Companies that make the biggest impact fuel progress, not just profits. And U.S. employers that champion the future can earn a place in history and a federal research and development tax credit (R&D tax credit).
With the R&D tax credit, companies can secure the incentive needed to pioneer new services, processes and technology. In fact, some businesses may already qualify based on their regular business practices.
However, receiving this tax credit takes more than just filling out a form. But with the right understanding of the credit’s qualification, eligibility may be closer than you think.
What is the R&D tax credit?
The R&D tax credit grants employers a potential $500,000 Social Security tax credit per year — and up to an additional 50% credit against the Medicare tax per quarter — for qualified activities. Introduced in 1981, the R&D tax credit incentivizes innovation. While overwhelmingly applied to technology and biotechnology, a company of any industry can potentially use it.
How does the R&D tax credit work?
Organizations that qualify for the R&D tax credit have two ways to take advantage of it.
One route is for it to be applied to a company’s payroll tax through the employer portion of Social Security and – beginning in 2023 – Medicare taxes. Alternatively, a business can apply the credit to its income tax to offset the alternative minimum tax (AMT). Companies that pursue this option must be:
- a corporation without publicly traded stock
- a partnership
- a sole proprietorship
Normally, a company that wants to offset its AMT can’t have average annual gross receipts that exceed $50 million over the previous three tax years.
The R&D tax credit adds an extra wrinkle. Regardless of how they apply their credit, the employer must be categorized as a qualified small business (QSB). A QSB can’t have any gross receipts over the last five tax years that exceed $5 million.
Benefits of the R&D tax credit
Businesses that earn the R&D tax credit:
- lower the cost of innovation
- position themselves to transform their industry
- reinvest to support even more development
- reduce the cost of payroll taxes since compensation is a qualified expense
What qualifies for the R&D tax credit?
Being a small business is a minimum requirement for the R&D tax credit, but that doesn’t guarantee eligibility. Companies can verify what actions qualify through the IRS’s four-part test. “Qualified research” must pass the following criteria:
1. Permitted purpose
Also known as the “business component test,” this part verifies the activity relates to an organization’s new or improved:
- function
- quality
- reliability
- performance
2. Technological in nature
Alternatively, the “discovering technological information test,” this portion ensures the activity relies on engineering, physical or biological sciences, or computer sciences.
3. Elimination of uncertainty
Sometimes referred to as the “section 174 test,” this determines if the activity is directly connected to the company’s trade or operations. Additionally, this step verifies the activity eliminates uncertainty around developing or improving a process or product’s:
- design
- method
- capability
In other words, the IRS will not support activities that don’t produce clear results or findings.
4. Process of experimentation
Finally, all qualified research must involve identifying and evaluating more than one path to achieve a result through:
- models
- simulations
- error methodology
A company still qualifies even if it can confirm its ability to achieve a desired result before experimentation. However, the design of the desired result must be unknown at the start of the research activity.
Ultimately, an action passes this part if the business can identify:
- the uncertainty of the result
- one or more alternatives to complete the research activity
- a process of evaluation for those alternatives
In addition to determining which actions qualify, the IRS also verifies eligible expenses. Section 41(b) specifies that qualifying costs can include:
- compensation paid to employees for work on the research activity
- materials used for conducting research and development
- technology purchased for the research
- a portion of contractor expenses related to the research
Remember, qualified research isn’t tied to a specific industry. A company may qualify for developing a new prototype or researching options to best launch a new digital service to consumers. Employers should always consult a tax adviser before assuming an activity — or the business itself — qualifies for an R&D tax credit.
How is the R&D tax credit calculated?
Like the branching paths of the scientific method, employers have two approaches for calculating the R&D tax credit. These options rely on:
- a company’s research and development history
- the amount of historical data a business has
- the rate an employer’s spending has changed
The availability of this data informs organizations of the best path forward. However, the ideal route can shift depending on needs, receipts and other factors. Understanding both can help you make this choice with confidence.
Research Credit Claims (RCC)
RCCs are ideal for organizations with the most extensive R&D tax credit data. Calculating this credit takes four relatively simple steps:
- Determine the average annual gross of research and development receipts over the past four years.
- Calculate the current year’s qualified research expenses (QREs).
- Identify the difference between the average of the prior four years’ and the current year’s spending.
- Multiply this difference by 20%.
Alternative Simplified Credit (ASC)
Since 2009, the ASC is 14% of all QREs from the current tax year, minus 50% of the average QREs in the previous three years. Companies that don’t have QREs from the last three years instead cite 6% of the current year’s QREs.
Given there’s more than one way to calculate the ASC, you should always consult a licensed professional. For example, Wall, Einhorn & Chernitzer, a Virginia-based CPA and advisory firm, uses this equation:
ASC = (QRE – the average of the past 3 years’ QRE x 50%) x 14%
Are R&D tax credits refundable?
The R&D tax credit is nonrefundable. If a company’s credit exceeds more than what it owes, that credit will roll over to the next year. Unused credits may be applied to future credits for up to 20 years. Additionally, eligible small businesses can apply unused R&D tax credits to upcoming payroll taxes.
How do businesses claim the R&D tax credit?
First, just as importantly, a company needs to complete a research and development study. Then, companies need to complete Form 6765 with the data and calculations they previously gathered.
Some organizations hire third-party contractors to conduct this study. These contractors review all activities and expenses that could possibly qualify for the R&D tax credit and make recommendations accordingly.
Afterward, businesses should prepare to present their findings and financial records. The IRS will then determine if:
- a company actually paid the claimed expenses
- the expenses were for a qualified purpose
- the expenses qualify even if they were incurred for multiple different purposes, such as hiring an employee who works in several departments
How does the right HR tech help businesses with the R&D tax credit?
Employers should always rely on certified professionals or licensed attorneys for any legal or tax advice. Although HR tech can’t apply for an R&D tax credit on behalf of a company, it is indispensable for consistent compliance.
For example, having payroll and reporting tools in the same single software makes it easier to determine which employees work on qualifying research activities.
Paycom also streamlines the process of claiming the R&D tax credit on Forms 8974 and 941. After completing a Form 6765 for the applicable year, clients simply fill in the top portion of their Form 8974 each quarter. From there, Paycom completes the bottom section of the form using the business’s Social Security and Medicare tax information. This process calculates the portion of the R&D tax credit an organization can claim through the Form 941.
Explore Paycom to learn how it helps businesses with R&D tax credits and other compliance concerns.
DISCLAIMER: The information provided herein does not constitute the provision of legal advice, tax advice, accounting services or professional consulting of any kind. The information provided herein should not be used as a substitute for consultation with professional legal, tax, accounting or other professional advisers. Before making any decision or taking any action, you should consult a professional adviser who has been provided with all pertinent facts relevant to your particular situation and for your particular state(s) of operation.