What is the R&D Credit?
Established in 1986, the Credit for Increasing Research Activities (a.k.a. the R&D Tax Credit) is one of the most beneficial sections of the tax code. The law allows for a dollar-for-dollar tax credit for any company engaged in “qualified research activities.” Many companies hear the word “R&D” and believe that it only applies to entities making new discoveries through controlled laboratory processes; however, the actual R&D Tax Credit rules expand the definition of qualified research and development. Thus, many companies who do not believe that their activities qualify as R&D miss out on this tax benefit.
What Activities Qualify?
There are numerous sections of the tax code and lengthy U.S. Tax Court rulings defining which activities qualify as R&D and which do not. The main framework for analyzing R&D credit eligibility comes from what is known as the four-part test of the Internal Revenue Code. As long as companies can pass each of the following tests, they can claim the R&D Credit:
Business Component Test: Taxpayers must be working on the development of new or improved products or processes. Special rules apply to firms performing work under contract.
Elimination of Uncertainty Test: Taxpayers must prove that technical uncertainties had to be overcome in the performance of its activities, meaning that the techniques, formulas, designs, processes, etc. needed to complete the project were not known at the outset.
Process of Experimentation Test: Taxpayers must show that the company uses a series of activities to develop and evaluate multiple options for completing the project. The process must be capable of evaluating alternatives. Generally, companies who use any sort of iterative design or trial-and-error process can meet this test.
Technical in Nature Test: The work must rely on the principles of science, engineering, mathematics, computer science, chemistry, etc. to qualify.
What Expenses Qualify?
If a company can show that it meets the four-part test, it can claim the following expenses towards the credit:
- Subcontractor/consultant expenses
- Supplies and materials used in R&D
- Cloud service provider costs associated with development and test server space
Any expense claimed toward the credit must be eligible for treatment as an expense under Section 174 of the tax code. In other words, no items that are depreciated for tax purposes can be claimed.
What Are the Benefits?
In general, for every dollar of qualified research expenditure, a company will receive between 8 and 10 cents of tax credits. These tax credits directly offset any taxes owed. For pass-through entities, the tax credits flow directly to the owner’s tax returns. Taxpayers can also amend tax returns for the previous three open years to claim the credit and obtain a treasury refund. For qualified start-up companies, these tax credits can be used to offset the employer portion of payroll taxes owed.
Companies from numerous industries qualify for this credit including, but not limited to: