If you are a small business owner, you know that you need to pay taxes and that paying more than you are required to pay can make it difficult to achieve your business goals. In other words, you need to meet your legal obligations and take advantage of any tax credits or deductions that apply to you to reduce your income tax liability.
At Cook Martin Poulson, we work with small business owners every day to help ensure they do not miss out on tax credits. One of the credits that we find is most often misunderstood is the Research & Development (R&D) Tax Credit. Businesses that qualify often don't take it. Is that a mistake you're making? Keep reading to discover if you are eligible.
What is the Federal R&D Tax Credit?
The Research and Development Tax Credit was a provision in the Economic Recovery Tax Act (ERTA) of 1981. In a troubled economy, such as the US being in a recession in 1981, the ERTA was intended to be a stimulus. At the time, members of Congress felt that declines in research spending by American companies were harming the country’s economic growth and competitiveness in the world marketplace.
The official title of the provision regarding R&D is the Credit for Increasing Research Activities. It allows eligible businesses to claim a tax credit for “Qualified Research,” and it applies to companies in both the public and private sectors.
Originally, the R&D credit was intended to expire on December 31, 1985. It has been extended a total of 15 times; and in 2015, Congress made it a permanent part of the tax code. It can be found under Internal Revenue Code section 41.
Does the R&D Tax Credit Increase R&D Spending?
If you have never taken the R&D tax credit before, you might wonder if you will need to increase your R&D spending to qualify. The short answer is probably “no”. If you are already spending money to research and develop new products, then you may qualify to take the R&D credit. You will not necessarily need to spend any additional money to take the credit.
If your company sees the R&D tax credit as an opportunity to put some money into research and offset it with the credit, you might decide to make room in your budget for R&D to help offset your expenses but that is not a requirement.
How Does the R&D Tax Credit Work?
The federal R&D tax credit is a dollar-for-dollar tax credit designed to encourage innovation. Companies that spend money to develop new products or improve existing ones can deduct their qualified research expenses from their federal tax return. Many states also offer an R&D credit.
If your company conducts qualified research, you should look into claiming this tax credit. In some circumstances, you may be able to claim the credit retroactively if you have not taken it before and have qualified research expenses.
Can a Sole Proprietor Claim the R&D Tax Credit?
Sole proprietorships make up approximately 12% of small businesses in the US and many entrepreneurs start their businesses as sole proprietorships before reorganizing as LLCs or S corporations. When you think of R&D, you might think of major corporations, but the truth is that many small businesses also qualify for the R&D credit.
If you have a business that is a sole proprietorship, you can qualify to take the R&D tax credit on the federal level. The limits are the same regardless of the size of your business, but as a qualified startup, you can take the credit to offset your payroll taxes instead of your income taxes.
Is the R&D Tax Credit Taxable Income?
People sometimes confuse tax deductions with tax credits. A tax deduction reduces the amount of your taxable income. For example, if you earned $100,000 in gross income, you can claim the standard deduction to reduce your income. Any other deductions you took, such as those for charitable donations, would also reduce your taxable income and have the potential to move you into a lower income bracket.
By contrast, a tax credit directly reduces the amount of taxes you pay. If your business had a total tax bill of $300,000 for the year and you qualified for a $200,000 R&D credit, you would subtract the R&D credit from your tax bill and reduce your balance to $100,000. The money you spend on qualified research activities is used to calculate the credit that offsets the amount of tax owed.
Is the R&D Tax Credit Refundable?
The federal R&D tax credit is not refundable; however, it can be carried forward.
What Qualifies for the R&D Tax Credit?
While R&D might not be the focus of your company’s activities, any company that meets and resolves technological challenges may be eligible to take the credit. The most common way of determining whether research is qualified is a four-part test. Here are the criteria established by the IRS’s four-part test:
- Elimination of uncertainty. A company taking the credit must demonstrate that it has tried to eliminate uncertainty in its development or improvement of a process or product.
- Process of experimentation. A company taking the credit must demonstrate that it has explored and evaluated alternatives for achieving the desired result. This demonstration may include modeling, simulation, systematic trial, and error, or other methods.
- Technological in nature. A company taking the credit must use a process of experimentation that relies on the so-called “hard sciences,” which include biology, chemistry, computer science, engineering, and physics.
- Qualified purpose. A company taking the credit must conduct research, the purpose of which is to create a new or improved product or process, to increase its function, performance, quality, or reliability.
