The Federal R&D Tax Credits

Finance your R&D efforts through the R&D Tax Credits
program. Learn more about eligibility and what the R&D Tax Credits have to offer.

What is the R&D Tax credit?

Innovation is what drives economic growth as well as global competitiveness for businesses. To encourage an entirely new level of innovation, the federal government constituted a research tax credit in 1981 named the R&D Tax Credit program. The research & development tax credit is the primary source for rewarding businesses that invest in research. There are three main components to tax credits. The Federal R&D tax credit is available as a Regular or Alternative Simplified credit, the Energy Research Credit, and the University Basic Research Credit. The Federal R&D tax credit is open to any company aiming to improve their products, processes, techniques, formulas, inventions, and software or ultimately develop brand new ones through the regular or alternative simplified credit. The credit gives businesses opportunities for increasing their research. Businesses can reach new heights and access a brand-new funding source.

Who is Eligible?

Businesses of any size, in any industry are eligible to apply if they fit into any of the following categories:
  • Developing new technology, new or improved products, processes, or formulas
  • Developing prototypes or pilot models
  • Developing or applying for patents
  • Testing new product designs
  • Developing or improving production or manufacturing processes
  • Developing new software applications
  • Expending resources on outside consultants or contractors to do any of the above-stated activities

What qualifies for the R&D Tax Credit?

Research that is technological in nature for products or services can qualify R&D Tax Credit expenses. There is a guideline to defining these expenses. The guidelines showcase how the R&D tax credit works through the four-part test. To be considered a scientific research and experimental development activity, your qualified research expenditures (QREs) must meet all four requirements:

1. Permitted purpose: activities should improve the functionality, performance, reliability, or quality of new and existing business components.
2. Elimination of uncertainty: business must have faced and attempted to eliminate technological uncertainty during the designing or development of the component
3. Process of experimentation: substantially, the activities are experimental and conducted for a permitted purpose
4. Technological in nature: the activities should rely on principles of hard sciences, such as engineering, physics, computer sciences, etc.

What can be claimed?


Salaries and wages for employees such as engineers, managers


Supplies consumed in the R&D


Payments to US-based contractors


Computer leasing expense

What are the potential benefits of the R&D Tax Credit?

The benefits of the R&D Tax Credit come mainly from reducing a company’s tax liability and accessing a brand-new funding source. Spending on R&D can lower your federal and state income tax liability dollar-for-dollar. Unused R&D Tax Credits can also be carried forward up to 20 years and back one year. Businesses can claim both Federal and state credit. State R&D credits have their own rules, and carryover rules may vary from state to state.

How much can you claim?

Qualified Research Expenditures (QREs)

Calculated by applying the fixed-base percentage to the average gross receipts of the previous four years
fixed-base percentage: Entity’s historical percentage of gross receipts spent on QREs
The fixed base percentage is limited to a maximum of 16% The base amount has to be greater than half of the current year QREs

How Has the R&D Tax Credit Expanded Over the Years?

The R&D Tax Credit was constituted in 1981 but has evolved, allowing the credit to become more accessible overall and businesses to continue increasing their research activities.

In 2003, The government created regulations to remove the Discovery Rule. The removal meant that research activities no longer needed to make something “new to the world.” It now just had to be something new to the business attempting it, allowing the credit more flexibility.

In 2015, the Protecting Americans from Tax Hikes (PATH) Act changed the credit to become more accessible and beneficial to SMEs, including the R&D Tax credit for startups. This act allowed firms with less than five years of revenues and less than $5 million in current year revenues to claim the R&D tax credit against up to $250,000 in payroll tax liability.

How is the R&D Tax Credit Calculated?

