At Cunningham and Associates, we understand the complexities of tax legislation. We aim to help large and small businesses alike to reduce their tax bill. While many companies benefit from the Tax Cuts and Jobs Act of 2017 (TCJA), few realize the significant benefits that R&D tax credit can provide. By claiming qualified research expenses in your federal income tax return, you can reduce tax liability.
Large and small businesses and startups can apply for state and federal R&D credit to reduce the amount of money due to the IRS.
In this guide, you will find out how you could benefit from the R&D Tax Credit scheme. You will also learn how to meet the four-point criteria to be eligible to offset tax liability.
What Is the R&D Tax Credit?
The R&D tax credit allows companies to deduct qualifying expenses reduce tax liability. In addition, the IRS provides a dollar-for-dollar tax credit to encourage tax-paying organizations to invest in improved or new products and services. Research and development tax credit qualifying activities include inventions or new and improved processes, products, formulas, performance, functionality, quality, and performance.
R&D tax credit for qualified expenses is available at a federal and state level. The research expenses deductibles can offset federal income tax liability. However, in some instances, it is also possible to reduce payroll tax expenses. Many states also offer a more generous R&D credit than the federal government. Together, the savings on tax returns can amount to between 10 and 20 percent.
The framework for who qualifies for R&D tax credit is set out in the Internal Revenue Code (IRC) 26 USC 41. Officially called “Credit for Increasing Research Activities,” the research credit is based on two criteria:
- Qualified research expenses (QREs)
- Basic research payments (BRPs)
Qualifying research expenses or payments can amount to 20 percent of the excess of QREs and 20 percent of the BRPs.
According to some estimates, almost all industries in the US receive around $18 million in R&D credits.
What Are the Potential Benefits of the R&D Tax Credit?
Companies in every industry should explore their eligibility to claim for qualified research activities. Lowering your tax bill liability can have a significant impact on improving cash flow. This can allow your company to hire extra employees, expand facilities, and benefit from enhanced R&D.
The potential benefits of utilizing the R&D tax credit can include the following:
- Receive a dollar-for-dollar reduction in state and federal income tax liability
- Receive federal and state tax credits for every qualified dollar
- Use the federal R&D tax credit to offset payroll tax liability
- Increase company profits
- Lower your effective tax rate
- Boost cash flow
- Carry tax credits forward for up to 20 years
Qualifying for research and development tax credit can be an immediate source of cash for your company. But, without realizing it, your business could already be involved in activities that qualify for the R&D tax credit. For example, is your company putting in the effort to make products cheaper, lighter, stronger, more economical, or precise? If so, you may already be involved in qualified services to claim the R&D tax credit.
Since 2015, businesses have benefited even further from the R&D tax credit. The Protecting Americans from Tax Hikes (PATH) Act of 2015 made the provisions for claiming R&D expenditure in the annual tax return permanent. In addition, the scheme was expanded to include small businesses and startups. These changes allow companies of all sizes to incorporate R&D credit into their tax-planning strategies.
What Are R&D Tax Credit Qualified Activities?
Your company must meet four criteria to claim the research tax credit, also called the “four-part” test. This test ensures that any research expenses are related to qualified activities, are technological in nature, include a process of experimentation, and eliminate technical uncertainty about an improved product.
All qualified research expenses must adhere to the IRC Section 174 test. The tax credit is to improve existing products or services related to the taxpayer’s business. Therefore, expenditure related to experimental processes and laboratory work would qualify.
We will look at the four-part test in more detail to see what qualified research activity is. For each test criterion, you will find a helpful question to help determine if you can use certain R&D expenses to offset any tax liability.
1. Qualified purpose
Qualified activities are those performed to improve the functionality, reliability, quality, or performance of a new or improved business product or service. This qualified activity doesn’t have to be unique to your industry. However, it must be new or innovative to your company’s products or processes.
Question: Was the information discovered used to develop a new or improved product, invention, process, formula, technique, or computer software?
2. Technological in nature
Qualified research activity must rely on the principles of hard science. This could be physical science, computer science, chemistry, biological science, or engineering. For example, if you are involved in food production, just changing an ingredient wouldn’t qualify. However, if the product was improved using a scientific process to enhance flavor or extend shelf life, this activity could be a qualified activity.
Question: Did you use scientific principles — biological, physical, computer, or engineering — in development?
