Aug 13, 2021Navigating the R&D Tax Credit
What Are R&D tax credits?
Research and Development (R&D) tax credits are a great way for businesses to make the most of their tax savings each year. R&D tax credits were introduced as an incentive for businesses to continue improving, developing, and producing new products and processes. Some businesses may qualify for this credit without knowing it, which is why this article seeks to inform businesses of the benefits of R&D tax credits, who qualifies for them, and how businesses can claim these credits.
R&D Tax Credit Overview and Benefits
The U.S. federal government has outlined certain specifications that allow businesses to receive tax credits for continued research and development. If a business meets the qualifications for these developmental activities, it can receive up to 20 percent of the excess (if any) of the qualified research expenses for the taxable year, over the base amount (Title 26 Sec 41 Internal Revenue Code). These tax credits allow for decreased tax liability, or a decrease in the amount of profit subject to taxes, which results in greater savings for businesses. They also promote continued innovation, research, and development in businesses by incentivizing these pursuits.
Who Qualifies for R&D Tax Credits?
Some businesses may incorrectly assume that R&D tax credits are reserved for laboratory researchers, scientists, and inventors, but that is not the case. These tax credits are available to any qualifying business, whether they are an engineering or an architecture company. Even newer businesses that have not yet made taxable profits can take advantage of the R&D tax credit. Note that the R&D tax credit isn’t refundable. If you don’t have a tax liability, you can carry forward the tax credit for up to 20 years, offsetting future liability.
The Internal Revenue Code section 41 defines what is meant by “qualified research,” stating that it is research “which is undertaken for the purpose of discovering information, which is technological in nature, and the application of which is intended to be useful in the development of a new or improved business component of the taxpayer” (Title 26 Sec 41 Internal Revenue Code). This means that the innovation or improvement does not have to be a brand-new development in the industry, but simply a new or improved development for the company involved.
Generally speaking, the following are some activities that can qualify a business for the R&D tax credit:
- New products
- New technology
- New processes
- Improvements on existing products, technology, or processes
The expenses then incurred by these activities are used to calculate the R&D tax credit. These expenses can include wages, materials, contractor fees and payments, and other operating costs. Small businesses can be covered up to $250k. (See “R&D Tax Credits: A Valuable Cash Infusion for Businesses” for more detailed information.)
Some research activities that do not qualify a business for this credit include the following, as listed in section 41 of the Internal Revenue Code:
- Research after commercial production
- Adaptation of existing business components
- Duplication of existing business component
- Surveys, studies, etc.
- Computer software (see Title 26 Sec 41 Internal Revenue Code for exceptions)
- Foreign research
- Social Sciences
- Funded Research
Funded research can include internal research costs toward new developments. For example, let’s pretend that a local restaurant decides to launch an app to improve the customer ordering experience. The restaurant is eligible for the R&D tax credit for the amount of hours that the employees worked on development, the cost of the contractors, and any associated testing costs. Small businesses can be significantly benefited by taking advantage of this credit.
The Internal Revenue Code goes through each of these activities and their exceptions in Title 26 Sec 41.
How Does a Business Obtain R&D Tax Credits?
For businesses to claim the R&D tax credit, they must provide the appropriate documentation that records both the activities involved in the research development as well as the expenses incurred. Businesses can claim R&D tax credits for the current tax year as well as previous tax years, which is why having the appropriate documentation is so essential. This documentation should include the following:
- Financial records, including the payroll and the general ledger
- Project details, including lists and notes
- Other documents relevant to the project and the company
With this information to back its claim to R&D tax credits, a business can be well on its way to saving money each year while simultaneously improving its operations. (See also 5 Common Misconceptions about the R&D Tax Credit—and Whether You Qualify.)