R&D Tax Credits: A Business Owner’s Guide

• What is the R&D Tax Credit?
• Qualifying Expenses for the R&D Tax Credit
• How To Calculate R&D Tax Credits
• How To Claim R&D Tax Credits
• What is the 280(c) Election?
• What is the four-part test for R&D tax credit eligibility?

If you haven’t looked into the R&D tax credit before, there’s a good chance that you’re missing a big opportunity to boost your cash position. Even if they’re aware of the credit’s existence, many businesses and their owners mistakenly assume that they aren’t eligible, or haven’t utilized the credit correctly.

It turns out that you don’t need an expensive laboratory or a Fortune 500 budget to take advantage of this incentive – offered not only by the IRS, but also by many states. By some estimates, as few as 5% of companies with qualifying research and experimentation expenses ever claim tax credit for them.

Here’s a quick business owner’s guide to the R&D tax credit and how it works.

What is the R&D Tax Credit?

The R&D tax credit was created in 1981 during the Reagan administration as a two-year incentive for companies to invest in innovations leading to sustained job growth. The thinking was that if companies were rewarded for the risks they took to invent new technologies and processes, the long-term benefits would enrich the economy as a whole.

The credit has remained part of the tax code ever since, with numerous extensions and revisions under both Republican and Democratic administrations. Two of the more recent renewals happened with the PATH act (Protecting Americans from Tax Hikes) signed by President Obama in 2015 and it was made permanent under the TCJA (Tax Cuts and Jobs Act) signed by President Trump in 2017.

The credit is known by several alternative names you might see in various public and private sector publications, but they all refer to the incentive defined in Internal Revenue Code (IRC) Section 41:

• The Research & Development (R&D) Tax Credit
• The Research and Experimentation (R&E) Tax Credit
• The Research Tax Credit
• The Credit for Increasing Research Activities

Is my business eligible for the R&D tax credit?

When you consider the complexity of the tax code, it’s no surprise that there are a lot of myths surrounding the R&D tax credit. Here are five of the more common ones:

1. Only large businesses are eligible (FALSE)
2. You need a big research budget and costly dedicated facilities to qualify (FALSE)
3. You can’t claim the credit without a successful breakthrough discovery (FALSE)
4. Supporting documentation is difficult to come by (FALSE)
5. The credit only benefits you for the current tax year (FALSE)

Chances are that if your business creates new processes or products, enhances existing ones, builds custom machinery, develops software from the ground up or in some value-added capacity, you can qualify for a federal and perhaps a corresponding state R&D tax credit. The credit also applies to a surprisingly wide number of common industries, not just to the ones you’d normally associate with purely scientific pursuits.

According to the IRS, the qualifying activity has to begin by addressing a particular “technological uncertainty” that’s essential to its function. Success has to be measurable according to a “hard science” of some sort, such as engineering, physics or the principles of computer science. It has to follow a documented “process of experimentation” and must serve a “qualifying purpose” of developing a new business component or improving the function or performance of something fundamental to your business.

How does the R&D tax credit work?

Simply put, the credit is calculated mainly on the wages paid to the employees engaged in qualified research or experimental activity and the value of the resources (i.e. supply costs) they use. To be eligible for a credit, the outcome of the activity does not have to result in something new to the industry – it just has to be new for your company, even if your innovation attempts are not successful in the year you apply.

As with any tax reduction strategy, you need to have the right documentation in place to claim the R&D tax credit. Unfortunately, many business owners miss out on this valuable opportunity by assuming that the qualification bar is higher than it actually is. You need the right professional assistance, of course, but with payroll and expense records, detailed project tracking and other routinely available business data, claiming the credit is a fairly straightforward process.

Examples of activities and expenditures that would not qualify for an R&D tax credit include:

• Capital investments in property or equipment you maintain on your books and records
• Market or consumer preference research
• Research conducted outside of the U.S.
• Routine quality control testing on existing products or processes

When you consider that a company’s wage bill is often among their biggest expenditures, it’s easy to see how a credit based on research activity payroll and supplies used in that activity can have a significant reduction to your tax burden. Even companies that currently claim the R&D tax credit may not be getting the full value out of it. Clayton & McKervey can evaluate your documentation for eligible expenditures you may not be claiming.

