Updated November 14, 2022
If your business has spent money on research and development in the past year, you likely qualify for the credit. While it's commonly believed that only large corporations can take the credit, the R&D tax credit can be claimed by businesses of any size, and across a variety of industries. To qualify, your business simply needs to have engaged in what the Internal Revenue Service (IRS) calls qualified research expenditures, or QREs.
We'll discuss QREs in more depth below, but in general, if your company has attempted to develop new products or processes, or has worked to improve existing products or processes, you'll likely qualify for the R&D tax credit.
If your business qualifies for the R&D tax credit, you'll have some discretion over when and how you apply it. For most businesses that are currently turning a profit, the credit will be applied against the company's income tax liabilities. For companies like startups that have yet to turn a profit, the credit is usually used to offset the company's payroll liabilities.
Below, we've broken down a few common ways the R&D tax credit is used to maximize its benefit to your business:
One of the more common methods that small businesses use to claim the R&D tax credit — using it to offset payroll taxes — can be a huge boon for your business. To qualify, your gross receipts for the year in question will need to be lower than $5 million, and you can't have gross receipts from more than five years ago.
If your business meets these requirements, you'll be able to use the R&D tax credit to offset the 6.2% employer portion of Social Security payroll tax liability and 1.45% employer portion of Medicare payroll tax liability, up to $500,000 in payroll taxes. You'll apply the credit to your payroll taxes by selecting this method as an option when filing your income tax return. If you find out that you've been qualified for the credit multiple years in a row, you use the surplus-value of the credit to help cover some of your income tax liability as well.
Note: The maximum allowable payroll credit election remains at $250,000 for tax years December 31, 2015, to December 31, 2022.
If you failed to claim the credit in previous years, while still qualifying for it, you might still be able to access it. It's possible to go back and amend your income tax return to incorporate the R&D income tax credit, which would allow you to receive a refund for a previous year.
Businesses that haven't yet achieved profitability but still have research and development expenses may feel like they're missing out on the full benefits of the credit — if the R&D tax credit is greater than your actual income tax, it's not refundable. Fortunately, businesses are allowed to carry forward unused portions of the credit for up to 20 years.
In general, expenses that have been used to develop new products, technologies or services, or improve existing products, technologies and services, will qualify for the R&D tax credit. More specifically, the following activities will usually qualify:
When it comes to the standards set by the IRS, there are four main categories of research and development costs that can be counted as legitimate expenses:
If your company qualifies for the R&D tax credit, there are standard ways to calculate it, both of which we'll discuss below.
The standard method — Under this method, the R&D tax credit will be worth 20% of the company's qualified research expenditures over a base amount, which will be a product of a fixed-base percentage and the average annual gross receipts from the past four years.
The alternative simplified credit (ASC) method — Under this method, the R&D tax credit is worth 14% of the company's qualified research expenditures over 50% of its average QREs from the past three years. If there are no QREs from previous years, the credit is worth 6% of the current year's QREs.
How should you choose between the methods? Consulting with tax experts can help you make the best decision, but in general, companies who are new to claiming the credit will find the ASC method slightly easier.
Figuring out how to claim the R&D tax credit, and then how to best apply it to receive the most benefit, can be a difficult process. Below, we've broken down how to determine if you qualify, how to claim the credit, how to apply it and which documents you'll need to claim it.
Claiming the R&D tax credit can seem like a difficult process, but it essentially comes down to three major steps:
Here is a simple, four-part test that can help you determine whether your business qualifies for the federal R&D tax credit and the potential benefits it offers. Under IRS Section 41, your company's activities must meet these criteria to be considered qualified research expenditures.
To treat an expense as a qualified research expenditure, a company must be able to establish that all four of the above tests have been met.
As with any credit, proper documentation is essential for successfully receiving the benefits of the credit, while also avoiding the potential for an audit. When claiming the R&D tax credit, you should prepare the following documentation and records:
The primary purpose of the R&D tax credit is to boost economic activity by encouraging companies to innovate and invest in new technologies, products and services. For individual businesses that claim the credit, the benefits include:
The R&D tax credit often goes unclaimed by companies and businesses that qualify for it, simply because it's so little understood. In fact, some estimates suggest that there are 6,000,000 corporations in the U.S. eligible for the credit, while on average only around 20,000 companies claim it each year. To put it another way, according to the National Science Foundation, in 2010 almost $9 billion in R&D tax credits were claimed — while an additional $4 billion went unclaimed.
Contrary to what many people think, the R&D tax credit is open to companies of all sizes. In fact, roughly half of all companies that claim the credit are classifiable as small or middle-sized businesses. Qualifying for the credit depends only on whether or not your company spent money on qualified activities that the IRS considers falling under the umbrella of research and development.
While this isn't an exhaustive list, these are some of the industries that often qualify for the R&D tax credit:
Regardless of your industry, it is a good idea to investigate potential tax credits that could improve your financial performance. Doing so won't only ensure you're taking advantage of all the possible credits at your disposal — it can also provide insight into ways you might reallocate funds or spending to maximize your tax benefits.
The R&D tax credit can offer a number of important benefits — including cost savings and the ability to fuel growth — to a number of industries. As we've seen, misunderstandings about what might qualify a business for the R&D tax credit can prevent companies from taking advantage of this valuable asset. Below, we've broken down some common industries that can benefit from the R&D tax credit.
