Innovation is a driving force behind business success and the federal Research and Development (R&D) Tax Credit rewards companies that invest in improving their products, processes, or technology.
Many businesses assume this credit only applies to high-tech industries or groundbreaking inventions, but a wide range of activities could qualify. From refining manufacturing methods to developing new software solutions, your company may be eligible for significant tax savings. Understanding the requirements and properly documenting expenses can help you take advantage of this opportunity to reinvest in growth.
What is the R&D Tax Credit?
The Research and Development (R&D) Tax Credit is a federal incentive designed to encourage businesses to invest in innovation within the United States. As a credit (rather than a deduction), it provides a dollar-for-dollar reduction in income tax liability for qualified research activities, helping businesses offset costs and reinvest in future growth.
For this reason, accounting for R&D is a critical step in tax planning for sustainable growth.
Who Qualifies for the R&D Tax Credit?
Regardless of the size of your business or what industry you’re in, you may qualify if you engage in activities that meet the following criteria:
- Permitted Purpose. With this activity, you are trying to develop or improve a product, process, software, technique, formula, or invention. Those are broad criteria that could include almost anything you do to serve your customers better, so this definition is refined with the following.
- Technological in Nature. The activity you’re claiming credit for relies on principles of physical or biological sciences, engineering, or computer science.
- Elimination of Uncertainty. The activity is trying to eliminate uncertainty regarding the development or improvement of a business component.
- Process of Experimentation. The activity involves a process of experimentation, such as systematic trial and error, modeling, or simulation.
Startups and small businesses can also benefit. The Protecting Americans from Tax Hikes (PATH) Act of 2015 allows eligible small businesses to apply up to $500,000 of the R&D credit against their payroll tax liability annually for up to five years. This amount was $250,000 for tax years 2015 to 2022.
Are you curious about your company’s valuation? Read Determining Your Business Valuation By Industry next.
Activities That May Count as R&D
Qualifying activities are not limited to groundbreaking inventions that deserve a big press release. They can include:
- Developing or improving products or processes
- Enhancing manufacturing techniques
- Developing software applications
- Conducting research to resolve technical uncertainties
- Prototyping and testing new concepts
Common Misconceptions About Eligibility
This tax credit can amount to a significant reduction in your tax liabilities. It could potentially support higher revenues, better cash flow, and stronger financial health that leads to business growth.
Still, several myths may prevent businesses like yours from claiming the credit they’re entitled to. We want to dispel these misconceptions here and now.
“Our company is not profitable.”
Unprofitable companies can claim the credit in later years. It can be carried forward for up to 20 years. Keep those receipts.
“We don’t conduct scientific research.”
The credit applies to a wide range of activities that don’t necessarily occur in traditional research labs. We’d venture to say that few businesses aren’t engaged in some kind of R&D every year. If you saw that $500,000 figure earlier and thought there was no way you could be engaging in that much research and development, you may be surprised once you start to add everything up.
If you’ve developed or substantially customized software/apps to meet specific company needs, you could qualify. You likely spent time running tests and may have initiated a pilot program before rolling it out. This is research and development. They designed the R & D tax credit to support you.
And don’t forget about process improvements. If you took a look at a process that wasn’t working, explored possible solutions, and systematically completed steps to improve, that’s what the R & D tax credit is designed for.
“Our projects weren’t successful.”
The credit is based on the attempt to develop or improve, not the project success. As the saying goes, “it’s better to try and fail than never try at all”. Those who set up the R & D tax credit recognized this. If you made a reasonable, systematic—and well-documented—effort to perform a qualifying activity, you can probably claim the credit.
How to Calculate Your R&D Tax Credit
To begin, identify Qualified Research Expenses (QREs). These could include:
- All taxable wages (including stock options and bonuses) for employees directly involved in R&D activities, including those directly supervising or supporting the R&D team or project. Does not include fringe benefits.
- Supplies used in the R&D process. These are non-depreciable and tangible. So, it doesn’t include things like telephone calls, meals, or travel.
- 65% of US-based contract research expenses for clearly defined research services and other services performed by a third party would fall under the “all taxable wages” point above if the entity were in-house.
- Non-capitalized computer costs like cloud services and leasing equipment
Once QREs are determined, businesses can use the Regular Research Credit (RRC) or the Alternative Simplified Credit (ASC) method to calculate the credit. It’s advisable to consult with a tax professional to ensure accurate calculations.
How DHJJ Can Help Your Business Qualify
In this article, we’ve provided the straightforward answers you were looking for. However, when the time comes to claim this credit, things can become complicated quickly. You don’t want to claim expenses that aren’t QRE accidentally. You also don’t want to leave credit money on the table that could help your company save, improve, and grow. You will also need an expert to help you document the qualified expenses.
At DHJJ, our team of experienced business tax experts can help you identify and quantify your qualifying expenses to ensure compliance. We work closely with you—like a partner invested in your success. We help you maximize your tax benefits, allowing you to reinvest in innovation and drive your business forward.Contact us today to learn how we can assist you in leveraging the R&D Tax Credit for your business’s growth.
