The federal Research and Development (R&D) Tax Credit (26 U.S.C. § 41) is a hidden gem in the United States tax code. With it, businesses of all sizes that incur qualified research expenses (QREs) can be eligible for up to $250,000 per year and significantly reduce their tax liabilities. Such a credit can result in millions of dollars of savings over time
The question is: “Why do so many businesses not claim it come tax season? Beyond simply not knowing about it, the R&D Tax Credit application process is notoriously complex. Yet, with the right tax partner and the appropriate documentation, eligible businesses can receive the credit they deserve under the US tax code.
Ultimately, the most assured way to ascertain whether or not your business qualifies for an R&D Tax Credit is to make an appointment with your tax professional. In the meantime, you can use this guide to understand:
- Who and what qualifies for the R&D Tax Credit
- How much money you can anticipate receiving
- How to claim the credit in your tax return
- Why it is critical to apply this year
Who can claim the R&D Tax Credit?
Introduced into the US tax code in 1981, the R&D Tax Credit is specifically designed to encourage American business innovation. While the most common misconception regarding the R&D Tax Credit is that it is only applicable to science laboratories and high-tech corporations, the truth is that businesses both large and small across the spectrum of industries can qualify if they have invested in innovation. This is especially true considering the modifications and expansions made in recent years to make the innovation credit more accessible to small- and medium-sized businesses.
When determining eligibility for the R&D Tax Credit, first confirm whether or not your company is making a new product or process. The product can be for someone else, such as a machine shop that constantly takes in designs from their customers and has to figure out how to manufacture the design.
For more clarity, ask yourself the following questions before applying for the R&D Tax Credit:
- Does your business develop or design proprietary software?
- Has your business incurred costs related to building a prototype?
- Has your business received patents (or is in the process of applying for patents)?
If you answered yes to any of the above, your business expenses may qualify for the R&D Tax Credit.
However, this list is not comprehensive, and there are multiple expenses that the IRS specifically excludes from qualifying for the credit, including:
- Research conducted outside of the United States and its territories
- Research in the social sciences, arts, or humanities
- Duplication of an existing product or process
For a more in-depth discussion of the complex qualifications and exclusions for the R&D Tax Credit, reach out to us at Credo.
How much can you expect to receive?
Although the R&D Tax Credit can help offset a percentage of your qualifying costs, it should not be anticipated to cover all of them. Traditionally, the IRS calculates 20% of your company’s QREs to be compensated through the R&D Tax Credit.
However, there is a second method that most first-time appliers will prefer: the Alternative Simplified Credit (ASC) method.
This four-step process is as follows:
- Deduce the average amount of your business’ QREs from the past three years
- Multiply that average by 50%
- Subtract that resulting number from your business’ QREs from this year
- Multiply that resulting number by 14%
Of course, every business is different. Contact the professionals at Credo to discuss your specific situation and glean a better understanding of how much money you can anticipate receiving from the R&D Tax Credit.
How does a business apply for the R&D Tax Credit?
Applying for and receiving the R&D Tax Credit is a tedious process that requires air-tight documentation and extensive filing. Unfortunately, too many businesses are deterred from applying due to such complexities, but the potential savings can make the tedium a worthy investment, indeed.
To claim the R&D Tax Credit, businesses must have exact documentation of their research activities and corresponding expenses. While some estimations may be acceptable, they must be grounded in (and supported by) factual information. Such factual documentation includes:
- Payroll records
- Project notes
- Project expense ledgers
Estimations could also be supported by employee testimonials to help build a solid claim.
Once your business has gathered the appropriate documentation, it’s time to submit with the appropriate form to the IRS, clearly listing the total expenses you’re claiming. For assistance gathering the appropriate proof and claiming the correct amount, contact us at Credo. Our professionals have the experience necessary to ensure your business receives the credit to which you are entitled.
Finally, once the IRS has approved your claim, your R&D Tax Credit will most likely be applied through your payroll. For this reason, it is paramount that your business keep a close eye on your payroll taxes to ensure that the credit is correctly applied throughout the year.
Why is it so important to apply for the R&D credit this year?
If your business has never claimed the R&D Tax Credit before, this year will be the time to do it. Let’s dive into the quick reasons why.
In 2015, the Protecting Americans from Tax Hikes (PATH) Act was signed into law, making the R&D Tax Credit, originally put into place almost forty years ago, permanent.
Years later, when the Tax Cuts and Job Act of 2017 (TCJA) was signed into law, vast changes were made to the US tax code, including the preservation of the R&D Tax Credit (under tax code Sec. 41); the repeal of the corporate Alternative Minimum Tax (AMT) for tax years beginning after December 31, 2017; and the permanent reduction of the federal corporate tax rate to 21% from 35% for tax years after January 1, 2018.
Essentially, these changes increased the value of the reduced R&D Tax Credit under Section 280C(c) and made the credit far more accessible to businesses of all sizes.
What’s important to note here is that while the PATH Act and TCJA cemented the R&D credit’s place in the US tax code, modifications set to take effect for tax years beginning after December 31, 2021, will negatively impact its current increased value. Specifically, the TCJA presently allows research expenses to be tax deductible; yet beginning in 2022, those expenses must be amortized.
Take for instance a business that amortizes research-and-development expenses over 60 months. Under the modifications taking effect in 2022, that business will only be able to take 20% of those expenses as a credit per year.
With this in mind, businesses should seek to have all research-and-development expenditures take place in 2021, if at all possible. Ultimately, taxpayers who have previously overlooked the reduced R&D Tax Credit should take advantage during this year’s tax season, before the current increased value is significantly decreased.
The surge in value—an increase of over 21%—is worth pursuing for many eligible businesses.
While the R&D Tax Credit offers sweeping benefits, its complex nature and grueling claim process have unfortunately deterred many applicable companies from receiving the tax credits they are entitled to under the US tax code. This year of all years, those businesses that shoulder eligible research-and-development expenses, regardless of industry, should claim their entitled credit to receive the maximum benefit before the opportunity passes.
Our team of experts at Credo has the knowledge and expertise to guide your company through the meticulous claim process. Reach out to us today to discuss your questions and unique needs.