The Research and Development tax credit is an important incentive meant to spur companies to invest in innovation. By spending money on eligible R&D activities, companies can lower their tax bill significantly. But to benefit, businesses must grasp how the credit works and what expenses qualify. We’ll cover the basics so you can judge eligibility and maximize the benefit.
Research And Development Tax Credit (R&D Tax Credit)
The R&D credit started in 1981 with two goals in mind:
Stimulate economic growth through innovation
Incentivize businesses to perform the R&D needed to develop new and improved products, services, and manufacturing processes.
Over the decades, the credit has helped countless businesses across industries and sizes. Yet many eligible companies miss out due to complexities. We aim to cut through some of that complexity to provide a high-level overview. We’ll cover:
- Determining if your company’s activities really qualify as “research and development”
- Identifying qualifying R&D expenses and good record-keeping habits
- Optimizing your potential credit by structuring R&D activities strategically.
While details around eligibility and calculations can be complex, a basic grasp of how the credit works and what activities qualify is the first step for businesses considering whether it suits them. With that foundation, businesses can then engage the proper experts to determine if pursuing the R&D credit makes sense for them.
Qualifying Activities for the R&D Credit
Not all company research and development activities qualify for the R&D tax credit. To claim the credit, expenses must be related to activities that meet the IRS definition of “qualified research.”
According to IRS guidelines, qualified research involves:
- Systematic experimentation and investigation to resolve uncertainty and advance knowledge
- Pursuit of technological information that aims to develop new or improved functions, performance, reliability, or quality
- Application of the scientific methods of experimentation.
In other words, qualifying R&D activities are those that seek to achieve technological innovation and advancement. They involve an element of technical risk and uncertainty that pushes the boundaries of current knowledge.
Some common examples of qualifying R&D activities include:
- Developing or improving products and processes
- Creating functional prototypes
- Designing materials with new properties
- Testing product alternatives
- Resolving technical uncertainties through experimentation
- Obtaining a technical advance
- Developing software for internal use.
Conversely, activities that do not involve technical uncertainty or that are aimed solely at style, taste, or cosmetic changes would generally not qualify. Nor would routine marketing, management, or compliance activities.
To claim the credit, companies must engage in a “systematic, investigative, and experimental” process to achieve an R&D goal related to a “new or improved function, performance, reliability, or quality.” This generally requires going beyond what is known through current knowledge or published materials and venturing into the unknown to make an innovation breakthrough.
Calculating the R&D Tax Credit
While the goals of the R&D tax credit are straightforward, calculating the actual value of the credit can be complex. There are two basic components involved:
Qualifying Expenses
The first step is identifying all expenses related to qualified research activities during the claiming period. Qualifying expenses typically include internal labor costs, supply costs, contract research expenses, and certain types of property used for R&D purposes.
Not all business expenses count. Only those directly related to conducting qualified research as defined by the IRS can be included. It is important to track and document qualifying expenses carefully to support any tax credit claim.
The Credit Calculation
Once qualifying expenses have been identified, there are two main methods for calculating the R&D tax credit:
- Regular Credit: Provides a credit equal to 14% of qualifying expenses above a calculated “base amount.” The base amount represents a company’s normal level of non-R&D expenditures.
- Alternative Simplified Credit (ASC): Provides an easier calculation by allowing a company to claim a credit equal to 14% of qualifying expenses above 50% of the average of their prior three years’ R&D expenditures.
Companies must calculate their credit under both methods and claim the larger amount. Regular credit typically provides a higher benefit for companies steadily increasing their R&D investments, while the alternative simplified credit favors those with fluctuating R&D expenditures.
Both calculation methods are subject to certain limitations and exclusions. And other factors like business structure, location, and affiliate status may further impact the amount companies can actually claim.
Claiming and Monetizing the Credit
Once a company has identified qualifying research expenses and calculated its potential R&D tax credit, it must take appropriate steps to claim the credit and realize its financial benefits.
To claim the R&D credit on their tax return, companies must complete IRS Form 6765. This form requires information about qualifying expenses and credit calculations. It is then filed along with the company’s annual tax return.
For companies that lack the in-house tax expertise to complete Form 6765, hiring a specialist to help file the initial credit claim is often advisable. Tax professionals can ensure all requirements are properly met and the maximum allowable credit is captured.
Beyond the initial tax return, there are a few other ways companies can monetize their R&D tax credit:
Carryback/Carryforward – If a company’s credit exceeds its tax liability in a given year, it may be able to carry back the excess credit to offset taxes in the prior 2 years or carry it forward up to 20 years.
Transferring – In some cases, companies may be able to transfer (sell) some or all of their R&D credit to an affiliate with higher taxable income. This requires meeting specific IRS criteria.
Monetizing – Companies can monetize their unused R&D credit by selling or “factoring” it to a third party for a discounted rate. This option provides an immediate cash benefit.
Regardless of how a company ultimately realizes the value of the credit, working with experienced tax and accounting professionals from the start can help maximize their dollar-for-dollar return on R&D investments over time. With proper claiming strategies in place, the R&D credit becomes a powerful incentive to accelerate innovation and growth.
Common Mistakes to Avoid
While the R&D tax credit is a valuable incentive, many companies still fail to claim it due to common mistakes. Understanding these pitfalls can help businesses avoid them:
Not tracking expenses properly
Companies often fail to track R&D expenses separately from other costs. Proper documentation of qualifying expenses is critical to support any credit claim.
Not documenting research activities
Companies must be able to show that qualifying research activities were methodically undertaken to resolve technical uncertainty. Documenting these processes helps satisfy IRS requirements.
Not involving tax and R&D experts
Many companies attempt to interpret IRS rules and calculate the credit on their own. Working with specialized tax and R&D professionals from the beginning increases accuracy and maximizes benefits.
Overlooking the Alternative Simplified Credit calculation
This alternate method provides a simpler way to calculate the credit for some businesses. Companies should evaluate whether the ASC may provide a higher benefit.
Missing carryback/carryforward opportunities
Many companies are unaware they can utilize unused portions of the credit by offsetting prior or future years’ tax liabilities.
Failing to claim the credit year after year
To continue benefiting from the R&D credit, businesses must claim it each tax year by submitting IRS Form 6765 with their return.
Conclusion
The R&D tax credit is a valuable, but complex incentive designed to encourage innovation and technology development. For companies that understand how credit works and take the proper steps to claim it, the financial benefits can be significant.
While this guide has aimed to provide a high-level overview of R&D credit basics, the details involved in accurately determining eligibility, documenting expenses, calculating the credit amount, and claiming the credit can be intricate and nuanced. Partnering with experienced tax and R&D professionals is often crucial to fully realizing the credit’s benefits.
For businesses that invest in research to develop new products, technologies, and processes, the R&D tax credit may provide an important return on those investments. But to actually qualify for and capture the credit requires navigating a complex tax incentive program.
The first step is simply educating yourself on the basics of how the R&D credit works and what activities may qualify your company. With that fundamental knowledge in hand, businesses can then engage the right experts to determine definitively if they are truly eligible and how to maximize the financial incentives available to them.
The potential reward for taking those next steps could be well worth the effort for companies committed to innovation. As businesses large and small continue investing in research that drives technological progress, public policy incentives like the R&D tax credit aim to help accelerate those efforts for the broader benefit of economic growth.
