U.S. tax law provides a valuable benefit — in the form of a nonrefundable tax credit — for businesses that engage in qualified research and development activities (see a list below). The Sec. 41 credit, which amounts to as much as 20% of the excess of qualified research expenditures for the tax year over a base amount, can create immediate cash flow by reducing current year tax liability dollar for dollar. While nonrefundable, any credit not used in the current year can be carried back one year and carried forward 20 years under Sec. 39. In addition, qualifying activities that can be documented in prior years can create additional cash flow in any open tax years (currently three years) by filing an amended tax return.
Activities that give rise to qualified research expenditures for purposes of the Sec. 41 R&D credit can include such activities as:
- Developing a new or improved product;
- Developing new technology;
- Creating a new production process;
- Improving current processes;
- Developing or improving software; or
- Developing prototypes or models.
Certain activities do not qualify for the credit, including activities conducted outside the United States, research after commercial production of the product has begun, and surveys (see Sec. 41(d)(4)).
The R&D tax credit is calculated as a percentage of the company’s expenses related to R&D activities. Qualified R&D expenditures can include operating expenses such as wages, materials, and payments to third-party contractors if the activity that gives rise to the expenditure is a qualified research activity. So, while these expenses are generally fully deductible when determining taxable income, what many companies do not realize is that they can also count toward the R&D credit.
Many businesses also have shied away from pursuing the credit because the calculations can be complicated. As originally enacted, the credit calculation was complex, and it required companies to have a great deal of historical knowledge about their research activities. In 2006, another a less complex method of calculating the credit was enacted called the alternative simplified credit (ASC) method (Sec. 41(c)(4)). This simplified method of calculating the R&D credit calculations offers companies additional flexibility, but many companies still don’t claim the credit, because they are not aware that they have activities that qualify.
The R&D credit amount can be very significant at the state level as well as at the federal level. South Carolina, for example, has a 5% credit against state tax.
The R&D Credit Is not Only for Technology Companies
Even if a company doesn’t employ scientists in white lab coats, it may be able to take the R&D credit. Some of the industries frequently overlooked for this credit include architecture firms, engineering design firms, and software development companies. Startup companies that do not have an income tax liability yet (i.e., they’re not generating taxable profits) can also take the R&D credit against a portion of their employer payroll taxes.
A small or large business may be eligible for the credit if it engages in activities such as these:
- It develops or designs new products or processes.
- It improves existing products or processes.
- It develops or improves upon existing prototypes and software.
In 2015, the PATH Act made the R&D tax credit permanent — which motivated many more companies to include the credit in their long-term tax planning strategies. Also, the PATH Act modified the credit for the benefit of small and midsize businesses, including startup companies. Startups and small businesses may qualify for up to $1.25 million (or $250,000 each year for up to five years) of the federal R&D tax credit to offset the Federal Insurance Contributions Act (FICA) portion of their annual payroll taxes (Sec. 41(h)).
Note: Certain stringent criteria, including not having gross receipts before the five-year period ending with the tax year, must be met to be able to claim the credit against payroll taxes, so it is important to plan from the inception of the business.
Additionally, as part of the PATH Act, small businesses (defined as nonpublic companies with less than $50 million in average annual gross receipts for the previous three years) can permanently use research credits generated after Jan. 1, 2016, against both regular tax and alternative minimum tax (AMT) (Sec. 38(c)(4)(B)(ii)).
Seek Professional Advice
Any business that is currently improving or creating new or improved products, processes, or technology can potentially take advantage of the valuable R&D tax credit. Contact us today to discuss whether your business qualifies.