters: Businesses with $0 in sales and one employee can have significant R&D credits.
Q: My R&D department is small, or I don’t even have an R&D department. Is the R&D credit worth pursuing?
Probably. Even companies with small or no R&D department may benefit from the credit. In fact, most taxpayers who benefit from the R&D credit don’t have departments explicitly named “R&D Department.”
The time and cost to estimate your R&D credit is generally very small relative to the benefit in most cases.
You may still be able to benefit currently from your R&D credits.
Startup taxpayers in certain circumstances may offset up to $250,000 of their federal payroll tax liability using R&D credits.
Many states provide credits that are refundable, i.e., states pay the amount of the credit as a refund whether you’re paying income tax now or not.
And if you don’t owe income taxes this year but paid income taxes last year, you can carry your credit back to the preceding year to offset some or all of that year’s tax liability.
If you don’t owe income taxes this year or last year, you might not be able to benefit from the credit this year. You still can carry it forward to future years, up to 20 years forward for federal and some state R&D credits, and even indefinitely forward for other states, e.g., California.
Startups may use R&D credits against up to $250,000 of their payroll taxes in five separate taxable years — a total of $1,250,000 — if they have:
- Gross receipts less than $5 million in the taxable credit year; and
- No gross receipts for any of the four preceding taxable years.
Smaller companies may use R&D credits against the alternative minimum tax (AMT) provided they:
- Are not a public company; and
- Have $50 million or less in average gross receipts for the preceding three tax years.
Generally, there are two methods for computing the QREs-based credit, regular and alternative simplified.
The two methods are the same in that they both calculate the credit as a percentage of the excess of qualified spending in the year for which the credit is being calculated over a “base amount.” For this reason, these credits are sometimes called “incremental” credits.
The credits are different in three ways.
- Rates - For 2019, the Regular Credit’s (RC’s) statutory rate is 20%, the Alternative Simplified Credit’s (ASC’s) is 14%.
- Important note: The RC’s higher rate in 2019 does not mean that a particular taxpayer’s RC will always be greater than its ASC. Its RC could be greater, but it could be much lower. This is because the RC and ASC calculate their “base amounts” differently.
- Base Amounts – The RC’s base amount is calculated using the taxpayer’s gross receipts and QREs; the ASC’s base amount uses just QREs, hence its name, “Alternative Simplified Credit.” In some cases the gross receipts a taxpayer needs to calculate its RC relate to tax years from as remote as the 1980s, which is part of the reason more and more taxpayers are electing the ASC.
- Election - The ASC must be elected for a tax year either on an original return by simply completing the ASC section of the Form 6765 on which all federal R&D credits are reported, or on an amended return, whereas the RC does not have to be elected under any circumstances, just reported or claimed.
- Important note: A taxpayer may elect the ASC on an amended return only if (1) the taxpayer has not previously claimed an RC on its original return or an amended return for that tax year, and (2) that tax year is not closed by the period of limitations on assessment under IRC Section 6501(a).
Yes. Most states offer a credit for expenditures to attempt to develop or improve a product, process, or software, and most adopt or follow rules similar to those of the federal R&D credit.
Some states require taxpayers to file an application other than just the tax return on which the credit is claimed to be eligible for their credits. Some also limit their credit to certain industries or the amount of credits that will be allowed each year.
In many cases, though, state credits are even more generous than the federal credit. For example, some states have higher credits rates; or they allow taxpayers to sell or to transfer their credits to other taxpayers; or they pay taxpayers the value of their state credits even if the taxpayers aren’t currently paying taxes; i.e., their credits are “refundable.”
Identify and gather support for the credit to which you’re legally entitled. Report the credit on a timely-filed (including extensions) federal tax return using Form 6765. If the entity reporting the credit is a pass-through, the partner or shareholder will report their share of credits via Form K-1 on their 1040 returns to monetize the credit.
The credit is claimed on a timely-filed (including extension) federal income tax return for the year in which the qualified expenses were incurred. The credit may also be claimed by amending a previously-filed return on or before the statute of limitations date to report credits related to expenses incurred during that period. The statute of limitations generally grants three years after the original deadline or filing date (whichever is earlier) to amend returns.
If you have any questions about R&D tax credits for large and small businesses contact the team at MFA today.
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