3. Elimination of uncertainty
The research activity should have the purpose of eliminating technical uncertainty for the taxpayer. This would mean that the activities would not only be for aesthetic purposes. For example, suppose there was technological uncertainty about the viability of a product. In that case, the company could undertake qualified research to eliminate doubt.
Question: Did your company use a discovery process to eliminate uncertainty or learn something new about a product to improve it?
4. Process of experimentation
Qualifying research activities must have an element of experimentation. The process could involve simulation, modeling, systematic trial and error, or similar methods. The research and development activity should show various alternatives used to achieve the desired result.
Question: Did your company evaluate alternatives or use a process of trial and error to improve the process or product?
If you can answer “yes” to all four questions, the chances are high that your company is engaged in qualified research and can claim R&D credit.
Eligible R&D Expenditures
To benefit fully from the research tax credit, knowing what research and development expenses can be included is crucial. This is because the tax credits from developing or improving new or existing products are based on expenditure related to the process.
Four types of R&D expenditures typically help reduce your tax liability. These include the following:
- Employee wages — All taxable wages for in-house expenses qualify. These are wages typically paid to employees directly supporting qualified research or working in the research department.
- Contract research expenses — If the R&D process requires a third-party contractor, then the associated costs are classed as qualified services. This could be for labor, research, or other services. However, the payment cannot be provisional on results. Additionally, the corporate taxpayer must have exclusive or shared rights.
- Supplies — Any tangible raw assets necessary for the R&D process may qualify. These can be so-called extraordinary utilities. However, they cannot include capital assets or costs related to general administrative services. Compared to other expenditures, supplies typically account for a small proportion. If the supply expenditure seems excessively high, the IRS may want to check that only qualifying expenses were included.
- Rental or lease costs — Equipment needed to carry out the research and development is a legitimate expense. Qualified services could also include renting server space or paying for a cloud service to facilitate the R&D process. These costs are typical in the case of software development.
Taxable wages that are expenses for qualified research activity are categorized into two areas:
- In-house research expenses — These expenses are wages the taxpayer pays to employees for qualified services and the cost of any required supplies.
- Contract research expenses — Tax-paying companies can claim 65% in their tax return for wages paid to outside vendors or independent contractors who perform qualified research.
Qualified R&D Employee Wages
All wages paid to employees involved in qualified R&D activities can be submitted in federal tax returns. There is a broad range of activities that qualify to tax credit. These include the following:
- Conducting qualified research. For example, an employee who tests a manufacturing prototype. Or a technician who is carrying out research based on hard sciences to improve a specific product.
- Supervising qualified R&D activities. This could be wages that the management team receives for directly overseeing a research project.
- Direct support staff. The wages of employees who are directly supporting the R&D team would qualify for the tax credit. For example, a clerk who compiles research data or a secretary typing laboratory result reports are considered activities associated with qualified research.
It should be noted that only the time attributable to performing qualified services can be included on the tax return. To successfully claim tax credit to offset the company’s payroll tax liability, employers must provide proof of taxable income. This can include any of the following:
- The employee’s IRS W2 tax form
- Time tracking data
- Payroll register
- Job descriptions outlining the specific
Typically, employee wages are the most significant expenditure on a research and design project. Therefore, it’s crucial to identify employees directly involved in the R&D process. The time they spend on qualified services is an integral part of an R&D tax credit study.
Qualifying Contract Research Expenses
In some cases, research involves hiring a third-party contractor or vendor to perform qualified services. Reasons for this usually include saving money or time or because the corporate taxpayer lacks the necessary skills. Therefore, expenditure relating to contract research is permissible in the R&D credit scheme.
To include QREs in the federal tax return, the research must pass the four-part test for R&D credit. Additionally, the same criteria exist as for in-house research. Therefore, contractors must be directly involved with the research project, and admin expenditure cannot be included. According to the IRC Code, a company can claim up to 65% of the costs paid for contract research. However, if a qualified research consortium performed the research, the tax credit rises to 75%.