Qualifying Expenses for the R&D Tax Credit

Now, let’s look at activities, which in general terms must pass a four-part IRS test. They must:

1. Serve a qualifying purpose for something fundamental to your business
2. Address an essential technological uncertainty
3. Be subject to measurement by a hard science of some sort
4. Follow a documented process of experimentation

The tax credit rules allow you to claim various percentages of labor, supply or outsourcing costs depending on conditions outlined in the corresponding IRS and Treasury codes, and all work must be performed inside the U.S.

• Taxable wages paid to employees who directly contribute to qualified research activities
• Taxable wages paid to people who directly assist such employees
• Taxable wages paid to people who directly supervise such employees
• Payments to contractors who perform direct services in the U.S. in support of such work
• Payments to vendors who supply materials consumed in support of such work

For example, let’s say that you run a company that manufactures paint coatings that wants to introduce improved curing additives to the market. A prescribed portion of the taxable wages of the engineer running the test routines qualifies, as do the taxable wages of the engineer’s direct leader or an assistant who may directly support the engineer by maintaining and cleaning the test apparatus.

In this example, the wages of the engineering department’s administrative assistant or the leader of the engineer’s boss are not eligible expenses. Neither are the costs of utilities, IT or phone service connected to the test space, or any rent or capital costs for the space itself.

The scientific-sounding name of the R&D tax credit might create the false impression that only companies like life science, pharmaceutical or microelectronics giants qualify. In fact, many small, medium and even startup business in many markets are likely eligible. Here are just a few:

• Engineering
• Software developers
• Custom Machine builders
• Plastic Injection molder
• Tool and Die companies
• Automation companies
• Prototype and Precision manufacturing

Expenses that are Not Eligible for the R&D Tax Credit

Beyond the three types of expenses described earlier, there are expenses that are unambiguously out of bounds for R&D tax credit qualification.

Capital investments for equipment or property are not eligible. You can’t claim the costs of routine focus group, consumer preference or market research, or testing or quality assurance activities for existing services or products.

The important thing is to keep detailed records. Most of what you need may already be captured in your existing business documentation. This might include:

• Project budgets, schedules and progress notes
• Detailed employee assignment and payroll records
• Experimentation logs and observation notes
• Supply inventories, purchase orders, receipts and other procurement documentation
• Contractor bids, proposals and scope documentation

How To Calculate R&D Tax Credits

Since the R&D tax credit was first introduced in 1981, both Republican and Democratic administrations have revised and extended it numerous times. Eligibility criteria and how the credit is applied have shifted along with changes in the tax code, but the qualification bar has tended to drift lower over the years. Businesses of all sizes may qualify.

Once you’ve decided to pursue the R&D tax credit, there are two established ways to perform the calculations:

• The Regular Research Credit (RRC) method looks at the INCREASE in research activity and investment in a taxable year compared with a base amount
• The Alternative Simplified Credit (ASC) method looks at the amount your Qualified Research Expenses (QRE) exceed the AVERAGE for your three previous tax years

To get specific, you calculate and report the credit on IRS form 6765 and submit it with your company’s tax return.

R&D Tax Credits – One Size Does Not Fit All

The calculation method that yields the maximum benefit (the best reduction in your overall tax burden) depends a lot on your individual business circumstances. Fortunately, you can change your election from year-to-year without being locked into one method if you file timely and don’t amend your return.

As noted briefly earlier, calculations are based on what the IRS calls Qualified Research Expenses, or QREs for short. Depending on conditions outlined in the corresponding IRS and Treasury codes, The tax credit rules allow you to claim various percentages of these QREs (wages, research supplies or contract research). All research and development work must be performed inside the United States. Offshore contract research is strictly ineligible.

Choosing the Calculation Method That’s Best For Your Business

The important thing to remember is that tax circumstances can shift significantly along with business conditions, so it’s a good practice to carefully evaluate both options for every tax year. You may also qualify for state credits depending on the state where the research is performed.

