The Research & Development Tax Credit became a permanent tax credit under the Protecting Americans from Tax Hikes (PATH) Act of 2015. The Research and Experimentation Tax Credit, AKA the R&D Tax Credit, allows taxpayers to claim a tax credit for qualifying innovation, research, and experimentation. The R&D Tax Credit especially benefits start-ups and small businesses.
If your business conducts research or development, you should take advantage of the R&D Tax Credit because claiming this credit can significantly reduce your tax bill and offset development costs. In this post, we’ll explain why you should claim the R&D Tax Credit. Plus, what qualifies as a research expense, and how to protect yourself from IRS scrutiny.
The Research and Development (R&D) Tax Credit
The R&D Tax Credit fosters innovation and incentivizes long-term economic growth. Furthermore, it creates an excellent incentive for businesses to invest in research and experiment continually.
Best of all, business can carry their credits back one year and forward for twenty years. The carry-forward clause primarily benefits businesses that invest heavily in R&D in their first years of operation but don’t have enough profits benefit from the credit.
As a result of the carry forward credit, businesses benefit from their high investment years when their revenues eventually increase. However, Businesses should evaluate all their expenses to determine if they qualify as a research activity or expense.
Check out our picks for The Best Tax Credits Available Right Now for 2022 using this link.
What are Qualified Research Activities?
Qualified research activities is a label for R&D expenses that meet the IRS’s R&D Credit qualifications. The IRS has a four-part test to determine if an activity can qualify as a research activity:
- The R&D activity must relate to a principle of biological science, physical science, computer science, or engineering.
- The research activity must try to improve the performance, functionality, reliability, or quality of a new or existing component.
- The research activity should try to eliminate the uncertainty of the product development or improvement.
- The activity must follow an experimentation process, including testing, modeling, simulating, and trial.
Businesses don’t have to invent something new or groundbreaking to claim this credit. If the research efforts improve the firm’s products and services, they often qualify under the credit’s terms. Furthermore, the qualifying activity doesn’t have to succeed in qualifying for the credit.
Types of Qualified Research Expenses (QRE)
A QRE is a business expense resulting from a qualified research activity. QREs can result from contracted or in-house research expenses.
- In-house research expenses: These types of expenses would include wages, supplies, and hardware leasing expenses.
- Contract research expenses: Businesses can claim 65% of payments made to an outside independent contractor or organization or 75% of payments made to a qualified research consortium, like a university.
Not sure if your research activities will qualify? Contact us for advice on which activities will count toward your R&D Tax Credit.
How Much Can You Claim?
The R&D Tax Credit is available to all businesses at the federal level. Depending where you live, you could possibly claim at the state level as well. However, percentages vary at the state level. You should talk to an R&D Tax Credit accountant for more details.
Your business can claim the alternative simplified credit or the regular research credit every year. These represent the most common types of R&D Tax Credits. In addition, your business may also claim the basic research credit and energy research credit if your research activities qualify. However, these credits are much more specific. The R&D Tax Credit includes:
Alternative Simplified Credit (ASC)
60% of businesses claim the ASC because it allows them to claim more QREs than the regular credit. The ASC credit provides 14% of the taxable year’s QREs, and it usually adds up to a better deal.
The ASC also allows start-ups that don’t have prior-year QREs to claim 6% of their current year expenses. As a result, you can still claim the credit without historical documentation to measure against.
Regular Research Credit (RRC)
Businesses can claim 20% of qualified research expenses from the current year over the base amount. However, the calculations for the RRC credit are based on the historical percentage of QRE gross receipts applied to the average gross receipts from the previous four years.
Basic Research Credit
The basic research tax credit is for businesses that pay non-profit organizations, like universities, to conduct basic research. Also, this credit is a percentage of QREs above a base amount spent on advancing scientific knowledge that is not intended for commercial application.
However, this credit is very specialized, so businesses need to document all expenses carefully. Always talk to an R&D Tax Credit accounting specialist to ensure your expenses qualify.
Energy Research Credit
The energy research credit is only available to businesses that pay a non-profit organization to advance energy research. Furthermore, This credit allows your business to claim a percentage of the total energy research expenses, and there’s no base amount to qualify.
Check out our R&D Tax Credit Calculator to see how much you can save.
Documents You Should Have to Claim the Research & Development Tax Credit
To avoid scrutiny from the IRS, businesses should provide detailed documentation of their QREs. The R&D Tax Credit allows some estimation for research, but you’re better off evaluating and documenting all research activities and their expenses.
This may incur extra cost to document every QRE, but it will be worth its weight if the IRS comes knocking. You’ll want to have documentation of:
- General ledger expense detail
- Lab results
- Payroll records
- Project lists
- Project notes
- Supply Invoices
By keeping accurate documentation, you’ll strengthen your eligibility for the R&D Tax Credit.
See the latest regulatory guidelines in this post: IRS Announces New R&D Tax Credit Guidelines
Innovative Businesses Should Claim the R&D Credit Every Year: Get Started Now
Your business can’t afford to miss out on the Research & Development tax credit. However, evaluate and document all research activities and expenses to protect yourself against IRS scrutiny. Talk to an R&D tax specialist to maximize your tax credit potential.
Tax Hack specializes in R&D tax credits for SMBs and enterprises, and our experienced team can help innovative tech and internet companies maximize their tax savings. So, we understand the challenges that technology start-ups face, and we can ensure your credit is 100% compliant.