There are a lot of firms that promise to get your business large R&D credits. But what is the R&D Credit, who can claim it, and how to calculate the R&D Credit? Let’s take a look.
What is the R&D Credit?
The full name of the credit is the “Credit for Increasing Research Activities,” but it is most often referred to as simply the “R&D Credit.” The R&D credit is a tax credit claimed on your business tax return. The credit is a dollar-for-dollar reduction in your taxes.
Any type of business is eligible to claim the R&D Credit, including corporations, LLCs, and sole proprietorships. The R&D Credit is claimed based on the time and money spent on qualifying research activities.
To qualify for the credit, your qualified research expenses (QRE) must be in pursuit of a specific qualifying project. A qualifying project can be the improvement of existing technology or the development of new technology.
You can consider other expenses basic research payments (BRPs) and don’t require a specific commercial purpose to be allowable.
Projects must pass the 4-part test to be includable in the credit calculation:
- Activities must have a qualified purpose.
- There must be some level of technological uncertainty whether the technology will work (or how to make it work).
- The development process must include experimentation.
- The research and development must use some form of hard science (such as engineering, physics, biology, etc.).
In order to qualify, projects must meet all four of the criteria above.
Once you’ve figured out which projects qualify under the four-part test, you’ll need to allocate overhead expenses based on your product and function mix. Payroll expenses can be allocated based on time surveys to determine how your employees allocate their time.
To claim the R&D Credit on your return, you file form 6765.
How to Calculate the R&D Credit
There are several options available to calculate the R&D Credit. You can choose the one that is most beneficial for your company.
The Regular Credit Method
The Regular Credit Method allows a business to take up to a 20% credit for QREs over a certain base amount. Unfortunately, calculating the base amount is difficult.
The first five lines of the credit calculation come from your previous work in allocating your products and function mix and the results of your time-based survey for allocating payroll expenses.
The percentage of the base amount varies based on maturity, which we explain in more detail in the next section.
Once you calculate the fixed base percentage, you reduce the credit calculation by the average gross receipts from the prior four years.
This is great for smaller companies with only a few gross receipts.
Limitations of the Regular Credit Method
There are several limitations when calculating your credit using the Regular Credit Method.
Let’s begin with the first limitation, calculating the fixed base percentage.
The fixed base percentage is the percentage of qualified research expenses that are gross receipts in the 1984-1988 period. In addition, special accommodations were made for those who do not fall within that time frame – these accommodations are called the startup method. In order to use this method, there are specific qualifications you must meet.
Examples
Expenses count as a startup if they meet ANY of the following:
- The first tax year in which both gross receipts and QREs occurred after 1983
- There were fewer than three tax years in the period beginning after 1983 and before January 1, 1989, in which the taxpayer had both QREs and gross receipts
In each of the first five tax years in which it has QREs, beginning after 1993, a startup’s fixed-base percentage is set at three percent.
Once the five years have passed as a startup, then you should calculate the percentage as:
- Determining the QREs for a selected period before the credit year
- Determining what percentage of the QREs are of gross receipts for that period
- Multiplying that percentage by a fraction that increases from the sixth to the tenth year (see the current year’s Form 6757 instruction booklet for the percentage that you should use)
Once the company becomes too large, meaning its gross receipts greatly reduce its credit amount, it should switch to the Alternative Simplified Credit method.
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Alternative Simplified Credit Method
This is the second way you can calculate the R&D tax credit can. In addition, the Alternative Simplified Credit Method may benefit certain companies.
This method still uses the same basic pieces we utilized in our calculation’s beginning, like qualifying projects, people, R&D time, and QREs.
The difference is that you should use the ASC method for companies with high gross receipts since this method considers previous QREs instead.
Limitations of the Alternative Simplified Credit Method
One of the most significant drawbacks of the ASC method is that a company must continue to use this method for every year moving forward. Therefore, you must do careful analysis and comparisons before choosing to proceed with this method.
If you form or spin off a new company from the original company using a new EIN, they may start over with the credit methods.
Some states allow you to calculate your state credit using the traditional method, even if you chose ASC for federal purposes.
As discussed above, this credit is reduced by the average amount of the total QREs from the previous three years.
If the company only has QREs from the prior two years, you would only average the two years. So the third year would not count as $0.
This calculation benefits companies that have grown incredibly fast while only claiming the credit for a short period.
Final Step for Claiming the R&D Credit: Electing 280C
In both methods, there is a final step that asks whether you are electing 280C.
280C is a reduction that you can choose to reduce the overall credit amount. To calculate the 280C reduction, multiply the ending credit amount by 15.8% for the regular credit method and 79% for the alternative simplified credit amount.
Why would anyone elect to reduce a credit?
A few reasons have to do with the entity type and cost analysis.
Electing the credit may increase your tax bill since it is income you are getting back. Therefore, if the tax increase exceeds the credit, you would want to reduce the credit.
The tax rate also plays a large part in whether you should choose to reduce your credit amount. This decision is different per entity type:
- C-corps, the tax rate remains constant, and with that, the credit amount should never reduce
- S-corps, flow to personal, so you must take the personal tax bracket/rate into account. If your personal tax rate is:
- Below 22% = do not reduce
- Exactly 22% = must run cost analysis
- Above 22% = reduce
Closing Thoughts on the R&D Credit
These differing credit methods, limitations & reductions, and 280C elections are all factors in why the credit amount may change from the initial estimated number from the functional analysis to the final amount from the filed tax return.
Calculating the R&D credit can be intimidating, but the reward can be worth the additional work by carefully following the steps. Just be sure that you have sufficient documentation to back up your credit calculations in the event the IRS elects to review your return.
