February 2, 2023
| Documentation | Incentive Calculations | Qualifying Criteria
R&D tax credits were enacted to stimulate innovation and research investment in the United States. The stimulus provides material non-dilutive capital to companies that improves their cash flow through reduced federal and state taxes. Furthermore, companies can claim R&D tax credits each year, thus creating a significant reduction to future years' federal and state tax liabilities.
The federal R&D tax credit is defined under Section 41 of the Internal Revenue Code and is a dollar-for-dollar reduction of a company’s taxes. The value of the credit is based on qualified U.S. expenses related to the design, development, or improvement of products, process, techniques, formula, inventions, or software. The credit was made permanent through the Protecting Americans from Tax Hikes (PATH) Act of 2015. The PATH Act also broadened the ability of many businesses, especially start-ups, to monetize. The Inflation Reduction Act of 2022 further expanded the opportunity for certain start-ups to monetize even more R&D tax credits.
Who qualifies for R&D tax credits?
Any company engaged in qualified research activities can qualify for R&D tax credits. These credits are not limited to any particular industry.
What are qualified research activities?
Qualified research activities include efforts related to the development or improvement of products, process, techniques, formulas, inventions, or software items. Examples of qualified activities include:
Developing new products for the market
Improving existing products by increasing functionality, performance, reliability, or quality
Evaluating alternatives to existing products or processes
Developing manufacturing processes to mass produce products
Improving existing manufacturing processes to increase throughput, reduce cost, or reduce scrap
Designing or developing new equipment
Developing or improving technical processes
Developing or improving chemical formulations
Creating new materials
Developing or improving software applications
How to determine eligibility?
R&D projects must meet qualifying criteria to establish that related expenses qualify for R&D tax credits. The following four-part test is applied to each project to determine eligibility.
The research activity must relate to the development of a new or improved business component. A business component is defined as any product, process, technique, formula, invention, or software item. The purpose of the research must be to increase the function, reliability, quality, or performance of the business component. Improvements do not have to be significant in order to qualify for the credit. Successful and failed projects are applicable.
The research must be technological in nature. This means the research relies on the principles of the hard sciences, including engineering, physics, chemistry, biology, and computer science. A company does not need to seek knowledge that “exceeds, expands, or refines the common knowledge of skilled professionals in the particular field of science or engineering”. A company may employ existing technologies and rely on existing principles of the hard sciences to satisfy this requirement.
The information sought during the project must be intended to eliminate uncertainty related to the development or improvement of the business component. Uncertainty exists if the information available to you at the outset of the project does not establish the capability (if it can be done), method (how it can be done), or appropriate design of the business component. The uncertainty must be technological in nature.
Substantially all of the research must constitute elements of a process of experimentation. A process of experimentation is a process designed to evaluate one or more hypotheses/alternatives to achieve a result where the capability or method of achieving that result, or the appropriate design of that result, is uncertain at the beginning of the research activities.
What expenses qualify for R&D tax credits?
Wages, supplies, cloud computing, and third-party expenses related to qualified research projects are included in R&D tax credit calculations.
Wages – Qualified wages for employees engaged in qualified services are included in R&D tax credit calculations. Qualified services include engaging in qualified research or in the direct supervision or direct support of qualified research.
Supplies – Qualified supplies are supplies that are used in the conduct of qualified research. Supplies are used in the conduct of qualified research if they are used in the performance of qualified services. Expenditures for supplies or for the use of personal property that are indirect research expenditures or general and administrative expenses do not qualify as in-house research expenses. Depreciable property and land are also excluded from consideration. Examples of qualified supplies include materials to fabricate and test prototypes.
Cloud Computing – Amounts paid or incurred for the use of personal property are not qualified research expenses, except for any amount paid or incurred to another person for the right to use (time-sharing) computers in the conduct of qualified research. The computer must be owned and operated by someone other than the taxpayer, located off the taxpayer’s premises, and the taxpayer must not be the primary user of the computer. Software developers will often host a development environment in the cloud through a service such as Amazon Webservices or Microsoft Azure. The hosting expenses for the development environment constitute an amount paid or incurred to another person for the right to use (time-sharing) computers in the conduct of qualified research.