In our experience at Cook Martin Poulson, it is not uncommon for businesses who don’t consider themselves to be innovators to apply this test to what they do and discover that they are eligible for the R&D credit. In other words, don’t assume that you aren’t eligible without looking at your activities through the proper lens as defined in the tax code.
What Qualified Research Expenses Apply to the R&D Tax Credit?
If you do feel that you qualify to take the R&D Tax Credit, you must next review your Qualified Research Expenses to calculate the credit you are due. These fall into four categories as follows:
- Wages paid to your employees for qualified services, including amounts that are considered wages for federal income tax withholding.
- Supplies, which are defined as any tangible property (excluding lands or improvements to land and property that is subject to depreciation) used or consumed in the R&D process.
- Contract research expenses that your company pays to a third party for performing QRAs on behalf of your company, regardless of the success of the research being conducted. Contract research expenses are allowed at 65% of the actual cost incurred.
- Basic research payments that your company makes to qualified educational institutions or scientific research organizations as part of your R&D activities. Basic research payments are allowed at 75% of the actual cost incurred.
You should plan on getting the advice of an experienced CPA or tax attorney to calculate your R&D credit, particularly if you have not taken it in the past. The experts at Cook Martin Poulson can be very helpful in this area.
What Activities Are Not Qualified R&D Activities?
We have talked about the activities that would qualify your company to take the R&D Tax Credit, but we think it is important to let you know that some activities specifically do not qualify. There are 10 types of primary activities that are specifically excluded, as follows:
- Research that you conduct after you have started commercial production or implementation of the business component
- Adaptation or duplication of existing business components
- Studies, surveys, and activities related to management techniques or functions
- Routine data collection
- Routine and ordinary testing or quality control inspections
- Computer software, except as outlined above, or were developed for a highly innovative internal use
- Research conducted outside of the United States
- Research in the social sciences (as differentiated from the hard sciences listed earlier)
- Funded research
- Costs associated with acquiring fixed assets used in your regular trade or business
R&D Tax Credit Carryforward Period
The R&D tax carryforward period allows businesses who qualify for the credit to take full advantage of it even if they spent more in R&D than they owed in taxes. The carryover period allows you to carry forward unused credits for as many as 20 years.
Keep in mind that you may be able to go back up to three years to calculate the R&D credit if you did not take it when you filed your taxes. You can then amend your tax return and amortize the credit using the carryforward period until you have taken the full amount for which your company is eligible.
Necessary Documentation to Claim the R&D Tax Credit
The IRS requires sufficient documentation to substantiate the qualified activities that were performed and to substantiate the applicable qualified expenses claimed for the credit.
Some examples of documentation that should be kept include the following:
- Chart of accounts for the general ledger
- Organizational charts
- Payroll records, specifically the wages paid for R&D activities
- Lists of all supplies used in QREs
- Copies of contracts with outside providers and vendors related to QREs
In other words, you need to retain records that document the R&D your company has completed and your calculations of the credit, and we are very experienced in helping taxpayers adequately meet the documentation requirements.
How Did Tax Reform Affect the R&D Tax Credit?
The PATH Act of 2015 is the law that permanently extended the R&D credit. As a reminder:
- Small businesses may take the R&D Tax Credit against their alternative minimum tax (AMT) liability for tax years beginning after December 31, 2015.
- Startup businesses with no federal tax liability and gross receipts of less than $5 million may take the R&D Tax Credit against their payroll taxes for tax years beginning after December 31, 2015.
You should also know that the Tax Cuts & Jobs Act of 2017 changed the way companies can claim first-year R&D expenses, for tax years beginning after December 31, 2021. Instead of claiming expenses in the year that they were incurred, companies are required to amortize expenses over five years. The net effect, thanks to normal inflation, is that startups do not receive as much immediate benefit from the R&D expenditures due to amortization requirements.
Reduce Tax Liability with the R&D Tax Credit
As a business owner, it is essential to take every tax credit that's available to you. By reducing your tax burden, you can put more money into your business and increase your chances of long-term success.
Do you need help determining whether your business qualifies for the R&D credit? Cook Martin Poulson can help! We offer R&D credit tax credit services to help your business identify and document qualifying activities to claim the credits you are due. Click here to schedule a free consultation today!
Aside from the R&D tax credit, there's another tax credit for small businesses that you can avail of that will help directly reduce your tax bill because it'll be deducted during the filing process. It's important to consult with a tax pro to find out what small-business credits your business can apply for.