How to Calculate R&D Tax Credit

The R&D tax credit presents a valuable opportunity for innovative companies to get a tax break for their investments in developing new products and technologies. However calculating the credit can be complex, leaving potential savings on the table. Don’t let the details deter you. With the right guidance, you can unlock the full benefits of this powerful incentive.

In this beginner’s guide, you’ll learn step-by-step how to qualify for and maximize federal and state R&D tax credits. We will break down the basics of documenting expenses, selecting the optimal calculation method, and claiming the credit correctly.

Overview of the R&D Tax Credit

The R&D tax credit is a federal tax incentive that allows companies to get money back on their investments in advancing their technologies and products.

Introduced in 1981, its purpose is to encourage American innovation and economic growth by offsetting some of the costs involved in domestic research and development. Any U.S. business that designs, develops or improves products, manufacturing processes, software may be eligible.

The credit can provide substantial tax savings each year – up to 10% or more of a company’s yearly R&D spending. For startups and smaller companies, credits that can’t be used currently can be carried forward up to 20 years to provide refunds down the road.

The benefits are well worth the effort of calculating and documenting the credit correctly. Potential advantages include:

Increased cash flow from direct tax savings
Funding to reinvest in further innovation
Reduced after-tax cost of R&D projects
Competitive edge in your industry

With the basics of what the R&D tax credit is and how your company could potentially benefit, let’s look at the two primary ways to calculate the credit amount.

Two Main Methods for Calculating the Credit

When claiming the R&D tax credit, companies have two primary options for computing the amount of the credit – the regular credit method and the alternative simplified credit method. The approach you use can significantly impact your potential tax savings, so it’s important to understand the differences between the two calculation methods.

In the following sections, we’ll provide an in-depth look at how each method works, when it is best applied, and walk through the steps for calculating the credit under each option.

Regular Credit Method

The regular credit method involves a more complex calculation but can result in a larger credit for established companies with significant R&D spending history.

This approach is best for companies that have steady, consistent qualified research expenses and gross receipts data available since the first year they conducted R&D. This allows the calculation of a baseline “fixed-base percentage” that the credit amounts are based on.

Here are the key steps to calculate the regular research credit:

Determine the fixed-base percentage — This is calculated as the ratio of total qualified research expenses to total gross receipts for a set 5-year period. For most established companies, this percentage will remain constant year-to-year.
Calculate the base amount – The base amount is greater of 50% of the current Qualified Research Expenses (QREs) or the result of multiplying the fixed-base percentage by the average annual gross receipts for the past 4 tax years.
Identify current year qualified expenses — Sum up qualified wages, supplies, contract research and other costs that were incurred in the current tax year.
Find the credit rate — If the current year qualified expenses exceed the base amount, the excess expenses are eligible for the 20% regular credit rate.
Calculate the credit — Multiply the excess qualified expenses by the 20% rate.

The regular method rewards companies that increase research spending over time. However, calculating the fixed-base percentage and base amount can be challenging for established businesses that have not previously claimed the R&D tax credit due to the difficulty in obtaining the necessary historical data

Alternative Simplified Credit Method

The alternative simplified credit (ASC) method does not depend on having as much historical data, making it as easy to use for both older and newer companies, including those with fluctuations in their research spending.

The ASC approach calculates the credit based on a streamlined comparison of the company’s qualified expenses for the current year versus the prior 3 years. This method may result in a smaller credit, but is simpler to calculate.

Here are the key steps:

Calculate the 3-year average qualified expenses – Add up the company’s qualified research expenses for the past 3 tax years and divide by 3 to get the 3-year average.
Determine the base amount – Multiply the 3-year average qualified expenses by 50%.
Identify current year qualified expenses – Sum up qualified wages, supplies, contracts and other costs incurred this tax year.
Find the credit rate – If current year expenses exceed the 50% base amount, the excess costs qualify for the 14% ASC credit rate.
Calculate the credit – Multiply the excess qualified expenses by the 14% rate.

The ASC approach is often better suited for companies that have incomplete records from the Regular method base period or those whose records have been complicated by mergers and acquisitions. While the credit may be smaller than the regular method, it is generally easier to substantiate.

Qualifying Expenses

When calculating both the regular and alternative simplified credits, companies must pay close attention to the types of research and development costs that qualify. The key is to identify expenses that directly support technological advancement.

Some costs that may qualify include:

Salaries and wages paid to employees directly involved in qualified R&D activities, such as engineers, scientists, developers, technicians, and their direct supervisors and support staff.
Supplies used during the research process, like prototypes, testing materials, lab equipment, and software.
Contract research expenses are paid to third-party contractors that perform R&D activities on your behalf.
Cloud computing costs for computer resources used in qualified research.

Meanwhile, other business expenses do not qualify if they support overall operations rather than specific R&D projects. Examples of non-qualifying costs include:

Rent, utilities, maintenance and other facility overhead.
Marketing, sales, and distribution costs.
Research conducted outside the United States.

Keeping detailed records and clearly tracking the purpose of each expense is key to substantiating your qualifying research costs.

Documentation and Record keeping

Thorough documentation and careful record keeping are critical when claiming the R&D tax credit. Companies must be able to demonstrate that specific wages, supplies, contracts and other expenses directly support qualified research activities.

For wage expenses, companies should:

Maintain detailed employee timesheets recording hours worked on eligible R&D projects
Keep records on employee qualifications, pay rates and benefits
Document supervisory roles and expenses

For supplies:

Save invoices showing costs of prototypes, lab materials, testing supplies and usage on specific R&D initiatives

For contract expenses:

Retain copies of contracts describing work performed, costs and terms
Keep invoices from contractors with detail on services provided

In addition, companies must follow IRS contemporaneous record keeping rules by tracking R&D expenses as they are incurred rather than recreating documentation later.

All records related to qualified research should be well-organized and easy to access in case of an R&D audit. Keeping clear documentation tied directly to R&D activities can help substantiate your tax credit claim and avoid delays or denials.

Claiming the Credit

Once you have calculated the credit and compiled the necessary documentation, here are the key steps to claim the R&D tax credit:

File Form 6765 — This form is attached to your federal income tax return. It is used to calculate and claim the credit amount.
Apply against payroll tax (startups) — Eligible startups can elect to use up to $500,000 of R&D credits against their payroll tax liability for up to 5 years.
Carry forward unused credits — If the credit exceeds your tax liability for the year, you can carry forward unused amounts up to 20 years to offset future tax bills.
Claim state credits — Many states offer their own R&D tax credits, which can provide additional state income tax savings.
Maintain records — Keep detailed documentation on hand to support your qualified research activities and expenses.

Partnering with an expert is recommended to ensure you complete all claim forms accurately and receive the maximum benefit from this valuable incentive.

Working with an Expert

With numerous calculations, qualifications, documentation and claiming requirements to follow, tapping into the full potential of R&D tax credits can be challenging. Mistakes can easily result in denied claims and lost savings.

To ensure you receive the maximum benefit from this complex incentive, partnering with an expert is highly recommended. The R&D tax credit specialists at FI Group have years of experience guiding companies through every step of the process:

Helping determine which projects and expenses qualify
Selecting the optimal calculation method
Compiling the required documentation
Accurately calculating optimal credit amounts
Filing correct claim forms