5 Common Misconceptions About the R&D Tax Credit—And If You Qualify (2023)

Eligibility for R&D credits is much broader than many companies realize and applies not only to product development but also to activities and operations such asnew manufacturing processes,software development, Ofquality improvements. Startups may also be eligible to apply the R&D tax credit to payroll taxes for up to five years.

Your organization may be eligible for the R&D tax credit if:

• Spend time and resources developing new or innovative products.
• Improve existing products.
• Develop processes, patents, prototypes or software
• Hire designers, engineers or scientists.

R&D tax credits can also be granted retrospectively. Depending on when your tax return was filed, you may be able to claim R&D credits for three prior open tax years. Losing companies can pull back even further; some states also allow more than three years for retrospective claims.

It's a dollar-for-dollar tax saver that directly reduces a company's tax liability. There is no limit to the amount of expenses and credits that can be claimed per year. If the federal government's R&D credit cannot be used immediately or in full, unused credit can be carried forward to one year or up to 20 years. Each state has its own transfer rules.

The R&D tax credit regularly provides a large number of companies with an additional source of income: up to 10% of annual R&D costs for federal purposes and much more if the state credit is included.

The Protecting Americans from Tax Increases (PATH) Act of 2015 made the R&D credit permanent and expanded its use to create a potential tax break for small businesses and emerging businesses. The CCJA endorsed these provisions.

With the permanence of the R&D credit, companies can now count on it and incorporate it into their annual tax planning strategy.

Despite this stability, however, there are common factors that companies perceive to be preventing them from taking out credit.

1. The organization pays no federal income tax

Startups and small businesses may be eligible to apply for up to $1.25 million, or $250,000 per year for up to five years, of federal research and development credit to each offset a portion of your payroll taxes under the Federal Insurance Contributions Act (FICA) balance year.

To be eligible, a company must meet two requirements:

• Have less than $5 million in gross income for the credit year
• Have no gross income or interest earned for more than five years.

The R&D credit is calculated as usual on your federal income tax return and may apply to payroll taxes beginning in the quarter after you elect the credit. For calendar year taxpayers, the R&D credit can be applied to payroll taxes from April of the following year.

2. The company does not focus on research and development

Not only high-tech or life science companies with their own research departments are eligible for the R&D tax credit. In fact, most companies do not have R&D labs and instead conduct R&D in their kitchens or test fields, wineries or distilleries, or manufacturing facilities. Where there is experimentation, R&D can be found.

OurThe site includes examples of qualifying activities across all industries.

3. Employees are not licensed engineers or scientists

Companies with a large number of engineers and scientists are excellent candidates for the R&D tax credit, as the credit is designed to encourage science-based research and experimentation.

This is true regardless of who is performing the activities and can include employees from many different job titles and backgrounds. Experiments conducted by both employees and third parties involved in improving projects and processes can be included.

4. The company does not develop anythingNovo

The R&D tax credit is intended for taxpayers who design, develop or improve any product, process, technique, formula or software. It is calculated from the increase in research activities and expenditures and therefore aims to reward companies that strive to innovate with steadily increasing investments.

R&D does not have to be new to the industry. You simply must be new to the company, which must have activities that pass the four-part test below.

5. The Company is subject to Alternative Minimum Tax (AMT)

Historically, many R&D companies have not fully benefited from the credit because, in the case of pass-through units, the company or its shareholders were subject to the Alternative Minimum Tax (AMT).

For tax years beginning on or after January 1, 2016, qualifying individuals or small businesses (ESBs) subject to AMT may offset regular taxes and AMT against the R&D tax credit. ESBs are privately held companies with average revenue of $50 million or less over the past three years.

This means that R&D credits that previously could not be used on ESBs can now be used to reduce AMT.

Any company that takes on and solves technological challenges is eligible for the R&D tax credit. However, eligibility depends largely on whether a company's work meets criteria set out in a four-part test set out in the Internal Revenue Code (IRC) and Treasury Regulations.

four-part test

Business-as-usual companies can innovate by looking at the four-part test.

1. qualified purpose.The research goal must be the creation of a new or improved business component that results in a new or improved function, performance, reliability, or quality. A business component can be a product, process, computer software, technique, formula or invention - a broad definition that applies to many different industries.
2. elimination of uncertainty.A company must demonstrate that it has attempted to resolve uncertainties about the development or improvement of a business component. Uncertainty exists when the information available to the entity does not establish the ability or method to develop or improve the business component or the proper design of the business component. Many companies have confidence in their ability to meet technical goals or have an established method for finding a solution, but the design is rarely fixed at the beginning of the project.
3. experimentation process.An entity must demonstrate, through modelling, simulation, trial and error or other method, that it has evaluated one or more alternatives to achieve the desired outcome. By their very nature, some activities follow an iterative process of trial and error. For example, engineering activities, software development or clinical research are based on a process that can evaluate one or more alternatives. The definition is also broad enough to be applied to many other types of activities.
4. Technological in nature.The experimentation process must be based on the exact sciences such as engineering, physics, chemistry, biology or computer science. It is important to note that companies are under no obligation to surpass, expand, or refine existing scientific principles.

