A surprisingly broad range of activities and industries may qualify for the research and development (R&D) tax credit. Businesses without scientists, laboratories, or even a focus on R&D often successfully claim the credit.
Many business owners potentially qualify, from a farmer testing alternative ways of harvesting crops, to an HVAC company developing a new way to service air conditioners, to a contractor learning a new construction technique.
The credit requires detailed documentation and a four-part test to determine which activities qualify. Even small businesses often earn a substantial credit, with several ways to use it if the company currently owes no federal tax.
What is the R&D tax credit?
The R&D tax credit rewards companies for increasing qualified research expenses (QREs) incurred inside the United States. A percentage of these QREs reduces federal tax liability dollar-for-dollar. Companies may use one of two methods to calculate the credit amount.
The traditional method yields an R&D tax credit of 20% of QREs above a baseline level. Determining the baseline level requires a complex series of calculations.
Businesses often prefer the alternative simplified credit (ASC). This equals 6% of QREs if the company had no QREs in the prior three years. Otherwise, the company subtracts 50% of its average QREs for the last three years from its current year QREs. It then multiplies the result by 14% to calculate the R&D credit amount.
Many—but not all—states offer a similar credit under their own rules.
What qualifies for the R&D tax credit?
QREs include wages, supplies, and contract research—provided the business funds the research and receives full or shared rights to the results. Only expenses for qualified activities count as QREs.
Activities must satisfy all the following tests to qualify:
- Business component. The company aims to create or improve a business component. This includes products, processes, formulas, techniques, software, and other inventions.
- Uncertainty. The company attempts to learn something it doesn't know—even if other businesses do—needed to create or improve the business component.
- Experimentation. The company uses a process to evaluate multiple ways to create or improve the business component.
- Technological. The process of experimentation relies on the principles of at least one hard science, including physical, biological, engineering, or computer science. Both established and new scientific principles satisfy this test.
The company must document the activity while it performs the research, not later. Any estimates must use assumptions based on fact.
Certain activities automatically fail to qualify, even if they meet all four tests. Examples include surveys, adaptations for a specific customer, and artistic research.
Basic research collaboration with universities, scientific organizations, and certain non-profits also qualifies as a separate part of the R&D tax credit.
How can a business use the R&D tax credit?
Companies which failed to claim the R&D tax credit on their original return may usually amend to cover at least the three prior tax years.
The credit first offsets the current year tax liability. Any unused amount then applies to the prior year. Finally, the remaining credit carries forward up to the next twenty years.
Eligible small start-ups may also elect to apply $250,000 per year for up to five years—a total of $1.25 million—of the R&D tax credit to payroll taxes. The election only applies to original returns. Companies must have gross receipts—defined as top-line revenue plus interest income—for five years or less. Additionally, the business must have gross receipts of less than $5 million for the tax year the election applies to.
The tax credit may also offset alternative minimum tax (AMT) for eligible small businesses. Non-publicly traded companies averaging no more than $50 million in gross receipts over the last three years qualify.
The R&D tax credit involves other nuanced rules and requires careful documentation. Tax professionals can review companies' unique circumstances to verify whether each business qualifies and how much credit it may claim.
Understanding the R&D tax credit, which expenses and activities qualify, and how to use the credit can prevent business owners from missing out on an impactful tax benefit.
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