What is the Research and Development Credit?
The Research & Development/R&D Tax Credit is a general business tax credit under Internal Revenue Code section 41 for companies that incur research and development (R&D) costs in the United States.
This is a dollar for dollar tax credit primarily designed to stimulate research and development activities of US companies. Many of our clients engaging in innovative work or processes take advantage of this tax credit, as its applications are expansive. The credit applies to many different industries. The credit calculation is fairly involved and contains several options/considerations, but primarily drives off of a 20 percent of qualified research expenditures calculation that is applied to a base amount.
Protecting Americans from Tax Hikes Act of 2015 (PATH Act)
On December 18, 2015, Congress approved the tax extenders enacting the Protecting Americans from Tax Hikes Act of 2015 (PATH Act). The bill retroactively extends into law a host of key expired individual, business and energy tax breaks. Although some have been temporarily extended, others have been made permanent, including the Research and Development (R&D) Credit.
Specifically, what constitutes Qualified Research?
- The research must be undertaken for the purpose of discovering information that is technological in nature;
- Substantially all of the research activities must constitute a process of experimentation; and
- The experimentation must relate to a permitted purpose.
If a company has been involved at any stage (from conceptual to commercial production) during the design, development, improvement or testing of any of the following new or improved business components then you might qualify for the R&D Tax Credit. To qualify for the credit, an activity must include the following elements:
- Permitted Purpose – Activity is related to new or improved function, performance, reliability or quality.
- Elimination of Uncertainty – Activities are intended to eliminate uncertainty concerning the development or improvement of a product or process.
- Process of Experimentation – Systematic testing of alternatives and evaluation of results were conducted.
- Technological in Nature – The research activity relies on principles of physical science, computer science, programming, software or engineering.
Eligible small businesses, including closely held corporations, partnerships, and sole proprietorships whose annual gross receipts for the three preceding tax years average no more than $50 million, may claim the R&D credit against the Alternative Minimum Tax (AMT), beginning in January 2016. This will benefit a significant number of closely-held businesses and their shareholders who previously had to defer some or all use of their credit due to the AMT limitations.
Payroll Tax Offset
Qualified small businesses, including corporations and partnerships with gross receipts of less than $5 million in the taxable year and having not generated any gross receipts prior to 2012, may now elect to take up to $250,000 in credits against the employer portion of their payroll (FICA) taxes. Elections can be made for up to five taxable years and cannot be applied to any previous tax years. This credit must be elected and filed on the original 2016 tax return before companies can begin the offset payroll taxes in 2017.
Examples of how the Payroll Tax Offset Works:
- Prior to 2016, if a company incurred a net loss for the taxable year, it could not claim any R&D Credit. As a result of the PATH Act, the R&D Tax Credit Eligibility can now be used to offset the payroll tax liabilities. If the R&D credit eligibility exceeds the payroll tax liability, the company will carry forward the remaining balance to offset future payroll tax liability.
- If a company used the R&D Tax Credit Eligibility against their income taxes and has credit remaining, the remaining credit may be used to offset a portion of its payroll tax liability.
Together, these two changes could mean well over $2 billion in added tax savings for startups and small business owners over the next few years. The removal of the AMT barrier may allow for a tenfold increase in the number of small businesses that can utilize the R&D Tax Credit.
Qualified Research and Development Expenses
The following outlines qualifying research and development credit expenses:
- Wages – Only the wages of employees performing qualified services constitute qualified research expenses. These employees are engaged in direct research, directly support the research activity, or directly supervising the research effort.
- Supplies – tangible property other than land, land improvements, or property of a character subject to the allowance for depreciation. To be considered a qualifying supply, the item must be tangible property and totally used or consumed in the qualified research activity.
- Contract Research Expense – contract research vendors/other third parties that meet the same qualification requirements as wages (65% of these costs are eligible for the credit)
Need for Supportive Documentation and Testimony and Examples
Companies must be able to provide documentation that links an employee and third party’s time directly to an R&D project or activity. Documentation, oral testimonies, registers, job descriptions, and other files needs to directly link an employee’s hours to specific projects. Listed below are examples:
- Credible testimony – valid method for providing adequate documentation of claimed QREs.
- Wages – any payment to a staff member for qualified R&D work. Supporting documentation includes W2’s, payroll register, interviews, work schedules, morning minutes or other tracking documents that associate the labor costs to the R&D project. Senior management needs to make note of time interacting with employees, giving guidance, receiving feedback, answering questions, etc.
- Supplies – the purchase of any necessary supplies being used in the qualified research activities. Backup documentation includes invoices that can easily allocate costs for R&D jobs and a company’s general ledger than notes costs to specific R&D activities.
- Contracted Research Services – payments made to a third party for conducting R&D activities. Backup documentation includes Invoices that easily identify vendors that support R&D projects and 1099s that property allocate regular jobs vs R&D jobs.
Please do not hesitate to contact us should you have any questions regarding the R&D tax credit and how it may benefit your business.