From manufacturing companies streamlining processes to architecture firms developing innovative building plans, businesses in a wide variety of industries routinely conduct research and development (R&D) activities. Unfortunately, however, many of these businesses do not realize that they may qualify for the R&D Tax Credit, a dollar-for-dollar federal tax credit that offers a powerful way for business taxpayers to boost their net profits.
While businesses that successfully claim the R&D Credit may save hundreds of thousands of dollars in taxes, this valuable incentive is widely misunderstood. Here are answers to ten frequently asked questions to help demystify the R&D Credit:
- What is the R&D Tax Credit?
Also known as the Research and Experimentation (R&E) Tax Credit or the credit for increasing research activities, the federal R&D Credit was created in 1981 with the goal of encouraging American businesses to innovate. This incentive is available to business taxpayers that incur qualified research expenses (QREs) in the process of conducting qualified research activities, such as the development of new or improved products, processes, or software.
- Will the R&D Credit be available in future tax years?
Yes. For many years, the R&D Credit was not a permanent part of the tax code. It lapsed every few years but was almost always renewed by Congress due to its widespread popularity. However, this pattern created uncertainty, which impaired the utility of the credit for both taxpayers and society as a whole—when there was doubt about whether or not the credit would be renewed, businesses were less likely to pursue costly innovative activities. Fortunately, the Protecting Americans from Tax Hikes (PATH) Act of 2015 permanently added the R&D Credit to the tax code, so businesses can rely on its existence now and in the future.
- Isn’t the R&D Credit only for companies that engage in scientific research or develop revolutionary new products?
No! One of the most common and damaging misconceptions about the R&D Credit is that it is only available to scientists in white lab coats or high-tech companies creating the next major breakthrough. In reality, the R&D Credit rewards businesses of all sizes in a wide range of industries, including architecture, engineering, manufacturing, and construction.
- What types of activities qualify for the R&D Credit?
Just as businesses in several different industries may be eligible for the R&D Credit, a wide variety of activities could be considered qualified research. A few examples include: pursuing green building initiatives; developing models or prototypes; evaluating new materials or design concepts; and improving tools, machinery, or equipment used in the manufacturing process. To be considered qualified research, an activity must satisfy each prong of the following four-part test:
- The activity must be intended to create new or improve the existing functionality of a business component.
- The taxpayer must seek to eliminate uncertainty about the activity.
- In attempting to eliminate the uncertainty, the taxpayer undertakes a process of experimentation designed to evaluate one or more alternatives.
- The process of experimentation is scientific in nature and relies on physics, biology, engineering, or computer science.
- Are there certain types of research activities that do not qualify for the R&D Credit?
Yes, there are several activities that are specifically excluded from the credit. For example, businesses generally may not claim the R&D Credit for activities conducted outside the U.S., the routine testing of products or materials for quality control purposes, research in non-scientific disciplines like the arts, humanities, or social sciences, and activities conducted solely with the goal of improving a product’s aesthetic appeal.
- Is it worthwhile for businesses that do not have significant income tax liabilities in the current year to pursue the R&D Credit?
Yes, many businesses with lower income tax burdens may still be able to take advantage of the R&D Credit. In addition to making the credit a permanent part of the tax code, the PATH Act expanded its availability to smaller businesses and start-ups. Specifically, the new law allowed businesses that have been in operation for fewer than six years, have gross receipts of $5 million or less in the current tax year, and did not have any gross receipts in the previous five years to apply up to $250,000 per year of R&D Credits against their payroll tax liabilities. Taxpayers may also carry the credit back for up to three years and forward for up to 20 years in order to reduce their tax burdens as needed.
- Does the alternative minimum tax (AMT) limit a taxpayer’s ability to take advantage of the R&D Credit?
The AMT was designed to prevent taxpayers from eroding their tax burdens by requiring them to pay tax at a designated minimum rate, regardless of available credits and deductions. However, recent changes have reduced AMT limitations for both businesses and individuals, so many taxpayers now face fewer restrictions when claiming the R&D Credit and other incentives. Businesses are advised to consult a tax professional in order to determine whether their credits will be limited by the AMT.
- What are QREs under the R&D Credit?
Qualified research expenses (QREs) are expenses that a business incurs in conducting qualified research under the R&D Credit. QREs include amounts paid for supplies, wages paid to employees who engage in qualified research or those who directly supervise or support these employees, and amounts paid to third parties who are under contract to perform R&D activities. The credit amount that a taxpayer receives equals a percentage of QREs over a certain base amount, up to a net thirteen percent of QREs.
- Are R&D Credits available at the state level?
Yes. Several states offer businesses tax credits for engaging in R&D activities, and most of these states follow the federal guidelines for determining what constitutes qualified research. Therefore, businesses may be able to claim both state and federal R&D Credits without much additional effort. At Capital Review Group, we have found that savings through state R&D Credits are often more substantial than savings at the federal level. For example, we recently worked with a mid-sized engineering firm in Phoenix that qualified for substantial state and federal R&D Credits. Based on activities like testing different design concepts, developing environmentally friendly plans, and complying with complicated building codes, the firm was able to save up to $152,000 per year in federal R&D Tax Credits and up to $234,000 per year in Arizona R&D Credits.
- What should businesses do if they think they may be eligible for the R&D Credit?
Claiming the R&D Credit is a complex process that requires thorough documentation—but if their claims are successful, businesses will be able to significantly reduce their tax burdens, thus freeing up capital to reinvest in their operations and future growth initiatives. Necessary documentation may include employee time sheets, payroll records, state and federal tax returns, and project lists. In order to assess potential eligibility and maximize savings under state and federal R&D Credits, businesses should consult experienced tax professionals like the team at Capital Review Group. At CRG, we have helped businesses in a variety of industries significantly boost their bottom lines through the R&D Credit.
Need additional information on the R&D Credit or think that your business may qualify? Contact CRG today at 877-666-5539 to schedule a pro bono analysis!