As a first step, a company should screen its operations for eligible activities. Companies applying for credit must also be prepared to identify, document, and support their qualifying R&D activities.

The amount of R&D tax credit a company can claim depends on many factors, but the potential tax savings are worth investigating. For example, R&D tax credits have the potential to offset income tax, which can reduce a company's tax burden in years when qualifying activities are conducted.

Businesses that have not previously drawn the loan also have the ability to look back at all open tax years, typically three to four years depending on when the tax return was filed, to claim the missed opportunity.

If a company currently has no taxable income or has limited use of the tax credit, the federal tax credit can be carried forward for 20 years or potentially used to offset the company's federal payroll tax under recent regulations. Government loans can also be carried over for a government-determined period of time.

Because R&D tax credits can be claimed for both current and prior tax years, companies can benefit from documenting their R&D activities and are therefore well-positioned to increase the number of credits claimed.

In order to claim this credit, taxpayers must simultaneously evaluate and document their research activities to determine the amount of qualifying research expenditure paid for each qualifying research activity. While taxpayers can estimate some research expenditures, they must have factual basis for the assumptions used to create the estimates.

Examples of contemporary documentation are these items:

• payslips
• General ledger expense details
• project lists
• Projektnotizen
• laboratory results
• E-mails and other documents that a company creates in the ordinary course of its business

These records, along with credible employee testimonies, can form the basis of a successful R&D loan application.

For taxpayers already applying for credit and those seeking to determine eligibility, due diligence in calculating and documenting research activities that qualify for R&D credit applications is critical. One possible consequence is increased IRS scrutiny and the cancellation of claimed loans.

the failure atSiemer Milling Company (Siemer Milling) v. Bundesfinanzkommissarit is a reminder of those consequences. On April 15, 2019, the US tax court ruled in favor of the appointee, finding that Siemer Milling did not have sufficient documentation to support the claimed R&D credits.

The importance of proper reporting when applying for R&D tax credits

In that case, the court denied more than $235,000 in research and development credits claimed by Siemer Milling in the 2010 and 2011 tax years. This refusal was due in large part to the taxpayer's failure to retain and provide supporting documentation showing how the company's activities met the four audits. necessary to form qualifying research expenditures.

Siemer Milling claimed that expenditure on activities related to the development of new flour products and improvements to its production line are eligible for the R&D credit. However, the company has not provided any documentation to show how the activities constitute experiments in a scientific sense.

The court ruled that the taxpayer merely stated that it was involved in the development of a new product involving technical activities, but these conclusive statements alone were not sufficient evidence. Merely reporting on the steps taken was not enough to conclude that the company had followed a methodical plan that included a series of tests to test a hypothesis for the development of new processes or products.

Other clarifications

This case provided some favorable facts for taxpayers about eligibility for qualifying research expenses:

• Technical uncertainties do not have to be resolved within the credit year, but can extend over more than a year.
• To determine that a company is engaged in technical activities, it does not necessarily have to employ people with technical titles.
• The US Tax Court discussed what types of evidence or estimates would be helpful to adequately support the claims made.

Increased credit through lower tax rates

Before the tax reform, taxpayers could not deduct the R&D credit under Article 174 of the IRC. This prevented companies from receiving a double tax break and forced taxpayers to shave off their R&D spending by the amount of the credit. The reduction in expenditure led to an increase in revenue and the corresponding taxes.

Taxpayers could avoid reducing their research spending by opting for a reduced IRC Section 280C(c)(3) credit withheld by the TCJA and calculated based on the maximum corporate tax rate. However, since the maximum corporate tax rate has been reduced from 35% to 21%, the AMT rate has been eliminated and taxpayers are given a larger credit.

However, there is still a cap on R&D credits to prevent taxpayers from using the credit to completely eliminate their tax liability. The rule, effectively known as the 25/25 cap, prevents taxpayers with more than $25,000 in recurring tax obligations from using the credit to offset more than 75% of their recurring tax obligations.

Eligible Small Business Credit

Previously, corporations or transient business owners with average revenue less than $50 million over the past three years could use the R&D credit to offset the AMT. Since the TCJA eliminated the Corporate AMT, this provision benefits individual taxpayers who receive R&D credits from a company in which they have an interest.

Payroll loan retention for qualifying small businesses

Startups with less than $5 million in revenue can still make an election that allows them to offset up to $250,000 in payroll taxes over the first five years of their gross revenue. From 2017 wage loans must be selected in an original declaration.

Increased usability for individual contributors

Prior to tax reform, individual taxpayers were sometimes prohibited from using the AMT credit on an individual basis. Now, AMT exemptions for individual taxpayers are increasing. As a result, individual taxpayers tend to use more of the R&D credits they receive from their companies.