Technology and innovation rule the markets these days. Consumers are demanding more efficient, and innovative products that make their lives easier. Many companies are forced to find ways to innovate new products and processes, and improve existing products, in order to compete with competitors and meet customer demands. This takes time and money. The R&D tax credit, can help alleviate some of the financial burden companies feel during the research and development phase of creating new products and revamping existing products.
What is the R&D Tax Credit?
The R&D tax credit has been around since 1981. Although initially it was created as a two year incentive, it has been apart of the tax code ever since. In 2015 it received permanent status as part of the Protecting Americans from Tax Hike (PATH) Act. The R&D tax credit is designed to relieve US companies of some of the financial burden associated with R&D (research and development). It is available to US companies who seek to develop new, improved, or technologically advanced products or trade processes. It is also available to companies looking to improve performance, functionality, reliability, or quality of an existing product.
Changes to the R&D Tax Credit Under the PATH Act
In addition to earning permanent status under the 2015 PATH Act, there were two other significant chances.
First, the PATH Act enabled small businesses to take the R&D tax credit against their AMT (alternative minimum tax) liability for tax years starting after December 31, 2015. An ESB (eligible small businesses) is defined as a corporation that is not publicly traded, partnership, or a sole proprietorship with average annual gross receipts not exceeding $50 million for the prior 3 taxable years. For newer businesses who weren’t in business for the previous 3 year period, including, the preceding entity, the gross receipts test applies. The total gross receipts for the short tax period will be multiplied by 12 then divided by the amount of months in the short tax period. For partnerships or S corporations, the gross receipts test must be met by the both the entity and the partner or shareholder.
Second, the PATH Act allows startups with no federal tax liability and gross receipts of less than 5 million for the previous 5 years to take the R&D tax credit against their payroll taxes beginning after December 31, 2015. In short, new businesses can take advantage of the R&D tax credit to offset their payroll taxes. To take advantage of this, companies need to have filed the tax credit on their previous years tax return. The offset is available on a quarterly basis, and starts during the first calendar quarter after the tax return is filed. The maximum amount a company can claim under the R&D tax credit is $250,000.
How Does the R&D Tax Credit Work?
The R&D tax credit may be applied to expenses incurred by the taxpayer while performing qualified research activities (QRA) on US soil. Qualified research expenses that are eligible include:
- Employee Wages for qualified services.
- Supplies used and consumed during the research and development process.
- Subcontractors expenses paid to 3rd party QRA contractors. With a 65% allowance of the actual cost.
- Research equipment costs like computer rental fees or fees to cloud service providers.
So, what qualifies as QRA? To qualify as a QRA the taxpayer must demonstrate that the activities are:
- Backed by hard science, engineering, computer science, biology, etc…
- Related to the development of a new or improved business component.
- Involve a process of experimenting, testing, and evaluating that is intended to resolve technological uncertainty.
Some exclusions do apply and include:
- Research that occurs after initial commercial production or implementation of business component.
- Duplication of existing components.
- Surveys or studies related to management functions.
- Market research including advertising and promotion.
- Research conducted outside of the US.
- Research in social science: psychology, sociology, economics to name a few.
- Funded research.
Remember the tax credit must be claimed on the previous years tax return before it can be applied to quarterly filings. Under the current law, amended returns are not allowed to take the credit.
Who Qualifies for the R&D Tax Credit?
Remember in order to qualify for the payroll credit, companies must meet the gross receipts requirement of less than $5 million for the year, and no more than 5 years of gross receipts. *Companies with revenues above $5 million can still claim the credit, but only against income tax liability. To learn more about the R&D tax credit subscribe to our newsletter.
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