There are additional factors to consider for including contract R&D expenses in a tax return. First, there must be an agreement — typically in writing — between the taxpayer and the contractor. However, to be classed as “qualified services,” the contract must also fulfill the following criteria:
- The agreement takes place before the start of any qualified research
- The taxpayer has full or shared rights to the research results
- The contractor receives payment regardless of whether the research was successful or not
- In the case of prepaid research expenditures, the credit can only be received when the qualified services are performed
For example, suppose the third-party contractor carries out qualified services for a company that wants to improve a product. However, the research is unsuccessful, and the company doesn’t benefit. Because there is no “result,” the contractor receives a partial payment. In this case, the expenditure is not for “qualified services” because the payment was contingent on the success of the research.
Additionally, if the contractor retains exclusive rights to research results, the taxpayer can’t include the expenditure on the tax return. Contract research expenses require that the taxpayer has rights to the research results, even if they are not exclusive.
Therefore, businesses must bear the financial risk of the contractor’s research and development.
What is a qualified research consortium?
A qualified research consortium is usually a scientific research organization or educational institution. However, a research consortium can be any organization that meets these three criteria:
- It is described in IRC section 501(c)(3) or 501(c)(6) and exempt from tax under section 501(a)
- It is organized primarily to conduct scientific research
- It is not a private foundation
Research payments made to a consortium allow businesses to claim up to 75% of the contract research costs. Additionally, there must be at least two businesses that pay the consortium for research.
Questions Regarding Qualified Research Expenses
Some uncertainty exists regarding was constitutes qualifying expenses related to research and development. In the past, many companies assumed that only scientific research organizations qualified for the R&D tax credit. The ambiguity about whether an activity qualifies as research meant that some companies missed out on qualifying for the R&D credit.
Here are a few questions to clear up misconceptions regarding research expenses deductibles.
Does the research have to involve a scientific breakthrough?
No. Qualified activities must relate to improving an existing product or service using established scientific or experimental methods. The research doesn’t have to involve any revolutionary or pioneering research to be classed as a “qualified expense.”
For example, suppose a drug manufacturer wants to improve a product to reduce specific side effects. In that case, the company has qualified research expenditure to develop a new and improved drug. However, if they want to change the packaging for marketing purposes, the expenses incurred wouldn’t be eligible as tax credits for R&D.
Must the research activity be successful?
No. Qualifying research activities don’t have to succeed to qualify for a tax cut. The taxpayer only must pass the four-part test to claim the R&D tax credit. So as long as the business was attempting to develop or improve the functionality, reliability, performance, or quality of a product or service, it can claim R&D credit on its federal tax return.
Is software development activity a qualified R&D expense?
Yes. Software development typically involves research, trial and error, and testing to develop a new or improved product. In addition, the taxpayer must hold the software for sale, lease, or license. It is even possible to claim qualified research expenditure if the product is primarily developed for internal use. However, additional requirements apply.
Excluded Activities from R&D Tax Credit Qualified Expenses
Although almost all industries can qualify for research expenditures, some activities are excluded from R&D credit claims. The “Credit for Increasing Research Activities” guidelines in Section 41 list disqualifying R&D tax credit factors. Primarily, these exclusions are related to product adaptation, duplication, market research, surveys, and funded research.
Here are certain activities excluded from qualified research expenditures.
Research after commercial production
The cost of any activity after starting commercial production isn’t regarded as qualified research expenditure. Therefore, no more research claims for tax credits can be made after the product is deemed ready for use and meets the functional requirements.
Some examples of post-commercial production research include:
- Trial production runs
- Commercial production costs
- Troubleshooting faults and bugs
- Research after production begins
- Tooling up to start production
- Quality control
- Collecting data relating to production activities
- Advertising and promotional expenses
Activities for adaptation
Suppose a company needs to adapt an existing business component to suit an individual customer’s needs. In that case, the taxpayer doesn’t perform qualified research and therefore cannot claim any R&D tax credit.
Activities of Duplication
Reproducing an existing business component where the plans or specifications are already available does not qualify for research credit. The company must be involved in researching or developing specific modifications to improve existing services or launch a new product.
Research activity related to surveys, studies, or management functions
Qualified research does not include any form of surveys, social sciences, or market research. Additionally, costs associated with management activity like employee training and organizing production is not qualified research expense.
Additionally, there are several other activities not included in QREs. These consist of the following:
- Purchase and improvement of land used in research
- Administrative duties like bookkeeping, budgeting, and payroll
- Managerial activities not directly supporting qualified research
- Employee training
- Customer service support
- Charitable fundraising
An organization can only claim a tax credit for research activities that take place in the United States. Therefore, any foreign research performed outside the US doesn’t qualify for R&D tax credit. This rule applies to contract research and in-house research expenditure.
