In General
The Research & Development tax credit is the credit for Increasing Research Activities (aka, R&D credit, research credit, meaning R&D, or R&E credit) is a federal tax incentive to encourage companies to spend more money on qualified research activities. The federal credit is filed on tax Form 6765 and is included with a company’s tax return.
Show me the money
For most companies, the credit offsets the amount of taxes due. The cash incentive in the form of a smaller tax bill. After all, a penny of income tax saved is a penny earned.
Offsetting taxes due doesn’t really work for many small businesses. Often, small businesses that are less than 5 years old and earn less than $5mm may not pay income tax. Congress, recognizing that these companies need cash today, allow them to offset payroll taxes with the R&D credit. Similarly, a penny of payroll tax saved is a penny earned.
Any R&D credits that cannot be used to reduce taxes in the current year can be carried forward up to 20 years and used when the company does pay tax. You may want to check with your tax return preparer to understand how you personally can get your hands on R&D credit cash.
What counts as research?
Research might not be what you think it is. The R&D credit rules have a unique definition of research. In short, research means using a trial-and-error process in hopes of learning new information to create a new, or improve an existing product, process, software, formula, or invention. Note research must be conducted within the boarders of the United States to qualify for the credit (including Puerto Rico and Guam).
Don’t worry. If that sounds complicated, remember that it took the federal government over 20 years to come up with it.
In the tax code, qualified research is defined by this 4-part test:
Test 1 – Uncertainty Test
An activity constitutes research or development if two conditions are satisfied:
- The information available to the taxpayer does not establish the capability, the method or the appropriate design of the product (i.e., there is uncertainty)
- The activity is intended to discover information that would eliminate that uncertainty.
Test 2 – Technological in Nature Test
The research must be undertaken for the purpose of discovering information that is technological in nature. (i.e., must rely on the principles of physical science, biological science, computer science, or engineering).
Test 3 – New or Improved Business Component Test
The application of the information being sought must be intended to be useful in the development of a new or improved business component (i.e., a product, process, computer software, technique, formula, or invention).
Test 4 – Process of Experimentation Test
Substantially all (80% or more) of the research activities must constitute elements of a process of experimentation (i.e., a trial-and-error process).
What costs are included?
The following costs may be included in the R&D credit computation:
Wages – This includes the wages associated with the amount of time (often referred to as the qualified %) employees spend on the following activities:
- Direct research activities
- Supervising research activities
- Supporting research activities
Supplies – This includes raw materials, utilities, other costs for supplies used in association with research. Supplies may include full-scale pilot models used in testing.
Payments for Computer Usage – This includes amounts paid to another person for the right to use computers in the course of qualified research.
Contract Research – This includes 65% of the expense paid to any person other than an employee for performing research activities on behalf of the taxpayer.
How much is the R&D credit?
Like everything in tax, that depends. The mechanics of the credit can be complex. And the amount of the credit is added back to tax able income which means there is a difference between the gross credit computed and the net credit benefit received.
Rough Estimate
These high-level computation models may give you a rough estimate:
Regular Credit
- The gross regular credit is 20% of no more than half your qualified costs. So if you’ve done the quick math, 10% of your qualified costs.
- The net credit is approximately 8% of your costs depending on your tax rate.
Alternative Simplified Credit (“ASC”)
- The gross ASC credit is 14% of your qualified costs after subtracting 50% of your average qualified costs from the prior 3 years. So if your spending is consistent year by year, 7% of your qualified costs.
- The first year you compute your credit, the gross ASC credit is 6% of your qualified costs.
State Credits
o Several states offer a state R&D credit. The rules and rates vary from state to state. Some states such as Utah and California offer credits that about match the federal credit. Other states offer much smaller credits.
When you consider all the variables above, you can start to get a rough estimate of your credit benefit. Typically total federal and state net credits fall around 12% of qualified research costs.
