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Understanding US Research & Development Tax Credit

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By: Sanika Gore

Many companies must constantly innovate to remain competitive in today’s economy. Luckily, the federal Research & Development (R&D) tax credit offers generous savings for businesses engaged in a wide variety of R&D activities within the United States. It is a common misunderstanding that only large companies qualify for R&D credit. In fact, this credit is available to any business that tries to develop improved, new, or technologically advanced products. It may also be available to companies that work to improve business processes.

How Does the R&D Credit Work?

Businesses that perform research in the United States may qualify for R&D tax credit on their research expenses. The R&D tax credit enables businesses to reduce their federal tax liability based on their qualified research expenses.

Eligible businesses can claim the R&D credit against both regular income tax and alternative minimum tax (AMT).

To qualify for the R&D credit, research must relate to the development of new or improved products and processes (Internal Revenue Code (IRC) section 41). A four-part test can help you determine whether your research and expenses qualify:

  1. Your research aims to eliminate uncertainty.
  2. You’ve evaluated different ways to achieve your desired goal through controlled
  3. Your experimentation process is technological, relying on the hard sciences (such as computer science, engineering, chemistry, and more).
  4. Your research seeks to create a new or improved product or process, striving for innovations in quality, performance, function, reliability, cost savings, or efficiency.

Qualifying Expenses for R&D Credit

Once a company has determined that they perform the right kind of research, the following types of qualified research expenses (QREs) count for R&D tax credit:

  • Wages paid to employees for qualified services, including income that is reported as wages for the purposes of federal income tax withholding
  • Supplies or tangible property (other than land or land improvements, or property that depreciates) consumed during the R&D process
  • Third-party contract research expenses incurred during research for the business, allowed at 65% of cost regardless of the success of the research

Basic research payments made to qualified educational institutions and various scientific research organizations, allowed at 75% of the actual cost incurred

Research Activities that do not Qualify for R&D Credit

Research qualifies for the R&D credit only if it is conducted in the US, Puerto Rico, or other US territories. Further, the research must not be funded by any external source.

Research activities do not qualify for the R&D tax credit if they are:

  • Conducted after a related component has been produced and is ready to sell
  • Adapting an existing business component to a customer’s needs
  • Reproducing an existing business component, partially or wholly
  • Focused on:
    • Style, taste, cosmetic or seasonal design factors
    • Social sciences, arts, or humanities
  • Market research
  • Efficiency surveys
  • Advertisements, promotions, or routine data collection

Claiming R&D Credit Against Payroll Taxes

Certain small and new businesses may be able to claim a portion of R&D credit against their payroll taxes (PATH Act of 2015). Businesses can take this credit can instead of the regular R&D income tax credit. The maximum credit allowed is $250,000 per year for up to 5 years, and it only applies to costs incurred after 2015.

Businesses may qualify if they are corporations or partnerships with gross receipts:

  • Totaling less than $5 million during the taxable year, and
  • Earned for five years or less

The payroll tax credit is allowed only against the employer’s portion of social security liability, or 6.2% of wages paid. It cannot be taken against the employer’s portion of the Medicare tax, income tax withheld, or federal unemployment tax.

  • Businesses planning to claim a portion of R&D credit against their payroll taxes must file timely tax returns (including extensions).
  • In their election, businesses must include the amount of credit they want to have applied to their payroll taxes. This may be revoked only with the consent of the Internal Revenue Service (IRS).
  • After a business elects to take the payroll tax credit on their income tax returns, they may claim the credit on a payroll tax return in the following quarter. Any excess credit is carried forward and applied to future payroll tax liability until the entire credit is used up.

Conclusion

Certain businesses may be able to save a significant amount on tax liability each year with the Research and Development (R&D) tax credit. Consult with an experienced Chugh tax professional today to find out whether your business qualifies – and how much you can save.