5 Reasons Businesses Don’t Think They Qualify for R&D Credit
Even though claiming a tax credit for R&D projects is accessible, many companies don’t realize they are eligible for a tax cut. In some cases, it could be due to a lack of knowledge. However, in other cases, businesses mistakenly assume that they are not eligible to claim the credit. For example, a few companies think that the credit is only if they want to conduct scientific research.
Common reasons company executives cite why they don’t file R&D costs in a tax return include the following:
- Not doing groundbreaking work
- The company is too small and probably won’t qualify
- They pay Alternative Minimum Tax (AMT)
- They have concerns about an IRS audit
- They lack the necessary documentation for their federal tax return
Let’s look in more detail at five common misconceptions about tax credit eligibility for R&D.
1. The business doesn’t pay federal income tax
Small businesses and startups can offset up to $250,000 of payroll tax liability per year for up to five years. In total, this can amount to $1.25 million. To be eligible, the business must meet two criteria:
- Have gross receipts less than $5 million for the credit year
- In business for less than 5 years
The tax credit applies to payroll taxes starting the first quarter after the payroll tax credit election for the tax year. For any businesses that pay taxes per calendar year, the credit is applied starting from April the following year.
Suppose a business doesn’t owe income taxes during the current tax year. However, it paid income taxes in the previous year. In that case, the credit can be carried back to the previous year to offset that year’s tax liability.
However, say the business doesn’t owe income taxes during the current year or previous year. In that case, it is possible to carry the credit for up to 20 years in the future. Some states have even more generous provisions, allowing businesses to carry the credit forward indefinitely.
It is also good to remember that you may be able to claim R&D credits for the previous three open tax years. And depending on the state, there may be a longer window than three years for making retrospective claims.
2. The organization is a research and design company
When claiming an R&D tax credit, a common misconception is that it’s only for businesses with a dedicated research facility. Although most companies don’t have an R&D department, many conduct ongoing research or experimentation to develop better products. For example, the research could be to produce a higher quality product. Or an organization could see a gap in the market and want to develop a product to meet the need.
Examples of industries that can benefit from credit for basic research payments include the following:
- Health care and pharmaceuticals — Develop new drugs, reduce side effects of existing drugs, design equipment to improve health care.
- Communication, media, and technology — Discover ways to produce visual effects, improve streaming services, or using digital equipment.
- Wineries and vineyards — Develop processes to store wine better or utilize by-products more efficiently.
- Retail — Investigate innovative ways to reduce fraud, develop eco-friendly clothing, use natural resources more efficiently.
- Food and beverage — Investigate ways to improve food storage, develop new flavors, reduce the need for chemical additives.
- Construction — Explore new construction techniques, design more efficient heating and cooling systems,
- Professional services — Come up with more efficient ways to streamline operations, implement new technology in processes, or facilitate employing remote workers.
For example, a technology business may want to develop new software to automate business processes. Or a winery may invest in research to improve bottling or packaging processes. Maybe a fashion house wants to create a mobile app to enhance the customer experience. These are just some examples highlighting the wide range of businesses that can benefit from research and development credit.
3. Employees are not qualified scientists or engineers
The research team in an organization doesn’t need to be degree-holding scientists. As long as a business can pass the four-part eligibility test for R&D, it can apply for a tax credit. The employees can have various levels of education and backgrounds.
The essential factor is that they use the principles of “hard sciences” to improve or develop new processes or products. For example, the research team could be experimenting with new prototypes or using trial and error to improve a product.
4. The business is not involved with new development
Credit for qualified R&D services is not only for advancing scientific knowledge or bringing a new product onto the market. Tax cuts are available for improving techniques, software, products, processes, or formulas. Companies can include R&D expenditure on tax returns when investing in improvements to their existing resources.
The critical factor is that a company shows innovation to improve on what it’s already doing. All it needs to do is pass the four-part R&D criteria test.
5. The company pay Alternative Minimum Tax (AMT)
Another common misconception is that businesses subject to AMT cannot claim credit for development and research. A small business is a privately-owned company with average revenue of less than $50 million during the previous three years.
