What Is the R&D Tax Credit?

If your company does any of the following, your business likely qualifies for the R&D tax credit:

• Develops or designs new products or processes
• Enhances existing products or processes
• Develops or improves upon existing prototypes and software

Since the credit may be claimed for both current and prior tax years, companies can benefit from documenting their R&D activities to ensure they are positioned to claim the credit in both situations. To claim the credit, you must evaluate and document your research activities to establish the amount of qualified research expenses paid for each qualified research activity. While you may estimate some research expenses, you must have a factual basis for the assumptions used to create the estimates.

Examples of such documentation includes:

• Payroll records
• General ledger expense detail
• Project lists
• Project notes
• Other documents a company produces throughout the regular course of business

To document their qualified R&D expenses, businesses must complete the four basic sections of Form 6765:

• Section A is used to claim the regular credit and has eight lines of required information (lines 1, 2, 3, 7, 8, 10, 11 and 17).

• Section B applies to the alternative simplified credit (ASC).

• Section C identifies additional forms and schedules that warrant reporting based on business structure.

• Section D is only required for qualified small businesses (QSBs) making a payroll tax election.

The IRS recommends that businesses calculate their credit using both the regular credit and simplified credit methods, and then fill out the section (A or B) that results in the greatest tax benefit.

Businesses can claim the R&D credit retroactively by filing amended returns for any open tax years, which in most cases, is three years. But the timeframe may be longer if the organization endured losses during that period.

The R&D credit reduces federal taxable income, so businesses receive a dollar-for-dollar tax credit and still get to deduct expenses related to research and development.

The Protecting Americans from Tax Hikes (PATH) Act of 2015 permanently extended the R&D credits available under Section 41 of the Internal Revenue Code. If there is a lack of tax liability, business may carry unused credits forward for up to 20 years.

No, the credit is available to qualifying businesses of all sizes. Even qualifying startups and small businesses with little or no federal income tax burden may use the tax credit to offset their payroll tax or AMT. 

Many small and medium sized businesses don’t pursue the credit due to a lack of internal resources. R&D tax credit studies, as well as compiling the supporting documentation, take time and effort. Thankfully, there are other options, such as working with a specialty tax partner like Engineered Tax Solutions.

Yes. Several types of research activities are specifically excluded from the tax credit. These include:

• R&D activities conducted outside the U.S.
• Funded research
• Research in non-scientific areas, including the social sciences, arts, or humanities
• Market and consumer research
• Ordinary quality control testing
• Routine data collection
• Internal business process development
• Management studies and surveys
• Adaptation or duplication of existing business components (products, inventions, formulas, software, processes, or techniques)
• R&D activities conducted solely to improve product aesthetics
• Research conducted after the start of commercial production or implementation of the new business component (some exceptions apply)
• Locating and evaluating mineral deposits, including oil and gas

Expenses that qualify for the R&D tax credit are known as qualified research expenses (QREs). They are certain expenses incurred by a business in conducting the qualifying research activities described above.

QREs include:

• Wages paid to employees who engage in QRAs
• Supplies used and consumed in the R&D process
• Contract research expenses paid to a third party to perform QRAs (allowed at 65% of the actual cost incurred)
• Basic research payments made to qualified educational institutions and scientific research organizations (allowed at 75% of the actual cost incurred)

QREs do not include (among others):

• Commercial production costs
• Advertising and promotional expenses
• Acquisition and improvement of land used in research
• General managerial and admin duties, including supervisory functions not related to R&D
• HR and personnel duties, including recruiting
• Accounting duties, including bookkeeping, payroll, and budgeting
• Customer service support
• Employee training, including attending conferences
• Routine status meetings
• Charitable fundraising

Yes. R&D involves risk and uncertain results, and the credit takes that into account. QRAs, up to the point of termination, can count towards the credit.

The R&D credit isn’t based on the total amount a business spends on QREs, but on increases in spending. To calculate the credit, a business must determine its QREs in excess of a certain “base amount.”

There are three different base period calculation methods available, based on a business’ date of incorporation, initiation of qualified research, and ability to collect required contemporaneous documentation.

The three calculation methods are:

Traditional Credit Calculation

The base amount is calculated by multiplying the taxpayer’s fixed base percentage and the average annual gross receipts for the four preceding taxable years. The fixed base percentage is the ratio of QREs to gross receipts for the 1984–1988 period. A modified rule is available for businesses not in existence during that time. The credit rate is 20% of QREs that exceed the calculated base amount

Alternative Simplified Credit Calculation (ASC)

The base amount is 50% of the average QREs for the three preceding taxable years. The credit rate is 14% of QREs that exceed the calculated base amount; rate is reduced to 6% if there are no QREs in any of the three preceding taxable years.

Start-Up Credit Calculation

The base amount is calculated by multiplying the taxpayer’s fixed base percentage and the average annual gross receipts for the four preceding taxable years. The fixed base percentage calculation is quite complex. The credit rate is 20% of Q t exceed the calculated base amount

For the traditional and start-up calculation methods, the base amount can’t be less than 50% of the current year QREs.

Yes. It reduces the taxpayer’s tax bill by a full dollar for each credit dollar. But the IRS wants to ensure companies don’t benefit twice by using QREs for both the R&D tax credit and for business tax deductions. Therefore, if a company wants to claim the expenses as a credit, they must either reduce the amount of their deduction by the amount of the R&D credit claimed or choose to take a smaller credit. This reduced credit decreases the credit rate from 20% to 13% under the traditional calculation and from 14% to 9.1% under the ASC.

Corporations and pass-through entities claim the R&D credit on IRS Form 6765, Credit for Increasing Research Activities.

No, but the excess credit isn’t lost. If there is any R&D credit that isn’t used to offset your company’s tax liability for the year in which the QREs were incurred or paid, you may be carry back to the prior tax year or carried forward for up to 20 years!

Yes, the 2015 PATH Act expanded the R&D tax credit to benefit startups with low or no income tax burden. Qualified Small Businesses (QSB) with less than $5 million in gross receipts can use the credit to offset the FICA portion of their payroll tax—not just their income tax. The credit is capped at $250,000 for up to five years.

Yes, this was another important expansion of the credit under the 2015 PATH Act. Eligible Small Businesses (ESB) with $50 million or less in average gross receipts in the past three years may use the credit to offset the Alternative Minimum Tax (AMT).

Currently, 37 states offer R&D tax credits. Since most follow the federal guidelines for determining QRAs and QREs, businesses in those states can claim both with little additional effort.

If you are taking an incentive for the first time on a timely filed return, the odds of being audited are really no higher than if you weren’t taking the incentive. The audit rate goes up if you are amending a return to claim credits you didn’t previously realize you qualified for. This is logical, since you’re asking the Treasury for a refund. If you work with an expert specialty tax partner like ETS, you can feel confident your claim will hold up under IRS scrutiny.

Yes, the R&D tax credit is one of the most important and valuable incentives offered by the government for businesses to innovate, improve and compete. It can significantly reduce your tax burden, freeing up capital to invest in operations and growth.

While the R&D tax credit is complex, it isn’t something you have to handle on your own as a business owner or CPA. Tri-Merit’s team of engineers, attorneys and CPAs make the process easier by taking a customizable, flexible and thoughtful approach to produce the best possible outcome. We engage clients in the most efficient and effective way possible, requiring minimal time and effort that results in a refreshingly simple process.

Tri-Merit helps companies determine the size of their potential credit, the usability of those credits, and the appropriate way to support their credit claims.