Whichever method you choose, the resulting credit can add up to real money in business terms and have a worthwhile impact on your company’s tax position. Chances are that the eligibility bar is lower than you think, and although it does require you to get extra documentation in order, the payback from an R&D tax credit can be significant.

How to Claim the R&D Tax Credit

To claim the R&D tax credit you file IRS form 6765 with your company’s tax return. The credit is referred to on the form as The Credit for Increasing Research Activities but it’s also known by other names in various publications. All of these popular references describe the same incentive that’s defined in Internal Revenue Code (IRC) Section 41:

• The Research Tax Credit
• The Research and Experimentation (R&E) Tax Credit
• The Research and Development (R&D) Tax Credit

Although it’s been revised and expanded many times, the credit has been in place since the early 1980s. Its purpose is to reward companies that invest in innovations leading to lasting job growth. It applies to a wide variety of businesses like manufacturing, architecture, construction, engineering and even retail – not just “big science” companies with expensive laboratories.

When you file your R&D tax credit claim, you’ll need documentation supporting your Qualified Research Expenses (QRE). These will include:

• The wages you paid to employees who were directly involved in qualified research activities
• The cost of supplies consumed during qualified research activities
• The cost of qualified research activities performed by third-party contractors

As mentioned in the previous article, there are two standard ways to calculate the amount of your R&D tax credit:

• The Regular Research Credit (RRC) method measures the increase in research investment in a taxable year compared with a defined base amount
• The Alternative Simplified Credit (ASC) method measures the amount your QRE exceed your average research and development investment over the three previous tax years

Business circumstances change from year to year. Choosing the method that yields the most benefit for your business is an annual decision you should make with the help of a qualified tax expert. Always consult a tax professional before implementing any tax credit strategy.

Do I really need to claim the R&D tax credit every year?

There are several reasons why it makes sense to evaluate the R&D tax credit every year:

1. Companies that do file often overlook valid expenses they can claim. Completing an accurate analysis is easier during or immediately after the end of the year while the details of qualified activities are fresh in everyone’s mind.
2. You can change your calculation method each year but must do so on the originally filed return. The calculation method cannot be changed on an amended return.
3. Unused credits can be carried back one year or forward 20 years. Business processes typically change from year-to-year, which is why it makes sense to analyze the R&D tax credit annually.

An important thing to remember about the R&D tax credit is that it’s intended to incentivize experimentation. There’s no requirement that your innovation attempts must be successful or result in something new to the world. You just need to document your improvement efforts toward a product or process that’s better for your business using technology and science.

What is the 280(c) Election?

Typically, when a company claims a tax credit they are required to add back the value of any expenses used to claim the credit. This results in an increase in taxable income and associated tax liability in the year the credit is claimed. The 280(c) election allows taxpayers to claim the after-tax value of the credit and does not require the add back of expenses.

Taxpayers make the 280(c) election on line 34 of IRS form 6765 (December 2020 revision) by checking YES or NO and completing the required percentage calculation. This election is made annually and cannot be changed on an amended return.

Why would a taxpayer make the 280(c) election?

As discussed previously, making the 280(c) election allows a taxpayer to claim the after-tax value of the credit without adding back the expenses used to claim the credit. This results in a lower tax liability than the taxpayer would have generated without the election. When you evaluate the remaining tax liability after applying the credit, there typically isn’t a significant difference with or without the election. The decrease in the value of the credit is offset by the decrease in the tax liability.

So, if there is no measurable difference for the taxpayer why would anyone make the election?  From a practical perspective, making the 280(c) election simplifies the preparation of the tax return because an adjustment does not need to be made to remove the expenses claimed as part of the credit.

More importantly, the 280(c) election can provide savings on a taxpayer’s state income tax return. The states use the federal taxable income as a starting point for determining the state taxable income. By lowering the federal taxable income, a taxpayer can also lower their state taxable income.

Does the R&D tax credit 280(c) election affect my eligible expenses?