Unsurprisingly, tech companies — think companies involved in software or app development, electronics or even telecommunications — have a lot to gain from the R&D tax credit. As the pace of technological innovation continues to grow, most tech companies will invest in data analysis, product design and development, and testing as a matter of course. Even if these processes are aimed at optimizing current technologies rather than developing new ones, they can still qualify for the R&D tax credit.
If your business model incorporates some aspect of the engineering process, you likely qualify for the R&D tax credit. Developing new designs or creating new products are activities that typically require a large amount of research and testing, which means they'll typically meet the R&D tax credit requirements.
Manufacturing is probably the widest umbrella in terms of industries that qualify for the R&D tax credit. If your company engages in a number of common internal processes, from customer analysis to part or product design, and even establishing your production line, you probably meet the R&D tax credit requirements.
Pharmaceutical and biotechnology companies, manufacturers of medical devices, and even agricultural companies all typically qualify for the R&D tax credit. Since many of these industries rely heavily on high-quality research processes, they'll easily meet the requirements, but there are other ways to qualify as well. Product testing, lab maintenance and any attempts to improve an existing product will all typically qualify a company for the R&D tax credit.
Many businesses that easily meet the requirements for the R&D tax credit don't take advantage of it, simply because they aren't aware they qualify. We've broken down some of the most common myths and misconceptions surrounding the R&D tax credit below.
Most companies are convinced that if they don't have a team of PhDs constantly conducting cutting-edge studies, they aren't really doing research. But that's simply not true. The definition provided by the IRS is broad enough that a wide variety of activities can qualify a company for the R&D tax credit, from researching customer behavior to improving a pharmaceutical recipe and even designing a building.
Because the R&D tax credit initially began as a temporary incentive, the rumor persists that claiming the credit might increase your company's chance of being audited. Again, this simply isn't true. As a permanent incentive, the R&D tax credit is designed to encourage companies to develop new products and technologies.
Of course, it's still possible you might experience an audit, which is why it's important to make sure you've filed properly, and have the right documentation prepared, just in case. Working with an experienced tax preparation expert can make sure you're ready to answer the questions the IRS might ask you — as well as making sure you safely get the most out of the R&D tax credit.
A common misconception is that only profitable companies can claim the R&D tax credit. In fact, the PATH Act of 2015 introduced new changes to the R&D credit, one of the most important of which makes it easy for startups and other companies that haven't yet turned a profit to access the credit. The new change allows businesses to reclaim part of their R&D investment by reducing their payroll tax liability.
The federal R&D tax credit is typically worth up to 15% of qualified research expenditures, or up to $250,000 of payroll costs each year, meaning successfully applying for the credit could potentially save your company millions of dollars over a period of several years. In more specific terms, companies will usually receive a credit of between 5% and 15% of the total amount of expenses that meet the requirements of the IRS.
In addition, most states in the U.S. offer their own version of the R&D credit, which can further increase the value of this deduction for companies that qualify.
One of the key stimulus initiatives of the CARES Act is the Paycheck Protection Program, or PPP, which offers forgivable loans to small and medium-sized businesses to help cover payroll, mortgage or rent payments, and utilities. Understanding how a PPP loan will impact your company's tax filings can be a difficult matter, however.
According to the latest guidance from the IRS, federal income tax deductions are allowed for any of a business's expenses that have been covered by a forgiven loan, which includes PPP loans. In other words, if the qualified research expenditures (QREs) that make up the R&D tax credit are also expenses covered by a PPP loan, you can use them to claim the federal credit.
Another initiative of the CARES Act, the employee retention credit, or ERC, provides employers with a refundable tax credit for employee wages and health plan expenses paid while the company's operations were fully or partially suspended due to a pandemic-related shutdown. You cannot use the same wages to calculate both the ERC and the R&D tax credit.
Many smaller or younger startups are not impacted by Section 174 (pre-revenue) and can claim against payroll to save cash. The amount of this credit was doubled for 2023 as part of the Inflation Reduction Act, so it is more important than ever to understand your opportunity for savings. Applying the credit to your company's payroll taxes needs to be done on an income tax form filed in a timely fashion, and will cover up to $250,000 of the employer's portion of Social Security payroll taxes and up to $250,000 of the employer’s portion of Medicare payroll taxes.
The first step in understanding the credit is verifying that you qualify. The following five-question test will help you better understand if these credits are available to your business.
If you answered "no" to any of the above questions, you do not qualify. If you have determined you are qualified for these savings, you can calculate an estimated amount for the credit, to give you a better idea of what you can expect on return.
For more information about the R&D tax credit, and to find out whether you qualify, consider taking a look at some of the resources below:
The R&D tax credit commonly goes unclaimed because of misinformation and lack of knowledge, but that doesn't mean deciding to claim it is necessarily an easy process. The R&D tax credit is a complex credit based on projects, meaning that your research needs to qualify for the credit. From there, it needs to be properly and accurately documented. Bringing in an experienced tax expert can ensure you're claiming as large a credit as possible, and that you'll be doing it successfully.
If you have questions about R&D tax credits, contact our experts.
Armanino has the industry expertise, tax credit experience and track record of customer satisfaction to best advise your tax credit incentive strategy and compliance needs.
Contact us today for a free assessment.