Innovation fuels the technology industry, making it a natural fit for R&D tax credits.
As the breadth and depth of the start-up ecosystem in the United States has grown, the number of companies that could benefit from beneficial tax policy favoring continued investment in start-ups has also increased. However, improperly calculating and claiming R&D credits can have consequences in the form of IRS penalties and fines.
But first, what is the R&D tax credit?
The R&D tax credit is a dollar-for-dollar tax savings that directly reduces a company’s tax liability. If the federal R&D credit can’t be used immediately or completely, any unused credit can be carried forward for up to 20 years.
In addition, previously filed tax returns can typically be amended for up to three years to claim the federal R&D credit retrospectively, providing an avenue to recoup previously paid taxes. New or small business may also be eligible to apply the R&D tax credit against their payroll tax for up to five years.
To help break down this complex topic, here’s a list of common questions technology companies often ask about the R&D credit.
How much can a company save with R&D tax credits?
There’s no limit, but several factors can impact savings—and because there’s such a wide variety of qualified expenses within the technology industry, it’s difficult to give an exact estimate of potential savings. Depending on a company’s size and the types of activities performed, our clients have saved anywhere from $50,000 to $5 million through the R&D tax credit.
The amount saved is based on the amount of expenses that are determined to be eligible for the credit, not the revenue generated by a company. Generally, the amount of credit can be approximately 5%–10% of a company’s federal R&D expenses during a given year. Typically, the more a company spends to innovate, the more they can potentially save.
The R&D credit is available both at the federal and state level, with more than 30 states offering an R&D credit to offset state tax liability. For example, California, which is a hotbed of technological innovation in various industries, including autonomous vehicles, energy storage, and biotech, provides a credit of up to 7% of qualified expenses.
What does the R&D credit apply to?
The advent of major technological innovations, such as rapid prototyping using 3D printing, simulation software, and pervasive wireless connectivity, has opened doors to rapid advancement in a variety of sectors.
For example, materials used for 3D printing of prototypes can be included in the credit calculation in addition to sensors, actuators, and other electrical components, as well as raw materials such as metals and other consumables used during development processes.
Additional expenses that may qualify for the R&D credit include:
- Expenses to engage third-party companies that perform development-related tasks, both physical and intellectual, that require a degree of specialized knowledge
- Cloud computing expenses for shared computer rental or cloud platforms that aid in artificial intelligence-related tasks
- Supplies expenses for materials used or consumed in performance of R&D
- Employee wages for those that engage in research, as well as those that directly supervise or support the research
When considering employee wages, it’s important to assess the impact of highly compensated employees on the credit, with a particular emphasis on those in executive roles. Technology companies often scale rapidly, so compensation can rise quickly with company revenues and the IRS may closely scrutinize the executive’s activity as well as the reasonableness of wages allocated to the credit. Additional proof of executives’ qualified services may be required to meet the credit such as technical documentation, emails, and calendar appointments pertaining to R&D.
What activities within the technology industry qualify for the R&D credit?
Technology companies tend to be experimental in nature, so many activities involved in developing new products and services may potentially qualify for the credit.
For example, evaluating technical considerations and advantages or disadvantages with respect to creation of product designs, material selection, formulations, or manufacturing processes are tasks frequently performed during the development or product improvement cycle. These tasks may entail a variety of testing methods to assess efficacy, such as structural tests, durability, or destructive testing, all of which may be eligible for R&D credits.
Some of the specific activities that could qualify include the following:
- Introducing new technologies to improve the manufacturing process, including the specification and design of prototypes and pilot models
- Designing new software architecture or algorithms
- Developing functional enhancements and new capabilities for existing applications, designed to create a competitive advantage
- Creating software in which scale and complexity present technological challenges
- Developing software to better manage customer relationships through improved collection, storage, and analysis techniques
- Creating specialized technologies, such as artificial intelligence or voice recognition applications
- Designing interactive software to support the delivery of multimedia entertainment, such as streaming music or video or Internet video games
- Developing software applications to use internally or to interact with customers or vendors
To apply for these credits, what’s the next step?
When seeking a research and development credit, it’s important to remember that there’s a certain level of documentation required to successfully claim the credit—and there could be penalties if done incorrectly.
The first step is to collect preliminary information about a company’s potential qualified activities, which is used to put together an estimate of what its credit benefit might look like.
Once the scope of the potential credit is outlined and the required supporting documentation is submitted, you can begin the necessary interviews and site visits needed to help support claiming the credit.
We’re Here to Help
Each company’s goals, values, and resources are unique, which makes it important to develop a customized project plan to identify, calculate, and support your company’s R&D credits and activities.
With recent increased IRS scrutiny around R&D credits, it’s crucial to understand what’s necessary to substantiate a credit claim. To learn more about R&D tax credits, see Five Misconceptions about R&D Tax Credits—and If You Qualify, or request a complimentary credit benefit estimate to see how much your company could save.