Innovation is the lifeblood of any economy. Since Benjamin Franklin tied a key to a kite string, American entrepreneurs, inventors, researchers and tinkerers have probed the limits of science to discover new concepts and create new products.
That’s why research and development (R&D) tax credits still matter. R&D tax credits help ease the financial barriers to innovation. However, IRS rules for claiming R&D tax credits can be arcane, and an unwelcome amortization by Congress has imposed a hefty tax burden on many companies that rely on R&D to expand their product lines.
Here, especially for tax preparers working with small and mid-sized businesses, is R&D tax credits explained. Learn the rules, and you can help your clients reach new heights in innovation.
What is the R&D tax credit?
R&D is vital to business growth but can drain resources while delivering only a promise of eventual returns. Since their introduction in 1981, R&D tax credits have helped close the gap. R&D tax credits offer dollar-for-dollar cash savings toward the development, design or improvement of products, processes, formulas or software.
Those credits can generate cash for hiring additional employees, expanding facilities or even ramping up R&D. They can also offset the alternative minimum tax, and startup businesses can utilize them against payroll taxes.
In fact, 35 states have adopted their own R&D tax credits. Many follow federal regulations and IRS guidance, but there are exceptions in thresholds and definitions, so it’s wise to check.
Industries that could qualify for R&D tax credits include:
- Architecture and Engineering
- Chemical and Formula
- Food and Beverage
- Life Science
- Software Development
- Tool and Die Casting
- Wineries and Vineyards
What are the benefits of R&D credit?
It’s easy to see the advantage of reducing federal and state income tax liability dollar for dollar. For small and mid-sized businesses, the tax credit creates a much-needed source of cash. Through R&D tax credits, businesses can:
- Reduce federal and state tax liabilities for current and future years.
- Increase market value, earnings per share and cash flow.
- Lower their effective tax rate.
- Keep more of the profits.
Tax filers can carry the credit forward for up to 20 years or do lookbacks to find unclaimed credits for open tax years, usually up to three or four years.
However, amortization rules from the 2017 Tax Cuts and Jobs Act put a damper on the credit’s benefits. Amortization, which was intended as a placeholder, remains in effect and requires that businesses amortize their U.S.-based R&D costs over five years and their foreign costs for 15 years. While Congress dickers over repeal, companies are watching their tax liabilities skyrocket. However, tax experts still advise businesses to track their R&D expenses and watch for a reversal with, it’s hoped, make-up provisions for reclaiming lost revenue.
Do I qualify for R&D tax credits?
Businesses claiming R&D tax credits must meet these criteria of a four-part test:
- Technological in nature: R&D must focus on discovering information and be steeped in hard science, such as computer science, engineering, biological sciences or the physical sciences.
- Permitted process: Activities must be intended to develop a new or improved business component for a permitted purpose, such as the functionality, quality, performance or reliability of the business’ products, internal-use software, inventions or techniques. The R&D doesn’t have to succeed to qualify.
- Eliminate uncertainty: Qualifying R&D explores new approaches in designs, methods or capabilities to achieve an intended result. The business owner can’t know, at the outset, whether a product or design is feasible or technically sound. They also can’t know how the result will be achieved.
- Process of experimentation: R&D must involve scientific experimentation and evaluation of alternatives, being systematic about modeling, trial and error, testing and simulating.
You’ll find R&D tax credit rules and regulations in Section 41 of the Internal Revenue Code.
How to claim R&D tax credits
It’s important to note the “hard sciences” element of the four-point test. The “soft sciences,” such as psychology, anthropology and political science, are excluded. While a forward-looking restaurant or psychology practice might be constantly probing for better procedures and higher-level practices, they can’t claim the credit. The same goes for businesses in the humanities, such as a dance troupe or museum. They are likelier to be audited if they try to claim R&D tax credits.
Qualified research also does not include surveys, advertising, or market research; duplication or adaptation of an existing business component; research conducted outside the U.S.; or research funded from a grant, government, or other outside entities.
No matter who claims the credit, the IRS has strict documentation rules, putting the burden of proof on the taxpayer to prove that the research qualifies. Knowing how to claim the R&D tax credit includes retaining every scrap of related documentation, including:
- Payroll records for employees involved.
- Expenses, receipts and accounts for supplies and equipment.
- Contracts and invoices paid to any third-party partners.
- Blueprints, patents, designs, drawings and prototypes.
- Project and meeting notes.
Help your clients gain an edge
The rules are changing, but R&D tax credits remain valuable for sparking innovation and economic growth. Tax preparers and advisers who offer help claiming R&D tax credits perform a valuable service for clients seeking ways to gain an edge on the competition and break into new markets. Surgent Income Tax School offers a broad range of timely CPE courses tailored to taxation trends and equips tax preparers to navigate the complex waters of IRS codes.
Surgent ITS can even help you learn how to start and grow your own business, making you the go-to adviser for clients seeking trusted guidance on taxation, including how to leverage R&D tax credits to take their businesses to the next level.