The following is a guest post from Bruce Warner, Co-Founder & Managing Director of Warner Robinson, LLC, a leading national R&D tax credit consulting firm.
The federal R&D tax credit is a valuable incentive to companies that carry out qualified research and development activities. The tax credit program rewards what many companies do on a daily basis, and with the now-permanent status of the credit, as well as new offsets for the alternative minimum tax and payroll tax, it’s become possible for an even broader range of companies to claim benefits for their research and development work.
What Is It?
The R&D tax credit is a dollar-for-dollar tax credit to offset a company’s income tax (or payroll tax), incentivizing certain research activities by reducing liabilities for spending money on such research and development. The R&D tax credit was enacted in 1981 to help encourage companies to undertake R&D to develop new and improved products and to keep R&D technical and engineering jobs in the U.S.
For more than 30 years since its introduction, the credit kept expiring and getting retroactively extended by Congress. This made it difficult for companies to plan in their financial statements that they would get the R&D credit each year. But the tax credit became permanent with the 2015 Protecting Americans from Tax Hikes (PATH) Act, and companies now can incorporate the credit each year into their financial statements and use it in their tax planning.
Some important updates in the 2015 regulation now allow businesses that have less than $50 million in receipts to use the R&D credit against its alternative minimum tax. Start-up companies—defined as those that have been around fewer than five years and have less than $5 million in receipts— can also use the credit, namely to offset the FICA portion of its payroll tax, which is a significant benefit now available for start-ups.
The R&D credit is not limited to large companies with dedicated R&D departments. Its broad reach covers various company sizes and numerous industries; generally speaking, any company developing products or continually improving its products can qualify. This includes manufacturing and product design activities, as well as software development and certain internal-use software.
For instance, qualified activities of a manufacturing company include development of new products; enhancements to existing product, such as new features or functionality; and development of prototypes and test pieces. For a software company, qualified activities include development of new software products or modules; product updates and new releases with enhanced or new features; and development and testing of new algorithms. Internal-use software refers to back-office software used by the taxpayer to operate the business and not by clients, third parties or customers; it, too, can qualify for the R&D credit.
There is a four-part test to see if a company is eligible to claim the credit.
- Permitted purpose: the business activity must relate to a new or improved functionality, performance, reliability, or quality
- Elimination of technical uncertainty: the activity must be intended to eliminate uncertainty concerning the development or improvement of a product or process
- Process of experimentation: the activity must constitute a process of experimentation involving evaluation of alternatives, confirmation of hypotheses, testing or refining
- Technological in nature: the activity must be technological in nature, relying on principles of engineering, computer science, or physical or biological science
Another important aspect of the qualification is that the work has to be performed in the U.S.; the employee or contractor has to be physically in the U.S. performing the services.
Calculating the R&D Credit – Qualified Research Expenditures (QREs)
There are a few categories that qualify as research expenses for the tax credit.
- Wages: for personnel who conduct, supervise or support qualified activities
- Supplies: tangible property used in research
- Contract Research: outside parties conducting, supervising or supporting research
Credit rates are typically calculated via the Alternative Simplified Credit method—a version more commonly used than the traditional method, which requires the company to refer back to research expenses going back to the 1980s. The ASC method pegs the credit rate between 4.5% and 7.5% of the total qualified research expenditures (QRE), and the traditional method sets a maximum benefit of 6.5% of the total QRE.
We’ll dig a bit deeper into the ASC method here which is the more common method used nowadays. To calculate the credit amount, a business needs to look at its QREs for the prior three years. Average those numbers and multiply by 50%, and that’s the company’s “Base Amount.” Take 14% of any QRE exceeding that base, and then take 65% of that amount, per a limitation in Section 280C of the Internal Revenue Code, for the company’s actual credit amount.
Here’s an example of how a company might go about calculating its anticipated credits using the ASC method:
Qualified Research Expenditures
Base Amount (50% of average of previous 3 years)
Creditable Amount (Current QRE - Base Amount)
Gross Credit Calculation (14% of Creditable Amount)
Net Credit Calculation (65% of Gross)
Now, you should be asking yourself whether your company qualifies for any R&D credit benefits. If it does, what measures do you need to take to tap into the benefits?
Consider this as a first step: Many firms specializing in R&D credit studies will do a Phase1 scoping at no cost to determine whether a business qualifies. It will be important to have the right professional partner from the get go to make solid, informed business decisions.
Timing also is crucial, especially this year. Many start-up companies as of 2017 are seeking to take advantage of the payroll tax credit. For this year only, the IRS in Notice 2017-23 is allowing companies to file an amended 2016 return to claim the R&D credit toward the payroll tax, as long as that amendment is made before December 31, 2017. So the timing is very important if your company still wants to claim the R&D credit against payroll tax in 2017.
Whether for this year or in the future, it would be beneficial to keep this tax credit in mind. Having the knowledge and having the right professional guidance will certainly be a support base as your business progresses and innovates.