What Qualifies For The R&D Tax Credit?
Did you know that 87% of R&D credits are claimed by companies with over $100 million in revenue? But, these credits aren’t made exclusively for large businesses.
So why do so many small to medium businesses (SMBs) miss the R&D credit?
There are a few reasons:
- Lack of understanding
- Can’t monetize the credit
- The complexity of the calculation
- Fear of audit
We’ll help you understand why SMBs often leave these credits on the table and some options for how to better serve your clients.
History of The Federal Research and Development Tax Credit
Originally established in 1981, the R&D credit was created to encourage innovation by US companies using US workers. Innovation is expensive, so the government tax break intended to offset some of the cost. New innovation leads to the growth of domestic businesses and new domestic jobs. But due to the way the credit was structured, it excluded many companies that create innovation, namely startups.
Until 2015, companies in a startup position that were operating at a loss, or pre-revenue, couldn’t take advantage of this credit. On December 18, 2015, the Protecting Americans from Tax Hikes (“PATH”) Act was signed into law.
The PATH Act wrote the credit into permanent law and made it possible for startups to take advantage of the credit as a reduction to a portion of their payroll taxes.
- No more worry about the credit disappearing
- Huge opportunities for SMBs and startups to monetize the credit
- 7-10% of qualifying spend
- Payroll tax election for Qualified Small Business
- Credit against AMT for Eligible Small Business
- Confidently claim investments in software
This change will have an estimated $11 billion impact over 10 years.
‘Qualified Small Business’
- <$5 million in receipts in the tax year in which it makes the payroll election, and
- $0 receipts in any tax year preceding the five-tax-year period that ends with the tax year of the election (e.g. for a 2019 payroll election, you cannot have had any revenue prior to 1/1/15)
Qualified Businesses can:
- Claim up to $250,000 R&D tax credit against their payroll taxes each year
- Make a payroll offset election for each year they are a qualified small business
‘Eligible Small Business’
- Average annual gross receipts of $50 million or less in the three preceding tax years
Eligible Businesses can:
- Apply credit to reduce Alternative Minimum Tax liability as well as regular tax for tax years beginning after December 31, 2015.
- Traditional scientific work qualifies for the credit, but so do activities in a wide range of industries that develop new products, processes, computer software, or make improvements to these types of technologies.
R&D Industries include:
- Consumer Products
- Medical Devices
- Software Development
- Food & Beverage
So what qualifies as R&D?
- Building new software/tech-based platforms, programs and applications
- Developing and iterating existing technology
- Scientific research and development
- Creating or improving products and services
Do you make anything? Do you have engineers? If yes, then you likely qualify for the R&D credit.
Software development has seen the largest changes over the past couple of years.
Before the 2015 regulations:
- Software that was not built exclusively for lease, license, or sale to third parties was presumed to be internal use
- The concept of ‘Internal Use Software (IUS) was broadly defined
- Work that would or would not qualify was unclear
- Conflicting concepts in regulations were applied in US Tax Court cases
- The 2015 regulations narrowed the definition of internal-use software excluded from qualified research, which expanded the pool of projects that do qualify.
- The role software plays in business today is very different than when the exclusion was enacted in 1986.
- Consideration is given to software that does not solely benefit the taxpayer developing the software
More Software Projects Now Qualify
Software developed primarily for internal use
- Developed for use in general and administrative functions that facilitate or support the conduct of the taxpayer’s trade or business
- Examples: Financial management, human resources management, support services
Software not developed for the taxpayer’s internal use
- Developed to be commercially sold, leased, licensed, or otherwise marketed to third parties (third party commercial exception) or
- Developed to enable a taxpayer to interact with third parties or to allow third parties to initiate functions to review data on the taxpayer’s system (third party interaction/initiation/review exception)
- Examples: vendor management system, customer portal allowing customer access to system data, a website with the capability to take customer orders- not IUS
Qualification: 4 Part Test
Here’s an easy way to see if you qualify for the R&D tax credit:
1: Permitted Purpose
Product, process, software, formula, technique with increased:
2: Elimination of Uncertainty
- Capability or method of development or improvement
- Appropriateness of business component design
3: Process of Experimentation
Evaluate one or more alternatives in an attempt to resolve uncertainty
- Implementation of the scientific method, trial and error process
- Evaluate alternatives, develop/test hypothesis, evaluate results, refine, success/failure
4: Technological in Nature
Activities must rely on:
- Physical sciences
- Biological sciences
- Computer science
The taxpayer must keep documentation of:
- How you met the requirements to qualify for the credit, and
- How the credit was calculated
IRS Audit Technique Guide
If you claim the credit and you are audited, here is the information they’ll want to see.
