How to Save Cash With the R&D Tax Credit?
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Each year, the federal government sets aside roughly around $50 billion in its research and development tax credit program to incentivize businesses and entrepreneurs to innovate. The R&D tax credit was first temporarily enacted in the Economic Recovery Tax Act of 1981 and was made a permanent federal tax credit as a part of the Protecting Americans from Tax Hikes Act (PATH Act) in 2015.
This policy, in part, aims to increase technical jobs in the U.S and discourage businesses from outsourcing their R&Ds abroad for cheap labor and lower tax rates. Companies in the U.S. pay relatively higher wages and contractor fees. So at the very least, they should be able to keep more of their profits if we plan to retain our competitive position in the global advanced-technology scene.
In addition to the federal program, 36 states currently offer R&D tax credit benefits at the state level as a means to stimulate regional economic growth and facilitate job creation. These tax credits, however, tend to be temporary or sporadic. For example, Oregon’s R&D tax credit expired in 2017 and has not been since renewed as of May 2022.
Nevertheless, many CPAs have not even heard of these R&D tax credits. In fact, only around 18 billion of the $50 billion get claimed every year. The other $32 billion, which is very well needed as a financial boost by many businesses, particularly SMBs, go unclaimed.
Lack of awareness plays a big role, but there are other reasons why only a small percentage of eligible businesses actually take advantage of the tax credit. Many business owners think their company does not qualify because they either have an inaccurate definition of what an R&D activity is or think they need to be profitable to be eligible.
The latter is simply not true because businesses without revenue can utilize the credit to offset payroll taxes as a result of the PATH Act. And as to the former, we are going to break down the requirements in the following sections. The application process for an R&D tax credit will be a time-consuming and arduous task but can save up to 15% of a company’s R&D expenses, which could amount to hundreds of thousands of dollars depending on the scope and nature of the business. And the load could be lightened by getting help from tax experts such as Clarus R&D.
What Makes Your Company Eligible for R&D Tax Credit
To know what activities and expenses qualify for the R&D tax credit, you need to know about four key requirements that must be met.
Permitted Purpose
The intended activity must be to develop or improve a product, process, software, technology, invention, patent, or formula.
Technological in Nature
The activities must rely on the hard sciences such as computer science, engineering, biology, physics, or chemistry. If the first two conditions are met, we can proceed to the next two components.
Process of Experimentation
The activities must include an element of experimentation. So at the outset of the project, process, or activity, did you know exactly how you would proceed? Or did you try processes of experimentation along the way, which include systematic trial and error, testing, modeling, simulating, or evaluating alternative methods, procedures, components, or materials?
Elimination of Uncertainty
Activities and research aimed at finding information that could eliminate technical uncertainty surrounding the development or improvement of a product.
In simpler terms, if you set out to develop or improve something you weren’t able to get right at first, and there were processes of experimentation in connection to resolving technical uncertainty, you’re performing R&D activities, and the expenses associated should be qualified.
Which expenses qualify for the R&D tax credit?
After identifying qualified activities, the next step is identifying the costs associated with those activities. The expenses that we can look at for generating R&D tax credits can be classified into two main categories of labor-based expenditures and supplies or materials.
Wages
The expenses associated with labor cover both w-2 employees and 1099 contractors. As for the employees, the qualified wages are for those who are directly involved and are allocating their time to qualified research activities. These employees are identified as those directly engaged in research and development, such as scientists and engineers, those involved in direct support such as prototype testing or quality assessment groups, and those involved in direct supervision, such as R&D managers and supervisors. The qualified wages in question are limited to taxable wages and don’t include non-taxable fringe benefits.
Contract Research Expenses
The qualified contract research expenses are those that are incurred by hiring US-based contractors and subcontractors to conduct R&D activities on behalf of the taxpayer. However, to be able to claim the credit, the taxpayer must retain ownership rights to the research results and be financially at risk for the research meaning they must bear the expense regardless of whether or not the research has been successful.
Supplies and Materials
A company can claim an R&D tax credit for the costs of supplies and raw materials consumed during the prototyping and testing phases. However, any depreciable procured assets are excluded, even if they are solely utilized for R&D purposes.