This is a thought leadership article by North American member firm Clayton & McKervey discussing research and development tax credits in the United States.
If you haven’t looked into the R&D tax credit before, there’s a good chance that you’re missing a big opportunity to boost your cash position. Even if they’re aware of the credit’s existence, many businesses and their owners mistakenly assume that they aren’t eligible, or haven’t utilized the credit correctly.
It turns out that you don’t need an expensive laboratory or a Fortune 500 budget to take advantage of this incentive – offered not only by the IRS, but also by many states. By some estimates, as few as 5% of companies with qualifying research and experimentation expenses ever claim tax credit for them.
Here’s a quick business owner’s guide to the R&D tax credit and how it works.
What is the R&D tax credit?
The R&D tax credit was created in 1981 during the Reagan administration as a two-year incentive for companies to invest in innovations leading to sustained job growth. The thinking was that if companies were rewarded for the risks they took to invent new technologies and processes, the long-term benefits would enrich the economy as a whole.
The credit has remained part of the tax code ever since, with numerous extensions and revisions under both Republican and Democratic administrations. Two of the more recent renewals happened with the PATH act (Protecting Americans from Tax Hikes) signed by President Obama in 2015 and it was made permanent under the TCJA (Tax Cuts and Jobs Act) signed by President Trump in 2017.
The credit is known by several alternative names you might see in various public and private sector publications, but they all refer to the incentive defined in Internal Revenue Code (IRC) Section 41:
- The Research & Development (R&D) Tax Credit
- The Research and Experimentation (R&E) Tax Credit
- The Research Tax Credit
- The Credit for Increasing Research Activities
Is my business eligible for the R&D tax credit?
When you consider the complexity of the tax code, it’s no surprise that there are a lot of myths surrounding the R&D tax credit. Here are five of the more common ones:
- Only large businesses are eligible (FALSE)
- You need a big research budget and costly dedicated facilities to qualify (FALSE)
- You can’t claim the credit without a successful breakthrough discovery (FALSE)
- Supporting documentation is difficult to come by (FALSE)
- The credit only benefits you for the current tax year (FALSE)
Chances are that if your business creates new processes or products, enhances existing ones, builds custom machinery, develops software from the ground up or in some value-added capacity, you can qualify for a federal and perhaps a corresponding state R&D tax credit. The credit also applies to a surprisingly wide number of common industries, not just to the ones you’d normally associate with purely scientific pursuits.
According to the IRS, the qualifying activity has to begin by addressing a particular “technological uncertainty” that’s essential to its function. Success has to be measurable according to a “hard science” of some sort, such as engineering, physics or the principles of computer science. It has to follow a documented “process of experimentation” and must serve a “qualifying purpose” of developing a new business component or improving the function or performance of something fundamental to your business.
How does the R&D tax credit work?
Simply put, the credit is calculated mainly on the wages paid to the employees engaged in qualified research or experimental activity and the value of the resources (i.e. supply costs) they use. To be eligible for a credit, the outcome of the activity does not have to result in something new to the industry – it just has to be new for your company, even if your innovation attempts are not successful in the year you apply.
As with any tax reduction strategy, you need to have the right documentation in place to claim the R&D tax credit. Unfortunately, many business owners miss out on this valuable opportunity by assuming that the qualification bar is higher than it actually is. You need the right professional assistance, of course, but with payroll and expense records, detailed project tracking and other routinely available business data, claiming the credit is a fairly straightforward process.
Examples of activities and expenditures that would not qualify for an R&D tax credit include:
- Capital investments in property or equipment you maintain on your books and records
- Market or consumer preference research
- Research conducted outside of the U.S.
- Routine quality control testing on existing products or processes
When you consider that a company’s wage bill is often among their biggest expenditures, it’s easy to see how a credit based on research activity payroll and supplies used in that activity can have a significant reduction to your tax burden. Even companies that currently claim the R&D tax credit may not be getting the full value out of it.
Clayton & McKervey PC
Headquartered near the international border of the U.S. and Canada, Clayton & McKervey is a Detroit-based, full-service accounting and business advisory firm focused on global business. The firm’s clientele includes closely held, middle-market, growth-oriented companies. Since 1953, Clayton & McKervey has created a strong reputation, both domestically and internationally, with four types of clients, U.S. entities with operations in other countries, foreign entities expanding to the U.S., businesses with international growth plans and clients in need of transfer pricing service.Learn more