Usually, 6% to 8% of your business’ R&D expenses can be applied dollar-for-dollar against your federal income tax liability. Under the R&D Tax Credit, certain qualifying expenses can be claimed, including:

•Employees directly involved in the R&D process
•Supplies consumed in the R&D
•Contract research expenses to US-based contractors
•Computer leasing expenses

The methods used for R&D Tax Credit calculations are
Regular Research Credit (RRC):

• Calculated by applying the fixed-base percentage to the average gross receipts of the previous four years
• Fixed-base percentage: Entity’s historical percentage of gross receipts spent on QREs
• The fixed base percentage is limited to a maximum of 16%. The base amount uses the more significant than half of the current-year QREs
• The minimum base amount must be greater than half of the current year QREs claimed.
• An incremental tax credit that is equal to 20% of a taxpayer’s current-year QREs that exceed a base amount

Alternative Simplified Credit (ASC)

• 14% of QREs for the year that exceeds 50% of the average QREs for the three previous years
• If the taxpayer has no QREs in any one of the three preceding years, the ASC rate equals 6% of the QREs for the year.
• Calculation of what you can claim is dependent on QREs.

Methods

Regular Research Credit (RRC)

  • Incremental tax credit that is equal to 20% of a tax payer’s current-year QREs that exceed a base amount

Alternative Simplified Credit (ASC)

  • 14% of QREs for the year that exceeds 50% of the average QREs for the 3 previous years
  • If the taxpayer has no QREs in any one of the 3 preceding years, the ASC rate 6% of the QREs for the year

How do I claim the R&D tax credit?

Companies can claim the credit for current and up to 3 prior tax years, meaning they can benefit from documenting their R&D activities, ensuring that they can claim their credits when necessary. Documenting these activities makes the business’ life easier when applying for R&D tax credits, but tracking your scientific research and experimental development can help prepare for the future. Proper documentation of R&D work is necessary for a successful claim. Failure to provide proof will lead to a failed claim. Some examples of appropriate documentation:

• Payroll records for people involved in the R&D
• Project lists
• Project notes
• General ledger expense

To claim the R&D tax credit, completing the R&D tax credit form given by the IRS, Form 6765, Credit for Increasing Research Activities is necessary. The document has four main sections:

• Section A: claiming the regular credit, with eight lines of the required information
• Section B: applying to the alternative simplified credit (ASC)
• Section C: identifying further information and schedules that are to be reported based on business structure
• Section D: required for small businesses making a payroll tax election

The IRS recommends that businesses calculate their credit using regular credit and simplified credit methods to maximize their tax benefit.

How can a company benefit from R&D Tax Credits?

Your company can devote time to creating innovative products that inspire the future and provide more significant funding for your own business. You can improve your actual products and develop processes, patents, prototypes, and more while getting funding for these exact processes. If you believe the process is too long or complicated to receive tax incentives, or if you think it may not work for the type of work you are doing, R&D consulting is always available. Firms would look to identify all your R&D tax expenses and help guide you through the process from preparation to approval.

How does the R&D tax credit work?

The R&D tax credit is so accessible because multiple major components allow the credit to be so widespread for a wide range of activities, allowing many activities to be claimable. There are four major components to the R&D tax credit applicable to businesses, which are:
  • The Regular Credit
    • The most standard way of claiming the R&D tax credit is equal to 20% of a firm’s QREs past a base amount
  • An Alternative Simplified Credit
    • This credit is more beneficial to claim for businesses that have relatively high fixed-base percentages
  • The Energy Research Credit
    • Exists for non-profit organizations conducting energy research for the sake of public interests
  • The Basic Research Credit.
    • It also exists for specific non-profit organizations, to foster collaborative research involving U.S firms, colleges, and universities.
Certain states have unique ways of calculating their credits. Within California, claiming the R&D Tax credit is applying for the Alternative Incremental Credit. The rates of credit sum also change depending on the state. California R&D Tax Credit covers 15% of qualified expenses exceeding the base amount and 24% of basic research payments.

How do the New IRS Updates Affect How We Claim the R&D Tax Credit?

