What is the R&D Tax Credit & How Does it Work?

The R&D Tax Credit is the biggest tax credit available to U.S. businesses, yet also one of the most underutilized.

Home > What is the R&D Tax Credit & How Does it Work?

The Credit for Increasing Research Activities exists to reward American companies for their investment in research and development activities domestically. Each year, the R&D Tax Credit yields billions of dollars of benefits to companies engaged in qualifying research.

How Does The R&D Tax Credit Work?

Singed into law by congress in 1981, the U.S. Credit for Increasing Research Activities – also called the R&D Tax Credit – helps companies remain competitive by providing a non-refundable federal and potential state income tax credit to offset taxes owed for qualified expenditures. U.S. companies are able to claim the credit by quantifying their total qualified expenditures by category and filing the corresponding Form 6765 on their annual tax returns.

For companies in their first 5 years of business with less than $5 million in gross receipts, a company may be eligible to apply the credit to their quarterly payroll tax bill and earn up to $250,000

Types of Qualifying R&D Expenditures

There are four categories of costs that can qualify for a particular R&D project which ultimately account for the credit claim – employee wages, contractor expenditures, supply or material costs, and computer lease and rental expenses. Each particular category’s criteria for qualification is established in Internal Revenue Code § 41 (26 U.S. Code §41) and further expanded upon in treasure regulations and various case law.

How R&D Credits are Calculated

The credit is calculated through an incremental comparison of the expenditures incurred in the tax year in question to the expenditures incurred in a historical timeframe. The most common method is the Alternative Simplified Credit Methodology which applies the delta of the current year’s R&D spend minus the average of the three previous years divided by 2, to a 14% factor.

Since these credits get filed and reported on annual tax returns, the deadlines follow and match the statute of limitations, allowing for a look back period of three years for open returns.

In the event a taxpayer does not have enough tax liability to utilize all of a credit being generated in a particular year, the credit carries back one year, and then forward up to twenty years.

Benefits of R&D Tax Credits

Investing in research and development is vital to innovation, and innovation is the driving force of the American economy. R&D efforts also help create and maintain technical jobs in the United States.

With no limit on the R&D Tax Credit funding, U.S. businesses can expect to receive several potential benefits with as much as $0.14 in return for every dollar investing in R&D. These benefits might include:

  • A reduction in your company’s federal and state tax liabilities.
  • Carrying forward money saved to reinvest in further research and development.
  • An increase in your cash flow.
  • Generating higher company profits and solidifying your business presence.
  • Gaining the technological advancements to maintain competitiveness.

Many Types of Businesses Qualify for R&D Tax Incentives

In order to qualify for the benefit of the credit, a company must be a U.S. for-profit taxpayer performing or funding research and development in the United States. It is a common misconception that research and development refers only to research activities conducted in laboratory environments.

Today, the list of industries and sectors that can take advantage of the R&D Tax Credit is growing. In fact, a vast number of American businesses (of all sizes and across a wide range of sectors) may already be involved in activities that qualify but are not yet claiming the credit. Industry sectors with businesses that commonly qualify for R&D Tax Credits include:

Challenges in Claiming R&D Tax Credits

As case law continues to evolve, staying abreast of precedential changes that impact the R&D Tax Credit analysis can be a challenge for most taxpayers. It is imperative to work with R&D tax experts to ensure qualification of projects and quantification of expenditures is accurate and adheres to the corresponding governing statutory authority.

Furthermore, as these credits are claimable on amended returns, the IRS recently expanded the requirements to include a detailed report providing 5 details of information relating to the R&D projects. The 5 items required are as follows:

  1. Identify all the business components (as defined in IRC § 41(d)(2)(B)) that form the factual basis of the IRC § 41 research credit claim for the claim year
  2. All research activities performed by business component
  3. All individuals who performed each research activity by business component
  4. All information each individual sought to discover by business component
  5. The total qualified employee wage expenses, supply expenses, and contract research expenses included on Form 6765

Learn more about what qualifies for R&D and how it may benefit your business by contacting one our our experts.