If you are a business owner or are considering starting a business, one factor that you will be focusing on is growth. As a business owner, growing the company to meet the needs and wants of the consumer can be an overwhelming desire. There is nothing wrong with that. But that desire should not be the only driving force in seeking growth. There must be passion and a vision that ultimately is the driving force. This is the entrepreneurial spirit.
It is that spirit that can lead to some amazing innovations. To keep up with the times, trends, and demands of the public, entrepreneurs must think outside the box. Usually, this “thinking outside of the box” is caused by a situation or problem that the business owner must overcome. A shortage of glue, no paper available, etc… This is where innovation comes in. In that innovation, research and development can be used in seeking a solution to a problem. An example would be testing other materials in your product, documenting that testing, creating a software, and the like. This testing of products or software, etc., in order to find a solution is what we call “Research and Development” (R&D). The good news is that if documented properly and with possible guidance from a knowledgeable CPA, it can count as tax credits.
What is a tax credit?
A tax credit is an amount of funds that can be used to offset your current or future tax liabilities and may be used for state or federal taxes.
What is a Research and Development Tax credit?
In 1981, the R&D tax credit was created to stimulate innovation and encourage investment in the United States as well as to increase the number of technical jobs in the U.S. Many small businesses are not aware of or do not think that this tax credit could apply to them. Often, small businesses leave these tax credits on the table.
How much can the credit be?
Every year, many companies benefit from billions of R&D tax credits. This can reduce a business’ tax burden, if not wiping it out completely. Some small businesses and startups can qualify for up to $1.25 million (or $250,000 each year for up to five years) of the federal R&D Tax Credit to offset the Federal Insurance Contributions Act (FICA) portion of their annual payroll taxes.
How R&D tax credit is calculated?
Basically, the tax credit is computed focusing on the salary of the employees who do the related work. Those may involve works related to applied science or other technical projects.
What qualifies as R&D?
Now that we have addressed some of the basics, let’s take a deeper dive into what qualifies as R&D tax credits. One common misconception is that to claim R&D credits, the business must have a laboratory or have scientists on the payroll. That is not the case. If your company does have any of the following, then you’ll likely qualify for the credit:
- Design and create products or processes
- Improve products and processes
- Develop existing software or prototype
How can R&D credit be claimed?
In order to claim the R&D tax credit, businesses must file IRS Form 6765. The business must also identify the qualifying expenses and provide documentation that states how these costs meet the requirements under Internal Revenue Code Section 41. There are also several factors to be considered such as: Can the business claim the credit for past and current tax years? Are all necessary documentation prepared? Which documents are needed? Every research activity should be well-documented.
- A record of payroll
- Details of the expenses in the general ledger
- A list of projects
- The project notes
- Other necessary documents (notes in reference to the research, or processes, etc.)
Aside from the said documents, a credible employee testimony can strengthen the claim. Having a well-prepared claim in accordance with IRS guidelines and treasury regulations helps ensure the claim is filed properly.
What changes have occurred to the R&D tax credit over the years?
In 2003, the first change was to the removal of the discovery rule. This means that the R&D doesn’t have to be about the innovation being “new in the world” but rather about it being “new to the taxpayer”. And after 12 years, the PATH (Protecting Americans from Tax Hikes) Act made the tax credit permanent. This act modified the credit for small and mid-sized businesses and made it available for startups.
How does tax credit work for startups?
Small businesses, as well as startups, can qualify for up to $1.25 million of tax credit that can be used to offset their annual payroll taxes. This would mean that $250,000 can be offset annually in a span of 5 years. To be eligible, the company must be able to have less than $5 million in gross receipts for the current year and also have no more than 5 years of gross receipts.
R&D tax credits can be a significant aspect of your business. R&D tax credits do not just help in offsetting taxes, but they also encourage business owners to become more knowledgeable and resourceful in their industry through innovation.
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