There have been some recent updates regarding the additional requirements for documentation that the IRS R&D tax credits require. Taxpayers must comply with these listed requirements to qualify:

  • To identify all the business components to which the R&D claim relates for the tax year.
  • For each business component regarding the IRS R&D tax credit:
    • Businesses should identify all the research activities conducted that they have applied for
    • Identify all the individuals that were involved with the research activities.
    • Identify all the information regarding what everyone sought to discover
  • Provide the total amount of funding claimed for the qualified research expenses

Filling out Form 6575

When applying for R&D Tax Credits, you must fill out IRS Form 6765. The use of Form 6765 is to claim the credit for when your business has increased their research activities, elect a reduced credit, and elect to claim a specific amount of credit as a payroll tax credit against the portion of your social security taxes. Partnerships, Corporations, and Eligible Small Businesses must fill out the form to claim, listed in the Form 6765 instructions.

Critical information highlighted in the Form 6765 instructions help you identify whether your work can qualify or not. The Qualified Research section in IRS form 6765 states that your business researched to discover information that could be qualified to be technological. The intention behind the application should be to develop a new or improved business component for the taxpayer. The research must be process elements regarding a new or improved function, performance, reliability, or quality.

There are four main sections to Form 6765:

  • Section A – Regular credit
    • This section is used when claiming the regular credit. It requires you to provide information like the amount paid for completing the research and the average annual gross receipts for the four tax years preceding the current tax year.
  • Section B – Alternative Simplified Credit (ASC)
    • In this section, you are declaring to apply for the Alternative Simplified credit instead of the regular credit
  • Section C – Current Year Credit
    • Fill out the information required to be reported based on your business structure within this section.
  • Section D – Qualified Small Business Payroll Tax Election and Payroll Tax Credit
    • You only need to complete this section if you are qualified as a small business (QSB) and making the payroll tax election.

How to fill out form 8974

Form 8974, titled Qualified Small Business Payroll Tax Credit for Increasing Research Activities, is used to determine the amount of the qualified small business payroll tax credit for increasing research activities to be claimed on Form 941 by employers for Qualified Small Businesses. You can track the amount of R&D payroll tax credit being generated, utilized, and is available to be used against your company’s employment tax returns. The form should be completed and attached to Form 941, 943, or 944 if you had made an election on your income tax return to claim the qualified small business payroll tax credit if you increased your research activities against your payroll taxes. Businesses would make this election on Form 6765, Credit for Increasing Research Activities. Without filing the income tax return to claim the payroll tax credit on Form 6575, you cannot file Form 8974.

To start on Form 8974, you must identify your employer identification number (EIN) and name. They should match the name of your business and the relevant EIN that the IRS has already assigned to you.

There are two significant parts involved in the completion of Form 8974.

Part 1: Tell Us About Your Income Tax Return

Part 1 is an informational section where you are to provide information regarding your business. You must list information such as the credit you received in previous periods and the end date for your income tax period.

Part 2: Determine the Credit That You Can Use This Period

In Part 2 of the form, you will calculate the credits available for the current period using the information provided in Part 1. Your business should review these calculations carefully as mistakes could cause further issues. Getting a consultant for such forms is recommended to save time on calculations and ensure that the necessary information is collected, analyzed, and accurately inputted into the form.

Does the R&D Credit Bring Increased IRS Scrutiny?

When claiming the R&D credit, there is a need for accurate and detailed calculations and documentation to back up the qualified research activities. Consulting firms are a valuable resource that can help you navigate the claim process to meet the requirements and reduce the chances of a review. One of the repercussions of inaccurate calculations and lack of documentation is review from the IRS and even a denial of R&D credits. Providing evidence for your R&D credit claims is a necessity. Though this may be alarming, there are many taxpayer-friendly acts in place to help you out with R&D credits:
  • With technical uncertainties, they do not need to be solved in the fiscal year claimed, but they may span more than one year
  • A company that participates in technical activities is not required to employ individuals with specialized degrees in the field
  • The U.S Tax Court also accepts a variety of documentation and supporting evidence of estimates for the R&D credit claim

How Tax Reform Changed the R&D Credit

The tax reform brought about a couple of changes regarding R&D credits. The first was the increase in R&D credit available from a decrease in tax rates. The retention for eligible small businesses also grew as they could access R&D credits more widely after the removal of Alternative Minimum Tax (AMT). Startup companies were also able to start accessing the R&D credit. Businesses can offset $250,000 in payroll taxes of the first five years in which they had gross receipts. After the tax reform, individual taxpayers can also access R&D credits. The removal of AMT allows them to apply R&D credits passing through to them from the businesses where they are involved.