Information Requests/Areas of Review:
- Breakdown of qualifying expenditures by category- wages, supplies, and contract research expenses
- Calculation approach- cost center, project, specific qualifying expenses
- Base period calculation
- Description of cost centers/accounts included
- Documentation of qualifying wages, supplies, and contract research expenses
- Evidence of excluded activities
- Documentation of how the activity or project meets the Four Part Test IRC Section 41(d)
- Expenditures must be for activities intended to discover information that would eliminate uncertainty concerning the development or improvement of a product.
- Uncertainty exists if information available to the taxpayer does not establish:
- The capability or method for developing or improving the product, or
- The appropriate design of the product
A process designed to evaluate one or more alternatives to achieve a result where capability, method, or design are uncertain as the beginning of the taxpayer’s research activities
Uncertainty must be resolved through a 3-element process of experimentation
- Identify the uncertainty
- Identify one or more alternatives and
- Identify and conduct a process of evaluating the alternatives
80% or more of the taxpayer’s research activities must constitute elements of a process of experimentation for a qualified purpose.
What project costs qualify for the credit?
- Internal Payroll expenses
- W-2 Wages
- Third-party contracting costs
- 1099 contractors work performed in the US
- Supplies used up in the development process
- Cost to maintain development environment, cloud-based data storage, prototypes
How is the credit amount determined?
After establishing a qualifying project, we must show nexus or connection between the project and the qualifying expenses.
Although commonly referred to as the R&D tax credit, the Internal Revenue Code identifies it as the credit for increasing research activities
The calculation of the credit compares qualifying R&D spend for the credit year to some base period amount.
Calculation methods include:
- Regular Metho
- Alternative Simplified Method
Either method can be more beneficial to the taxpayer, so both should be considered.
- Regular Method = 20% of current year QREs in excess of the base amount
- Requires consideration of qualifying spend as a percentage of revenue for the five year period 1984 to 1988 or
- For a company defined in IRC 41 as a startup company, consideration of qualifying spend as a percentage of revenue in years five through ten that the company had qualifying research expenses.
- Alternative Simplified Method = 14% of current year QRE in excess of 50% of prior 3-year average QRE
- Requires consideration of qualifying projects and spend for the 3 years prior to credit year
Credit = 20% of current year QREs in excess of the base amount
- Base amount = fixed-base percentage * average annual gross receipts for the 4 taxable years preceding the credit year
- Minimum base amount 50% of credit year QREs
- Fixed base percentage = aggregate 1984-1988 QRE/aggregate 1984-1988 gross receipts
- Maximum fixed-base percentage 16%
This method of calculating the credit determines the fixed-base percentage using qualifying R&D spend from the mid-1980s.
Alternative Simplified Method
The alternative simplified method allows taxpayers to determine a base amount considering only more current data on qualifying activities
Credit = 14% of current year QRE in excess of 50% of prior 3-year average QRE
Detailed documentation for qualifying expenses is ideal, but estimates are permitted
- Taxpayers claiming the credit are encouraged to retain records “insufficiently usable form an detail to substantiate that the expenditures claimed are eligible for the credit”
- IRS may request any project accounting records and timesheets, however:
- Union Carbide Corp v Comr: court stated that a “taxpayer is not required to substantiate its research credit with any particular types of documents.” The court in this case accepted reconstruction methodologies for both the claimed qualified research expenditures and base year information.
