Innovation is the key and the force driving many sectors, involving many agents, from companies to institutions and governments. Therefore, it is no surprise that the importance of Research and Development (R&D) activities is being increasingly recognized and promoted, especially by promoting the economic growth of different countries.
Governments incentivize investing in innovation by offering tax benefits through tax credits for R&D. In the U.S., R&D Tax Credit benefits a lot of industries, both small and large corporations that conduct research and development within the country. R&D applies to a wide range of disciplines in the applied sciences field and other technical research areas.
Understanding R&D Tax Credits
The Research and Development (R&D) Tax Credit is a government-sponsored tax incentive that rewards companies for conducting research and development in the United States. The credit was implemented to incentivize innovation throughout the economy, granting funding for companies to promote internal innovation. Research and Development Tax Credits were created to be accessible to businesses of all sizes, with a large list of activities eligible for credit. Every state in the U.S. can offer its R&D Tax Credit, which is typically combined with the federal one. U.S. Companies can benefit from an incremental R&D tax credit, made up of two different incentives known as the Traditional R&D Tax Credit and the Alternative Simplified Credit.
How Does R&D Tax Credit Work?
First, a four-part test is made to determine the eligibility for the R&D Tax Credit, established in the Internal Revenue Code (IRC), and an activity that must meet all parts to qualify. The test consists of:
- Business Component test (Permitted Purpose): the company will have to prove that the activity performed intended to develop new or improved business component (product, process, computer software, technique, invention, or formula).
- Uncertainty Test: a business will have to demonstrate that the project intended to eliminate a technical uncertainty.
- Experimentation Test: to satisfy this test, the applicant will have to demonstrate that they went through a process of assessing different alternatives to achieve the final product or process.
- Technology Test: the company will have to illustrate that principles of physical or biological sciences, engineering, or computer sciences were used during the experimentation process.
With these steps, you can get an idea of whether or not your company may be eligible for the R&D Tax Credit. Typically, the R&D tax credit represents 6% to 8% of a company’s annual qualifying R&D expenses.
Benefits of the R&D Tax Credit
Claiming R&D can result in significant cost savings and other benefits. These benefits include:
- Increasing Cash Flow
- Federal and State Dollar-for-Dollar Income Tax Reduction
- Claim Credits for Open Tax Years Going Back 3 Years
Specifically for startups, we can also mention:
Immediate tax savings
You can get immediate tax savings on your payroll obligations. Instead of waiting until it’s profitable to use income tax credits, you can instantly offset up to $500.000 per year of your payroll taxes to Social Security and Medicare.
Extra money for growth
Saving extra money each year gives startups more working capital to reinvest in growth. Which means hiring more developers, renting better equipment, increasing their marketing budget, or purchasing materials and supplies for further R&D.
Qualifying Activities
The tax credit is available for big and smaller businesses, and if your company conducts any of the following activities, it will likely qualify for the R&D Tax Credit:
- Innovation/customization for product development or an existing business process
- Safety testing for durability or quality
- Tooling and equipment fixture design or development
- Developing computer control programs
- Designing or engineering
- Prototyping and modeling
- Development or enhancement of software applications
- Experimentation of a product or process
- Improvement of operational efficiencies
What does not qualify?
As defined by the IRS, activities that do not qualify include research conducted after commercialization, research that adapts an existing product or process to the needs of a specific customer, surveys, studies, and duplication of an existing product or process. R&D conducts outside of the U.S. does not qualify either.
Eligibility
Eligibility for R&D tax credit is much broader than many realize. Applying not only to product development but also to activities and operations. To be considered eligible for the R&D tax credit, your company must:
- Dedicate time and resources to creating new or innovative products.
- Develop processes, patents, prototypes, or software.
- Hire designers, engineers, and/or scientists.
How can I apply?
First, collecting all the documentation requested is important before submitting your project. The more detailed the documentation you present, the greater your chances of obtaining credit are.
Next, you will complete IRS Form 6765 with your income tax return. Note: credit can be claimed from prior tax years, so it is essential to document your R&D activities and expenditures for evaluation.
Calculation
There are two calculation methods used to determine the Federal Research and Development Tax Credit:
- Regular Research Credit (RRC): 20% tax credit based on the excess amount of QREs (Qualified Research Expenditures) over a determined base amount.
- Alternative Simplified Credit (ASC): 14% tax credit on the difference between the current year’s qualified research expenses and 50% of the average of QREs (Qualified Research Expenditures) of the three prior taxable periods.
These formulas are provided by the IRS so businesses can calculate their correct R&D tax credit. Specifically, the ASC method involves a five-step process, in which you should:
- Calculate your business’s qualified research expenses going back three years.
- Calculate the average of the three totals.
- Multiply the average by 50% to get your credit base.
- Subtract your calculated credit base from the year’s total R&D expenses.
- Multiply this number by 14% to calculate your R&D credit.
New companies that don’t have three years of expense to calculate a credit base can multiply the year’s R&D expenses by 6%. The process might sound simple but requires that you understand which expenses qualify, so it’s important to have an expert view to guarantee that both the calculation and the documentation necessary for your case and company are properly prepared.
How can you reach us?
FI Group is a worldwide R&D tax credit company, with 44 offices across 15 countries and 4 continents, specializing in helping companies finance innovation, and managing Public Tax Credits for Research, Development, and Innovation (RD&I). We have more than 1,800 qualified employees from different areas, with specialists on several fronts ready to support you and your company in identifying and optimizing your investments in R&D activities. a
