While tax reform, often referred to as the Tax Cuts and Jobs Act (TCJA), introduced many new changes for businesses, the R&D tax credit continues to provide reliable opportunities for reducing income tax liabilities—often saving companies hundreds of thousands of dollars.
However, many companies aren’t fully benefiting from the R&D credit because of common misconceptions about its applicability to their operations. Businesses that fail to claim the R&D credit often do so because of confusion around four key topics:
- Which activities qualify as research
- What expenditures qualify for the credit
- What documentation sufficiently supports research
- How businesses use the credit
Gaining clarity around these topics can provide the foundation for identifying and claiming the R&D credit—and lowering a company’s tax burden.
The Protecting Americans from Tax Hikes (PATH) Act of 2015 made the R&D credit permanent and expanded its application to create a potential tax benefit for small businesses and start-up companies. The TCJA retained these provisions.
Because of the permanency of the R&D credit, companies can now rely on and incorporate it into their annual tax-planning strategy.
Common Reasons Companies Don’t Think They Qualify
Even with this stability, however, there are common factors that companies assume prevent them from claiming the credit.
Not Paying Federal Income Tax
Start-up companies and small businesses may be eligible to apply up to $1.25M—or $250K each year for up to five years—of the federal R&D credit to offset the Federal Insurance Contributions Act (FICA) portion of their payroll taxes each year.
To be eligible, a company must meet two requirements:
- Have less than $5 million in gross receipts for the credit year
- Have no more than five years of gross receipts
The R&D credit is calculated on the federal income tax return as usual and may be applied against payroll taxes starting the quarter after the credit is claimed. For calendar-year taxpayers, the R&D credit can be applied against payroll taxes as early as July of the following year.
Not Focused on R&D
It’s not only high-tech or life sciences companies with dedicated research departments that qualify for the R&D tax credit. Indeed, most companies don’t have R&D laboratories and instead perform R&D in their test kitchens or fields, wineries or distilleries, or on production floors. Wherever experimentation occurs, R&D may be found.
The Moss Adams R&D Tax Services page contains examples of qualifying activities across industries.
Employees Aren’t Degree-Holding Engineers or Scientists
Companies with large numbers of engineers and scientists stand out as prime candidates for the R&D tax credit because the credit was created to encourage research and experimentation based on the hard sciences.
This holds true regardless of who performs the activities and can include employees with many different job titles and backgrounds. Experimentation performed by both employees and third-party contractors who engage in the improvement of projects and processes may be included.
Not Developing Anything New
The R&D tax credit is for taxpayers that design, develop, or improve products, processes, techniques, formulas, or software. It’s calculated on the basis of increases in research activities and expenditures—and as a result, it’s intended to reward companies that pursue innovation with increasing investment.
R&D doesn't have to be new to the industry. It simply needs to be new to the company, which must have activities that meet the four-part IRS test below.
Subject to the Alternative Minimum Tax
Historically, many companies performing R&D haven’t benefited fully from the credit because the company—or its shareholders, in the case of pass-through entities—were subject to the alternative minimum tax (AMT).
For tax years beginning on or after January 1, 2016, individuals or eligible small businesses (ESBs) who are subject to AMT can offset regular taxes and AMT using the R&D tax credit. ESBs are nonpublicly traded companies with average revenue of $50 million or less over the previous three years.
This means R&D credits that may have been previously unusable for ESBs can now be applied to reduce AMT.
Determining which Companies Qualify
Any company that encounters and resolves technological challenges may be eligible for the R&D tax credit. That said, eligibility depends largely on whether the work a company does meets the criteria established by the IRS’s four-part test:
- Elimination of uncertainty. A company must demonstrate it has attempted to eliminate uncertainty about the development or improvement of a product or process.
- Process of experimentation. A company must demonstrate—through modeling, simulation, systematic trial and error, or other methods—that it has evaluated alternatives for achieving the desired result.
- Technological in nature. The process of experimentation must rely on the hard sciences, such as engineering, physics, chemistry, biology, or computer science.
- Qualified purpose. The purpose of the research must be to create a new or improved product or process, resulting in increased performance, function, reliability, or quality.
Companies that consider their activities to be business as usual may actually find themselves innovative once they look at the four-part test. As a first step, a company should review its operations for eligible activities. Companies that go on to claim the credit must also be prepared to identify, document, and support their qualifying R&D activities.
Claiming the Credit
The amount of R&D tax credit a company can claim will depend on many factors, but the potential tax savings make it worth the time to investigate. For example, R&D tax credits have the potential to offset taxable income, which can reduce a company’s tax burden in the years qualified activities occur.
Companies that haven’t previously taken advantage of the credit also have the option to look back at all open tax years—typically three to four years, depending on when tax returns were filed—to claim the missed opportunity.
If a company doesn’t currently have taxable income or is otherwise limited in how much tax credit it can use, the federal tax credit can be carried forward for 20 years or potentially applied to offset the company’s federal payroll tax under the newly expanded rules. State credits may also be carried forward for a length of time determined by the state.
Because R&D tax credits may be claimed for both current and prior tax years, companies can benefit from documenting their R&D activities so they’re well positioned to claim the credit for both situations.
To claim this credit, taxpayers must evaluate and document their research activities contemporaneously to establish the amount of qualified research expenses paid for each qualified research activity. While taxpayers may estimate some research expenses, they must have a factual basis for the assumptions used to create the estimates.
Examples of contemporaneous documentation include these items:
- Payroll records
- General ledger expense detail
- Project lists
- Project notes
- Lab results
- Emails and other documents a company produces throughout the regular course of business
These records combined with credible employee testimony can form the basis of a successful R&D credit claim.
We’re Here to Help
For help determining whether your business is eligible for R&D tax credits—or for assistance evaluating, documenting, and submitting R&D activities to the appropriate tax authorities—contact your Moss Adams professional.