When most business owners hear “taxes” they either stop paying attention or only think about how much in taxes they’re going to owe. However, Research & Development (R&D) Tax Credits are something every entrepreneur & existing business owner MUST understand and utilize. Many expenses that qualify for R&D Tax Credits are expenditures that your business is already encountering which you may not be capitalizing on. Having a thorough understanding of the following rules & ideas can save your business a lot of money each year in taxes.
Let’s start by understanding the difference between a tax credit and a tax deduction. Tax credits are more valuable because they are a dollar for dollar offset of a tax liability. In contrast, a tax deduction simply reduces your taxable income before the tax rate is applied. A tax credit directly reduces your tax liability in the amount of the credit, whereas a tax deduction only reduces a portion (your tax rate) of your tax liability. Because certain R&D costs are treated as a tax credit rather than a tax deduction, the tax savings are much larger for your business.
Internal Revenue Code Section 41 outlines the “Credit for Increasing Research Activities” (better known as the R&D Tax Credit). This program was introduced in 1981 and introduces a “Four-Part Test” to determine eligibility. For expenses to qualify, businesses must analyze whether the expenditures Eliminate Uncertainty, are a Process of Experimentation, are Technological in Nature, and are for a Qualified Purpose.
The first test, Permitted Purpose, means that the work being done must relate to a new product or service or be focused on improving existing function, performance, reliability, or quality. An example of permitted purpose is something that is new to your company, not necessarily new to market or new to your industry (e.g. setting up a new accounting software system or upgrading your CRM systems.
The second test, Eliminating Uncertainty, can be met by proving that the work being done would eliminate uncertainty about a product or service. These efforts must focus on the capability or design of the improvement of the product or service. For example, many feasibility studies within the development, engineering, or construction industry could potentially qualify.
The third test, Process of Experimentation, can be met by showing appropriate modeling, trial and error, or simulation to prove the desired result. The business must engage in a process that would identify and evaluate one or more alternatives to achieving the result. For example, an app development company might be evaluating the feasibility of multiple server platforms and thus, some of the expenses related to this testing could potentially qualify.
The fourth test, Technological in Nature, means that the activity performed must be scientific, engineering in focus, or related to computer science. For innovators & entrepreneurs, receiving a patent in the United States is solid proof that the activity was technological in nature.
The IRS also outlines the timeline of eligible expenses. A portion, or all of the following expenditures could potentially qualify: wages, supplies, contract research, and research payments.
Once businesses understand which expenditures count towards R&D expenditures, they can then calculate the total amount of R&D Credit which they are eligible to take in a given year. Internal Revenue Code Section 41(c)(3)(B) establishes a fixed percentage calculation for companies that incorporated after December 31, 1983. New startup companies would follow these guidelines. The amount of the credit is based on the year in which taxpayers have qualified research expenses. The fixed-rate percentage is applied in the appropriate year of which the taxpayer has had qualified research expenditures. Alternative, taxpayers can also use an alternative simplified credit calculation. The R&D Tax Credit calculation is quite complex, and should involve a tax professional. However, taxpayers can reasonably expect to receive a credit of anywhere from 3% to 10% of their Qualified Research Expenditures. To get an idea of the real dollar amounts you can save try this article in the Journal of Accountancy.
Now that you have a high-level understanding of the calculation of the R&D Tax Credit and which expenditures are eligible, let’s look at it’s applicability in a few different industries. The software & tech industry is an area which many startups operate & where there are several R&D Tax Credit opportunities. Companies that are developing a new software system, enhancing an existing software system they developed, or programming or testing source code can be eligible.
Another major startup industry where there are many R&D saving opportunities is engineering. Because buildings, roads, bridges, & products are becoming more and more complicated, engineering firms are being engaged to do more research, statistical analysis, and modeling than ever before. Many expenditures in engineering such as evaluating alternative parts, design changes, improving mechanical systems, improving computer modeling techniques (such as CAD or Revit programs), or conducting impact studies can be eligible for R&D tax credits.
While established companies that have positive taxable income can benefit from the R&D Tax Credit, the IRS offers startup businesses who don’t yet make a profit a way to still benefit from these R&D expenditures. These companies can elect to apply up to $250,000 of R&D Credit as a portion of their payroll social security tax each year as long as the company's gross receipts are less than $5m in the year of the election and the taxpayer must not have gross receipts more than five years before the year of the election. This means that the company must be a relatively new company who hasn’t yet cleared $5m in gross revenue. This option is attractive to startups and the payroll tax credit can save these companies money during their vital early startup years.
Both Startup and established companies need to analyze their development activities and engage an expert to evaluate their expenses to determine eligibility. If you have questions or want more info contact me and I’ll put you in touch with the amazing tax professionals who have helped me a lot over the last few decades!
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