Inflation. It’s a word disliked by many, from individuals struggling with a higher grocery bill to businesses trying to achieve a strong profit without markedly raising prices.
To assist business owners financially, the United States government has enacted numerous pieces of legislation over the years, one of the most recent of which is the Employee Retention Credit (ERC). The ERC offers a refundable tax credit for eligible employers on the payroll taxes paid to on qualifying wages during the COVID-19 pandemic.
Although understanding the complexities of the ERC is often somewhat difficult for business owners, it’s a tax credit not as overlooked as the Research and Development (R&D) tax initiative. Also known as Research and Experimentation (R&E) tax credit, it was created to make research activities more affordable for businesses.
How does the R&D initiative achieve this? As a dollar-for-dollar tax credit, it enables businesses to directly reduce their tax liabilities for research and experimentation efforts that support the creation and distribution of new products and services. Basically, businesses that qualify for the R&D tax credit can deduct the cost of qualified research and innovation from their taxable income.
Here’s where it gets a little more confusing: many states — but not all — offer their own version of the R&D tax credit, meaning businesses that qualify can claim it at both the federal and state level.
Why is the R&D Tax Credit So Important for Businesses?
A lot of businesses eligible for the R&D tax credit don’t think they qualify for it. However, U.S. companies across more than 65 industries are eligible to claim it.
What’s the big benefit? For one, small businesses can utilize the R&D credit to offset payroll taxes of a current tax year — if their expenditures are greater than a certain base amount. Plus, depending on when that return was filed, it allows them to potentially receive a cash refund for the taxes they paid in the past three years.
For small businesses without an income tax liability, the R&D credit can be used to offset the FICA portion of their payroll taxes — up to $250,000. Overall, it helps businesses to increase their market value and cash flow, retain more of their profits and lower their effective tax rate. For the government, the goal of this credit is to stimulate economic growth by encouraging businesses to invest in research and innovation.
Eligibility Criteria for the R&D Tax Credit
If you don’t think the industry in which your business operates qualifies for the R&D tax credit, you might want to examine the rules a little more closely. Although this certainly isn’t a comprehensive list, companies in the following industries often are eligible for it:
|Food and Beverage
|Tool and Die Casting
The R&D credit is available to any U.S. business engaged in domestic research activities, regardless of its size or industry. These companies must be creating new or innovative products, redesigning existing ones, developing new processes, techniques, prototypes, formulas or software.
Other activities that may enable businesses of any size to qualify for the credit include developing intellectual property and hiring engineers and designers who are engaged in qualified activities. Sometimes, a company is eligible for the R&D tax credit if it manages certain types of employees, such as plant operators, assembly technicians, drafters, fabricators, machinists and various engineers.
It’s important to note that as of 2022, businesses’ research and development expenses for employee salaries and payments to third-party contractors are no longer tax deductible. Under the newer rules, companies must capitalize and renumerate such expenses over five years for domestic activities and 15 years for foreign ones.
Another R&D eligibility criteria is that a business must have less than $5 million in gross receipts for the current year and no more than give years of generating gross receipts — including the current year. One way you can find out if your company qualifies for this tax credit is by visiting the Internal Revenue Service (IRS) website and examining regulations in Section 41 of the Internal Revenue Code (IRC).
Some businesses are eligible for the R&D tax credit through the 80 percent rule. What exactly is it? It’s a rule that lets businesses claim 100 percent of the W2 wages they paid to employees who spent 80 percent or more of their time engaged in or supervising qualified research and development activities.
A Step-by-Step Guide: How to Claim R&D Tax Credits
The IRS’ offers a four-part R&D credit qualification test for businesses. Take this test to find out whether your company and/or project is eligible.
Once you’ve verified that your business qualifies for the R&D credit, the next step is to calculate the amount of your claim. The best way is to multiply the fixed base percentage by the average of your business’ gross receipts from the past several tax years. Gross receipts are the total amounts of sales a business has — without eliminating expenses or costs.
There are multiple steps necessary to file for your R&D tax credit. Here’s an overview of the process:
- Procure the appropriate documentation. Examples include:
- Charts of accounts
- Employee W-2s
- Payroll registers
- General ledger expense details
- Meeting minutes
- Project lists and notes
- Service contracts
- Find IRS Form 6765: Credit for Increasing Research Activities. Read through the corresponding instructions.
- Document your qualified R&D expenses by filling out sections A through D (the parts that pertain to your claim) of IRS Form 6755. You must include a thorough breakdown of all the business components related to your claim and submit the total cost of employee wages, qualified supplies and contracted research. A business component consists of any of these that are used in trade or for sale, lease or license:
- Attach IRS Form 6755 to your tax return. It should be filed as part of your Annual Income Tax Return for C-Corporations and accompanied by a completed 1120 package, including these two forms:
- IRS Form 3800: General Business Credit
- IRS Form 8974: Qualified Small Business Payroll Tax Credit for Increasing Research Activities. This form should be filed quarterly one your 1120 package has been submitted.
Common Challenges in Claiming the R&D Tax Credit
Perhaps the biggest obstacle many businesses encounter in taking advantage of the R&D tax credit is a lack of awareness about it — including the qualifications. They either don’t realize their R&D activities qualify for the credit or aren’t equipped with sufficient documentation to claim it.
Another challenge in claiming the R&D credit is understanding all the changes through which it has gone. Although it was introduced in 1981 as a temporary tax incentive under Section 41 of the IRC to drive investment in new technology, it wasn’t permanently extended until 2015. The newest round of revisions to the R&D tax credit came in 2022.
The Role of a Tax Professional in Claiming R&D Tax Credits
Understanding the bevy of IRS rules and regulations can be frustrating for any business owner. At StenTam, our specialty tax associates will review your specific data to estimate the credits you may be eligible for and project the claim timeline. They’ll do this by examining your expenditures, base amount, tax rate, contract research and gross receipts in all open tax years. If there are no credits to be claimed, there is no cost to you. Plus, with our compliance-first approach, you’ll receive full audit protection support to defend your claim if it’s scrutinized by the IRS or state tax authorities.
Contact StenTam today to learn more about how to begin filing for R&D credits.