From 2016, small businesses that are subject to Alternative Minimum Tax can benefit from the R&D credit. Even if the company doesn’t make any sales or only has a few employees, claiming for R&D expenses can have a significant impact in offsetting
Frequently Asked Questions About R&D Tax Claims
To help realize the benefits to your company of claiming tax credits for R&A, here are answers to many questions that we frequently receive.
How Does My Company Know If It’s Eligible for the R&D Tax Credit?
Regardless of size, industry, or revenue, almost any company can benefit from tax credits for research and development. The four-part test should show that the company is based in the United States, pays regular federal income tax or similar state tax, and is involved in qualified R&D activities.
The most common industries to benefit from research and development credit are manufacturing, information, and scientific services. However, industries such as wholesale, technical services, health, hospitality, architecture, fishing, transportation, and real estate can all file tax returns with R&D expenditures.
The most important thing to remember is that the type of industry isn’t important — it’s the activities that establish eligibility for federal or state tax credits.
What Documentation Is Necessary to Claim R&D Tax Credit?
Any taxpayer filing for tax credits must retain specific records to substantiate claims. The IRS can carry out an audit to ensure that all in-house research expenses and contract expenses are for qualified services. Failure to provide the necessary documentation could mean that you lose credits for previous tax years.
Examples of documents the IRS requires when submitting Form 6765 include the following:
- Financial information — This includes payroll records of employees who are directly involved in research and design. Also included are QREs for supplies, in-house research expenses, and contract research expenses.
- Records of R&D endeavors — These documents could be records of experimentation tests, project notes, project lists, lab results, and copies of contracts with third-party contractors regarding rights to results.
- Time-allocation determinations — It is also vital to keep minutes of meetings, email correspondence, work plans, and similar documents that provide credible testimony of R&D work.
- Design drawings or reports — Documents showing the results of the research and development project are also vital. These could be documents like blueprints and progress reports. This is required regardless of whether the testing and experimentation processes were a success or failure.
At Cunningham and Associates, we can help determine the correct documents you need to support your claim. The burden of proof relies on the taxpayer to substantiate the credit. Therefore, we can assist you in gathering all supporting documentation to ensure your claim is successful.
What if My Business is Already Getting R&D Credit for Research?
It is possible that even if you already receive tax credits for research, there are additional ways to benefit. Unfortunately, the tax system is highly complex when it comes to filing claims for credit. Cunningham and Associates can conduct a detailed R&D review to explore where you could lower your tax liability even further.
Here are a few ways we can do this:
- Cost and calculation review — A systematic review of your research documentation could find red flags and errors. In some cases, these are due to outdated regulations and files. Additionally, an audit of your work could uncover missed, understated, or non-qualified costs that can help to improve your R&D claim.
- Documentation review — Successful R&D credit claims depend on the proper documentation. Our documentation review ensures you have the necessary records, files, and documents to support your tax return. In addition, we can audit your claim in a similar way the IRS would do to. This gives you peace of mind about current and future tax returns.
- Systems and technology review — Even if you already receive R&D credits, there could be other qualified activities to include in the tax return. We can help identify processes or implement additional procedures to help offset your tax liability even more.
Are There Risks Associated With Claiming R&D Expenditure?
Generally, the risks associated with filing a tax return that include QEDs are no greater than a standard one. However, it is critical to ensure that you seek professional advice to claim R&D tax credits. Here are some reasons why:
- Possibility of increased IRS scrutiny — Usually, there is no increased risk of an IRS audit when filing original tax returns that include R&D expenses than a regular tax return. However, it is possible that amended tax returns claiming R&D tax credit come under more scrutiny. During the audit, the IRS may or may not disallow credits.
- Disallowed credits — If the appropriate documentation does not support claims, there could be issues with credits. If there is substantial proof of qualified R&D activity, then the credits stand. However, undocumented or vague activities may result in disallowed credits. Additionally, there is the “Consistency Rule” to consider. It’s crucial to define QREs in the same way from year to year.
- IRS penalties and interest — If the IRS discovers that R&D claims were made without regard to the rules or regulations, they could impose penalties. This could result in paying 20% of the disallowed credit and possibly interest. However, this event is rare.
To find how your company can offset its taxable income by claiming the R&D tax credit for research activities, contact a member of our team today. We have the expertise to give you the advice you require for filing a tax return that results in a lower bill.