The Credit for Increasing Research Activities was first enacted in 1981 and is one of the most valuable tax credits available to companies spending money on qualified research activities. Each year the R&D credit yields billions of dollars in federal and state benefits to those companies experimenting with new technologies, creating new products, implementing new production processes, developing new software solutions or improving performance, functionality, reliability or quality of existing products or systems.
The federal credit is a dollar-for-dollar offset against a taxpayer’s tax liability. For eligible small businesses, the credit can offset alternative minimum tax, and for qualified small businesses, the credit can offset a portion of the taxpayer’s payroll taxes. Both of these benefits were introduced as part of the PATH Act in 2015 and are eligible for taxpayers beginning in 2016.
One of the common misconceptions surrounding the R&D tax credit is that qualified activities are limited to only those performing the most advanced scientific experiments on par with space exploration and cancer research. This could not be further from the truth. In reality, the definition of R&D for tax credit purposes is fairly broad. Taxpayers are able to qualify activities beginning with the development of concepts and extend to the point where a product, process, formula, or other business component is ready for commercial release. These qualifying activities include:
- Developing or engineering a new or improved product, process, formula or software
- Evaluating the feasibility of a product, process, formula or software
- Developing engineering architecture
- Developing experimental models & prototypes
- Testing an experimental product, process, formula or software
- Beta testing
- Improving processes or the manufacturability of a product
- Technical design reviews
- Participating in technical meetings
- Documenting the results of research
- Compiling research data
- Fabricating experimental models
- Creating more efficient and environmentally-friendly designs
- CAD or 3D modeling
- Supervising technical personnel engaged in R&D
To the extent a taxpayer performs these activities, the following expenses can be captured toward the R&D credit:
- Wages of employees directly performing R&D, as well as those directly supervising and directly supporting the R&D.
- Supplies used in the development process. These are the materials used in the prototype development.
- Amounts paid to third party contractors performing research on behalf of the taxpayer.
The R&D credit for each credit year equates to roughly 10% of the total qualified research expenditures. For example, if a taxpayer has $1 million of qualified expenditures, it can estimate a credit of $100,000. Most states also offer an R&D credit on the same qualified expenditures occurring within the state and is offered in addition to the federal credit. Credits are available for all open tax years.
To the extent your company is involved with developing new or improved products or processes in the course of your businesses, we would welcome the opportunity to have a conversation with you to see how claiming the R&D tax credit can significantly reduce your tax liability.