The protective 280(c) election will not impact the QRE you can claim. All it changes is the calculation of the credit used when filing your return. In many cases, business owners actually underestimate their qualifying research expenses. Here’s a quick recap of eligible items:

1. Taxable wages paid to employees who directly contribute to qualified research activities
2. Taxable wages paid to people who directly supervise such employees
3. Taxable wages paid to people who directly assist such employees
4. Payments to U.S. vendors who supply materials consumed in support of such work
5. Payments to U.S. contractors who perform direct services in support of such work

The IRS considers all of these kinds of research expenditures legitimate, provided they serve a qualified research purpose that’s essential to your business, address a specific technological uncertainty, have a basis in hard science and follow a documented experimentation process.

Of course, all of this is contingent on your specific business circumstances and the nature of your research and development activity. The important thing for now is to be aware that a protective 280(c) election exists as part of the R&D tax credit rules. This is a question you’ll want to raise with your company’s tax preparer so that you know what your potential tax benefit will be with or without the election.

What is the four-part test for R&D tax credit eligibility?

When the R&D tax credit was introduced in 1981, it was originally a two-year limited incentive to spur investment in innovation. The thinking was that if businesses were rewarded for research and experimentation that led to long-term job growth, the economy as a whole would prosper. The credit has been extended and expanded many times over the years.

The ground rules for the credit set four basic eligibility criteria for qualifying activities:

1. First, the activity must serve a qualifying purpose that’s fundamental to your business. Broadly, the purpose can be to develop a new or improved product or process. Your discovery does not have to be new to the world, or to your industry. It just has to be new and relevant to your core business.
2. Second, the activity must address a specific technological uncertainty. In an industrial automation company, for example, you might be developing a new automation system for a unique customer application or implementing efficiency or quality improvements to an existing system.
3. Third, the activity must be based on one of the established branches of hard science. This means that the product or process improvement you envision can be observed and explained in the accepted terms of chemistry, physics, earth science, microbiology, or computer science.
4. Fourth, the activity must follow a documented process of experimentation. You will need to capture and preserve detailed logs of things like your guiding assumptions, testing methods and timelines, and the iterative changes you make on the way to your desired outcome. These don’t have to be any more elaborate than the project plans and notes you may already use to run your business. IMPORTANT: To qualify for the credit, your attempts do not have to be successful. They just have to be properly recorded.

Are there other R&D tax credit qualifications I need to know about?

To bust another R&D tax credit myth, you do not need to have expensive laboratory facilities or a Fortune 500 research budget to qualify. Many small, medium and even startup businesses in a wide variety of industries are able to comfortably pass the four-part eligibility test. Contrary to popular belief, the credit is not limited to companies you’d normally associate with “big science” such as the pharmaceutical, microelectronics or life science giants.

Here are the primary items the IRS considers Qualified Research Expenses (QRE):

• Taxable wages paid to employees who directly contribute to qualified research activities
• Taxable wages paid to people who directly assist such employees
• Taxable wages paid to people who directly supervise such employees
• Payments to contractors who perform direct services in the U.S. in support of such work
• Payments to vendors who supply materials consumed in support of such work

Lists can be abstract, so let’s set up a quick illustration:

Imagine that you’re a systems integrator developing a new control system for a food and beverage manufacturer’s production line. A defined part of the taxable wages of the engineer who designs the control hardware and software, as well as the taxable wages of the engineer’s direct supervisor or assistant who supports the development would be considered QREs.

If your business creates new processes or products or enhances existing ones in a value-added way, there’s a good chance you can qualify for a federal and perhaps a corresponding state R&D credit. It’s best to seek advice from a qualified tax expert on the supporting documentation you’ll need such as payroll records, vendor receipts or contractor agreements.

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If you’re considering the R&D tax credit, or currently claim the credit but aren’t certain how IRS code changes might impact your tax return, we can help you evaluate your options, check for federal and possible state eligibility and prepare a personalized strategy to get the maximum benefit from the credit – possibly for multiple tax years. Contact us today to learn more.