The research and development (R&D) tax credit is a useful tool for a business to substantially decrease its federal tax liability. Businesses do not need to have an R&D or engineering focus in order to qualify for the credit. However, many businesses that qualify are not taking advantage of it. If you create new products or improve any existing processes or products, your business may qualify for the credit.
What is the R&D tax credit?
The R&D tax credit is a federal income tax credit designed to incentivize technical jobs and product innovation. Businesses that develop, design, or improve processes, products, formulas, prototypes, or software can claim the R&D tax credit. With the broad scope of qualifying activities, more businesses qualify for the tax credit than currently take advantage of it. It is available to businesses of all sizes, including start-ups and small businesses.
Additionally, many states offer R&D tax credits for state income taxes.
Is your business eligible for the R&D tax credit?
Your business may qualify for the R&D tax credit if it incurs expenses related to:
- Development or design of new products or processes
- Enhancement of existing products or processes
- Development or improvement upon existing prototypes, formulas, and software
There are four main components to determine if an activity is eligible for R&D tax credits.
- It must create a new or improved business component, which results in new or improved function, quality, reliability, or performance. The business component can involve a process, product, formula, prototype, or software sold or used within the business.
- It must intend to resolve a technological uncertainty that exists at the start of the project.
- It must involve a process of experimentation that involves the testing and evaluation of alternatives. The business should have records that demonstrate it evaluated other alternatives in the systematic trial-and-error process.
- It is technological in nature and relies on hard science, such as engineering, computer science, biology, chemistry, or physics.
Start-up and small business eligibility
The R&D tax credit is available to start-ups and other small businesses, even if they don't owe federal income taxes. These businesses may apply the R&D tax credit to offset the Federal Insurance Contributions Act (FICA) portion of their payroll taxes. If your business qualifies for this treatment, you can offset up to $250,000 in FICA taxes each year for a maximum of five years and $1.25 million.
To receive this special treatment, the start-up or small business elects and calculates the R&D tax credit on its income tax return. The tax credit may then be applied against the FICA portion of the business's payroll taxes starting in the quarter after electing the credit.
To qualify as a start-up or small business, a business must have:
- Less than $5 million in gross receipts for the year
- No gross receipts or interest income dating back more than five years
How to claim the R&D tax credit
To claim the R&D tax credit, you must thoroughly document your business's R&D activity to establish the total amount of qualified research expenses paid for each qualified research activity. You can estimate expenses, but you must have a solid reasoning and factual basis for the estimates.
Qualified research expenses include wages paid to employees for qualified activities, supplies used in the R&D process, and contract research expenses paid to third parties such as educational institutions or scientific organizations.
Examples of appropriate expense documentation include:
- Payroll records
- General ledger expense detail
- Project lists
- Project notes
- Lab results
- Emails
- Other documents regularly used by the business
Future of R&D tax credits
As of 2022, businesses in the United States will no longer be able to immediately expense costs related to R&D. They will instead be required to amortize research expenses and deduct them over a five-year period for activities conducted within the United States. Businesses will have to amortize and deduct expenses related to research conducted outside the United States over a 15-year period.