Is R&D tax credit taxable income?

The R&D Tax credit is a dollar-for-dollar reduction in income tax liabilities. In addition, firms can also take advantage of the current tax law and choose to deduct their R&D costs from their taxable income for the fiscal year. However, starting on January 1st, 2022, firms will be required to amortize their R&D expenses over five years instead of expensing the entire amount in one fiscal year.

Evaluating the Federal R&D Tax Credit

The Federal R&D Tax Credit provides a reason for businesses to invest in R&D. The opportunity to claim these credits is widely accessible to firms conducting R&D activities. There are four main elements to the Federal R&D Tax Credit:

The Regular Credit

  • The Regular Credit is an incremental tax credit that provides a benefit equal to 20% of the current year qualified research expenditures (QREs) that exceeds the base amount. This credit aims to incentivize an increase in R&D credits investment year over year.

Alternative Simplified Credit (ASC)

  • The alternative simplified credit is another incremental tax credit, providing a benefit equal to 14% of current year QREs that exceeds the base amount of half of the average QREs over the three prior years.
  • This credit differs from the Regular Credit as the ASC has a moving average base, whereas regular credit has a fixed one.

Energy Research Credit

  • The energy research credit provides a flat benefit equal to 20% of the amounts paid or incurred for energy research by the firm to an organization operating primarily to conduct energy research or conduct energy research in the public interest.
  • Organizations Firms such as colleges, universities, federal labs, and small firms qualify.
  • Only applicable if the taxpayer is not holding a majority of the stake for the firm performing the research.

Basic Research Credit

  • The basic, also known as university research credit, is incremental, able to provide 20% of the QREs over a base amount, to pursue collaboration between the university and the private education sectors. Payments are made to educational firms, non-profit scientific research organizations, and some grant-making organizations to claim this credit.

Taxpayers must pick between the regular credit and ASC, but businesses can claim the energy research credit and basic research credit for the fiscal year.

Companies can expense R&D costs, but to do so, they must either reduce the amount deducted for R&D expenses by the amount of R&D tax credits claimed or reduce the credit claimed by the statutory corporate tax rate.

What is the Federal Research and Development Credit?

The Federal Research and Development Credit, commonly referred to as the Research and Experimentation (R&E) credit, is a benefit provided by the federal government. Worth $18 billion, this credit provides businesses a dollar-for-dollar offset on their federal income tax liability and even can work as an R&D payroll tax credit. Considering the research and development credit is provided at a federal level, the potential benefit for the research and development credit can be up to 10% of a companies’ qualified research expenditures (QREs) and basic research payments (BRPs). A part that businesses may not know about this credit is the fact that many of their daily operations could qualify. Some eligible costs are:

  • Raw materials and supplies
  •  Computer cost
  • Wages for R&D involved employees
  • Sub-contractors

Many businesses and industries qualify for R&D credits. Even companies with a minor or non-dedicated R&D department can benefit from the credit. Most companies claiming the credit do not have devoted R&D departments. Examples of industries that qualify for R&D tax credits include:

  • Aerospace
  • Agriculture
  • Automobile
  • Life sciences
  • Manufacturing
  • Software development

Businesses can claim up to $250K per year against their payroll taxes. To be an eligible recipient, you should have under $5 million in gross receipts for the current year and no more than five prior years of generating gross receipts. It allows companies to claim usually 6% to 8% of their QREs against their federal income tax liability.

Deadlines

S-Corporations

  • 15th day of the 3rd month after the Fiscal Year End
  • Can request a 6 month extension by submitting a form to the IRS

C-Corporations

  • 15th day of the 4th month after the Fiscal Year End
  • Can request an extension by submitting a form to IRS – varies by FYE
to access your eligibility and potential benefits!