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.
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 it 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.
What Types of Expenses are Used to Calculate the Credit?
There are primarily three types of expenses that are integrated into the calculation of the R&D tax credit:
- 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. Owners direct supervisory time would also qualify
- 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).
Can You Provide Examples of the Broad Range of Activities That Qualify?
There are many activities that qualify in all different types of industries. Below is a small sample of some of the activities that qualify and is certainly not all encompassing:
- Developing new or improved products, processes or formulas;
- Developing prototypes or models;
- Developing or applying for patents;
- Implementation of a new process or improvements to an existing process
- Certification testing and environmental testing;
- Streamlining internal processes
- Developing or improving software technologies;
- Develop new, improved or more reliable products, processes or formulas
- Building or improving manufacturing facilities; and
- Design tools, jigs molds and dies
- Automate/streamline production process or manufacturing process
- Testing new solutions in the cloud • Development of specifications and requirements
- Evaluation and establishing functional specifications
- Design and develop new products in areas of safety, functionality, improved performance and shelf-life
- An attempt to develop a new or improved product or process that was eventually abandoned.
- Development of new products in which technical uncertainties must be overcome in-order to satisfy the requirements of a customer specification or performance requirement.
What Types of Supporting Documentation is Required?
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.
- Other examples of supporting documentation
- Email communications which show failures, problems, or concerns encountered during the development
- Product or project specifications, descriptions, or proposals
- Technical reports/test reports and results
- Documentation of alternative supplies/materials/technology evaluated
- Project diagrams/drawings/pictures including older versions and conceptual
- Drawings which differ from the final product
- Issue logs/meeting minutes/flowcharts or time schedules/schedules of releases
- Patent applications or abstracts
- Contractual agreements with consultants and customers
2016 Changes for AMT and Payroll Tax Offset:
As Part of the “Protecting Americans from Tax Hikes (PATH) Act of 2015” we were excited to see that the research and development (R&D) tax credit was permanently extended. This is a huge victory for U.S. businesses that were previously frustrated by the regular uncertainty around the R&D credit
AMT Offset :
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 2017 tax return before companies can begin the offset payroll taxes in 2018.
As a result of the PATH Act, the R&D Tax Credit Eligibility can now be used to offset company 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. We would work with your payroll company to ensure they have the appropriate paperwork to integrate the R&D credit against your upcoming payroll tax liabilities. The payroll filing that integrates the credit would typically occur in the quarter after your business entity return was filed. 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.
We can help you maximize this valuable credit and properly document support. 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.