Research and Development are two words that many taxpayers don’t think apply to their businesses. However, the Research & Development Tax Credit has changed considerably since its introduction in 1981. Companies are increasingly unaware of their eligibility for the credit because the term R&D is often associated with the idea of scientists experimenting in labs and technicians developing new products.
To Whom Does it Apply?
As companies encounter technical challenges related to developing new or improved products or trade processes and integrating them within their existing business, opportunities can arise to qualify for the R&D credit.
To qualify for the R&D Tax Credit, your R&D activities must satisfy the “Four Tests” laid out by the Internal Revenue Service, and you must bear the financial risk. These Four Tests pose the following questions:
- Was the activity undertaken for the purpose of discovering information that is technological in nature and relies on one of the following sciences – physical sciences,
biological sciences, engineering, or computer science?
- Was the activity intended to develop or improve a product or process which would result in increased performance, functionality, quality, or reliability?
- Was the activity undertaken to resolve a technical uncertainty about the development or improvement of a product or process, which includes computer software,
techniques, formulas, and product designs?
- Did your activity involve a process of experimentation in which more than one hypothesis was tested and there was an evaluation of alternatives in order to
eliminate any technological uncertainty?
Given the broad nature of those questions, businesses in many industries may, in fact, qualify. Here are just a few examples of companies that may not think they would qualify at first glance: architecture or engineering firms bidding on a proposal and evaluating and modeling out several options to overcome a particular issue; a retail store developing a software program for its inventory management system or developing software related to its internet store; a company designing tools, molds, dyes,
and other parts for its operations; a company required to perform certification testing.
Additionally, certain startup businesses, defined as qualified small businesses (QSB’s), can offset R&D credits generated against the employer portion of Federal Insurance Contributions Act (FICA) payroll taxes instead of income tax. A QSB is a corporation (including an S corporation) or partnership, which meets both of the following tests:
- It has gross receipts of less than $5 million for the credit-claiming year; and
- It did not have gross receipts for any tax year preceding the five-tax-year period ending with that tax year.
This allows businesses that had not previously considered the R&D credit (as they had no taxable income to offset) to receive a tax benefit against their payroll taxes.
On Dec. 18, 2015, the Protecting Americans from Tax Hikes (PATH) Act made the R&D credit a permanent credit.
What Expenses Would Qualify?
Expenses that qualify for the credit include:
- Wages paid to employees working directly on the activities (and their managers)
- Amounts paid or incurred for supplies used in conducting qualified research activities
- U.S.-based contractor expenses incurred for services relating to qualifying research activities
Why Should I Care?
The R&D credit is particularly relevant this year, in light of the Tax Cuts and Jobs Act (TJCA). The TCJA makes the credit more valuable because the new lower corporate tax rate of 21 percent indirectly increases the net research credit benefit upon applying IRC Section 280C. Section 280C was enacted to prevent taxpayers from receiving both a tax credit and a tax deduction for the same research expenditures. This section gave taxpayers the ability to take a reduced credit and still take the deduction for
The mechanics of the 280C reduction would take the 20 percent R&D credit rate and reduce this by 20 percent of the corporate rate of 35 percent, resulting in a 13 percent credit (20% – (20% x 35%) = 13%). Under the new tax act, using the new corporate rate of 21 percent, the reduced credit percentage would be 15.8 percent (20% – (20% x 21%) = 15.8%). Thus, the R&D credit would be more valuable than in prior years.
What Else Is New?
Under previous law, taxpayers could elect to expense research and development expenses paid in connection with a trade or business in the year they were incurred. Alternatively, taxpayers could capitalize these research expenses and amortize them over the useful life of the research, but no less than 60 months. These rules remain in
effect until tax years beginning after December 31, 2021.
Under the new tax law, specified research or experimental expenditures paid or incurred in tax years beginning after December 31, 2021 should be capitalized and amortized ratably over a five year period for research conducted in the U.S., and 15 years in the case of expenditures for activities performed outside of the U.S. Amortization of these capitalized expenditures begins at the midpoint of the tax year in which the specified R&D expenses were incurred or paid. Thus, the new requirements may incentivize a company to keep or move its research to the U.S. to gain the benefit of a shorter amortization period.
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