- United States vs McFerrin: court determined taxpayers, in the absence of certain contemporaneous records, may estimate expenses by looking to testimony, institutional knowledge of employees, and other available evidence in determining a fair estimate for purposes of claiming the research credit.
- Statistical sampling is permitted to determine qualifying expenses, but is generally only used by very large companies.
Controlled Group of Corporations
- In determining the amount of R&D credit, all members of the same controlled group of corporations are treated as a single taxpayer, and
- The credit allowable by each member will be based on its share of the aggregate qualified research expense for the group.
- All trades or businesses (incorporated or not) which are under common control shall be treated a single taxpayer, and
- Credit allowable shall be determined based on the share that each person under common control incurred of the aggregate QREs for all persons under common control.
Controlled Group of Corporations
1563(a)(1) Parent-Subsidiary controlled group
- At Least 80% vote or value ownership by a common parent in one or more chains of corporations
1563(a)(2) Brother- Sister controlled group
- 5 or fewer individuals own at least 80% vote or value in more than one corporation
It is important to consider portfolio companies of a common venture capital group. The same majority ownership in different businesses can impact the credit for those businesses.
Monetization of Credits
R&D credits used against income tax are non-refundable general business credits with a 20 year carryover period.
IRC Section 280c(1) requires that deductions are reduced in the credit year by the amount of credit determined for the year
- The result is increase in income tax for reduced deduction before use of tax credit
- The net benefit of the credit is credit amount *(1-tax rate)
Taxpayers can elect on form 6765 of the originally filed tax return to receive a reduced credit under IRC280C(c)(3)
- Credit is reduced by the tax rate in this case but deductions are not adjusted.
Monetization of Credits- Payroll
Use of the R&D credit against payroll tax requires capturing the credit on quarterly form 941 and filing form 8974 each quarter. Full utilization requires coordination with client payroll providers.
- Real-time application of credit- reduction of payroll tax impounding during the applicable quarter
- IRS refund- refund of the tax offset by credit provided to the taxpayer directly by IRS, or indirectly through a refund issued to the PEO then remitted to the taxpayer
- Credit not supported- some payroll providers do not support the credit; using the credit requires amending quarterly payroll tax returns
Submission and Tracking of Credits
- Payroll providers have varying processes for receiving client credit information and tracking use
- Single submission vs quarterly submission
- Electronic submission of credit details vs email submission of completed tax forms
- Access to reporting of credit use vs quarterly requests made of provider
IRC Section 311(f)(4)- Credit shall not be taken into account for purposes of determining the amount of any deduction allowed under Chapter 1 for taxes imposed under subsection (a).
- Adjustment of deductions by credit amount is not required.
- IRS has been sending notices expressing concern where deductions are not adjusted by the credit amount.
Amending Returns for R&D Credits
How far back can you go?
Income Tax Credit: Returns can typically be amended to claim the R&D tax credit as long as the statute of limitations for the tax year has not yet run out. There is potential to adjust closed years for open items in some circumstances.
Payroll Tax Credit: Making the payroll election on an amended return, if missed on the originally filed return, was permitted through 12/31/17.
Employee Retention Tax Credit
Established as part of the ARES Act in March 2020, there was a limitation that prevented employers from claiming the ERTC if they received a PPP loan. The restriction will likely be removed. Although the Senate and House are still deciding the structure of the legislation, your customers may be eligible to claim ERTC in addition to the R&D tax credit
- The R&D tax credit and ERT are both credits against payroll tax
- ERTC is fully refundable, use R&D credit against FICA tax obligation then claim ERTC
- Full or partial shutdown with material impact on business, or
- Experienced a significant decline in gross receipts (50% CARES, 10% HEROES, 25% HEALS)
- Tax credit percentage: 50% CARES, 80% HEROES, 65% HEALS
The R&D tax credit is a significant benefit. It’s important to get it right.
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