Contract Research – Contract research is an expense paid or incurred to any person other than an employee of the company for the performance of qualified research on behalf of the company. An expense is paid or incurred for the performance of qualified research only to the extent that it is paid or incurred pursuant to an agreement that (i) is entered into prior to the performance of the qualified research, (ii) provides that research be performed on behalf of the taxpayer, and (iii) requires the taxpayer to bear the expense even if the research is not successful. This does not necessarily have to be a written agreement. Qualified research is performed on behalf of the taxpayer if the taxpayer has substantial rights to the research results. Qualified research can be performed on behalf of the taxpayer notwithstanding the fact that the taxpayer does not have exclusive rights to the results. Examples of contract research include third-party software development, engineering, design, and testing.
How are R&D tax credits calculated?
The credits are calculated as a percentage of current year qualified research expenses in excess of a base amount. There are currently two calculation methods available for companies to use – the regular credit (RC) method and the alternative simplified credit (ASC) method. Companies are allowed to calculate the credit using both methods and select whichever method provides the best result. The federal credit result for most companies is 6% to 8% of the current year qualified research expenses.
How are R&D tax credits claimed?
Companies claim R&D tax credits by filing Form 6765 with their income tax return. Companies are expected to maintain documentation to support the information included on Form 6765. The current record keeping requirement requires companies to maintain documentation to substantiate the value of the credits being claimed. This includes financial documentation related to wages, supplies, cloud computing, and contract research expenses as well as project documentation to illustrate the qualified nature of projects.
Can start-up companies that are not profitable claim R&D tax credits?
Qualified small businesses are able to elect to use their R&D tax credits to offset payroll taxes if there is no income tax to offset. Qualified small businesses are companies with less than $5 million in gross receipts for the credit year and no more than 5 years of gross receipts. The election to use R&D tax credits against payroll taxes must be made on an original tax return.
How are R&D tax credits applied?
R&D tax credits are used to offset income taxes; however, qualified small businesses operating at a loss may elect to use up to $250,000 of R&D tax credits to offset the 6.2% employer portion of Social Security payroll tax liability for tax year 2022. Beginning in 2023 qualified small businesses may elect to use up to $500,000 annually to offset the 6.2% employer portion of Social Security and 1.45% employer portion of Medicare payroll tax liability.
Can I file amended returns to claim credits for prior years?
Companies can claim credits for prior years through filing amended returns for any open tax years. This is generally a three-year period.
Do unused R&D tax credits carryforward?
Unused federal R&D tax credits can be carried back one year and carried forward twenty years. The carryforward rules also apply to qualified small businesses using R&D tax credits to offset payroll taxes.
What are the documentation requirements?
Companies claiming R&D tax credits must maintain documentation that supports the credit's value. This includes financial documentation and qualified project documentation. Companies need to illustrate the accumulation of QREs and highlight how projects meet the qualification requirements. When pursuing R&D tax credits, businesses should prioritize the quality rather than the quantity of their supporting documentation. Instead of generating and submitting a great deal of paperwork, companies will have more success if they organize pertinent records in advance that are capable of substantiating their claim.
How can Earnd help?
Our founders bring an unmatched depth of experience to your business. Our experience spans tax credit accounting, consulting, finance, manufacturing, data analytics, software development, technology infrastructure, and cyber security. As your partner, we’ll manage the complex process of calculating your applicable tax credits and incentives as well as provide comprehensive technical and financial results.
Earnd will provide your accounting firm with the paperwork needed to incorporate our identified credits into your annual or quarterly tax filings. Our materials will include the calculation details for your account’s review as well as forms detailing where and how the savings should be applied. Your current CPA will make your subsequent annual or quarterly filings.