The R&D Tax Credit is an incentive credit for entrepreneurs under section 41 of the Internal Revenue Code that is headed as ” 26 U.S. Code § 41 – Credit for increasing research activities“.Under this provision of law, a portion of the expenditure incurred by the taxpayer in carrying on research (R & D) necessary for carrying on business is allowed tax credit. Hence, this tax credit is a super saver on tax for small businesses. The federal government and many states also provide incentives for R&D by business entities.
Under the newly enacted Inflation Reduction Act, Qualified Small Business (QSB) is allowed to use their qualified R&D credits up to $500,000, i.e. to offset the 6.2% employer portion of Social Security payroll tax liability, up to $250,000 and an additional $250,000 that can be used to offset the 1.45% employer portion of Medicare payroll tax liability.
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What is the R&D tax credit?
The research and development tax credit or R & D tax credit is designed for companies developing new or innovative products, processes, computer software, techniques, formulas or inventions that result in new or improved functionality, performance, reliability, or quality. The research tax credit is available at the federal and state level, but this post is devoted to the Federal tax credit for R&D.
Simplified R&D Tax Credit Calculator
Who is Eligible for the R&D Tax Credit?
The companies can be eligible for the R&D tax credit for product development, activities, and operations, such as new manufacturing processes, software development, and quality enhancements. Start-ups may also be eligible to apply for the R&D tax credit against their payroll tax for up to five years. A business organization could be eligible for the R&D tax credit if it:
- invests time and money in creating new or innovative products or improving existing products or
- invests in developing processes, patents, prototypes, or software and
- to improve products or build innovative products, hires designers, engineers, or scientists
The Research and Development Credit is available across many industries:
Aerospace, Agriculture, Architecture & Engineering, Automobile, Brewery, Cannabis, Chemical & Formula, Fabrication, Food & Beverage, Foundry, Life Science, Machining, Manufacturing, Software Development, Tool & Die Casting, Winery & Vineyard.
Is R & D Tax Credit Prospective or Retroactive?
The research tax credits can also be retroactive as the law allow you to claim the R&D credits for three prior open tax years. Some states also allow more than three years for retrospective claims. The Loss companies may be able to go back even further;
What are the methods of computation of R & D Tax Credits?
There are two methods of computation of R & D tax credits -the Traditional Method and the Alternative Simplified Credit Method.
Under the traditional method, you get research credit @ 20% of the company’s current year qualified research expenses over a base amount. But, the pain point is the calculation of the base amount, which is the product of a fixed-base percentage, and the average annual gross receipts of the company for the prior four tax years.
Alternative Simplified Credit method
The Alternative Simplified Credit (ASC) method for calculating the research credit is generally adopted by companies who forgot to claim the R&D tax credit in the past or by those companies who don’t have the data necessary to determine their historically qualified research expenses. The alternative simplified credit method involves a four-step process:
- Identify and calculate the company’s average qualified research expenses (QREs) for the prior three years.
- Multiply average QREs for those three years by 50%
- Subtract half of the three-year average (Step 2) from current year QREs.
- Multiply the result of Step 3 by 14%
What Documentation Must You Maintain to Claim the Credit?
The R&D tax credits may be claimed for current and prior tax years there is an increased chance of an IRS audit. There may be cases where you will be asked to substance your claim – both eligibility and the actual credit claimed. So, the law compels you to have proper documentation on the research activities and establish the amount of qualified research expenses paid for each qualified research activity. The research expenses should primarily be based on a factual basis. Examples of contemporaneous documentation include these items:
- Payroll records
- General ledger expense detail
- Project lists
- Project notes
- Lab results
- Emails and other documents a company produces throughout the regular course of business
These records, combined with credible employee testimony, can form the basis of a successful R&D credit claim.
What form is required for claiming R & D tax credit?
You need Form 6765 to claim the research tax credit. This form is used for computing.
- Figure and claim the credit for increasing research activities.
- Elect the reduced credit under section 280C.
- Elect and figure out the payroll tax credit.
Read the IRS instruction for Form 6765
Which states offer R&D Tax Credits?
Apart from the Federal tax credit for R&D, most of the states currently provide R&D Tax Credit. Except twelve states listed below, all states in the United States offer the R&D Tax Credit.
District of Columbia, Missouri, Mississippi, Montana, Nevada, Oklahoma, Oregon, South Dakota, Tennessee, Washington, West Virginia, Wyoming
Please note that the calculation methodology varies significantly from state to state. For example, some states provide a refund or exchange of unused R&D Tax Credits so that even if a taxpayer has no tax liability, it can still derive a cash benefit. Also, most states require research activities to be conducted within their borders to qualify.
What can the R&D Tax Credit be used for?
Research and Development Credits can be used to adjust current or future income tax liabilities. The IRS issues a cash refund for companies filing amended, prior-year returns in which income tax was paid. For startups with no tax liability, the R&D Tax Credits can be used to offset payroll taxes.
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