The US Research & Experimentation Tax Credit or R&D Tax Credit is a general business tax credit under Internal Revenue Code section 41 for companies that incur research and development (R&D) costs in the United States. The US R&D tax credit has been around since 1981.
However, it has never been permanent – it would periodically expire and be renewed by Congress. Companies wishing to include this in their long-term budgeting plans couldn’t count on the credit being around for certain. Additionally, many companies couldn’t benefit from the credit since they didn’t owe federal income tax or were subject to the alternative minimum tax (AMT).
In 2015, Congress made the R&D tax credit permanent and also made key changes so that more companies can benefit from the credit. Here is a summary of those changes:
1. Offset payroll taxes
Starting January 1, 2016, the R&D tax credit can be applied to the employer portion of payroll tax up to $250,000 for each fiscal year. Prior to the change in legislation, R&D tax credits could not be applied to payroll taxes.
2. Offset AMT
Starting January 1, 2016, the R&D tax credit can be used to offset AMT. This is applicable for eligible small businesses (less than $50 million in average revenue for the 3 preceding years). Prior to this change in legislation, the credit could only be used to offset regular tax.
What work qualifies for the R&D tax credit?
Qualified research is work intended to achieve innovation within a scientific or technological field. The R&D efforts must pass a 4-part test in order to be eligible:
- Permitted Purpose: develop new (or improve existing) functionality, performance, reliability, or quality of a business component i.e. any product, process, technique, invention, formula, or computer software that the taxpayer intends to hold for sale, lease, license, or actual use in the taxpayer’s trade or business.
- Elimination of Uncertainty: discover information that would eliminate uncertainty concerning the development or improvement of the business component. Uncertainty exists if publicly available information and knowledge cannot be applied to achieve the desired result i.e. capability of development or improvement, method of development or improvement, or the appropriateness of the business component’s design. Some questions to ask yourself are:
– What uncertainties did you attempt to overcome that could not be removed using standard practice?
– What work did you perform in the tax year to overcome the uncertainties described above?
– What advancements did you achieve as a result of the work described?
- Process of Experimentation: utilize a systematic process to identify the uncertainty as well as identify one or more alternatives to eliminate that uncertainty through, for example, modeling, simulation, or a systematic trial and error methodology.
- Technological in nature: within physical or biological sciences, engineering, or computer science.
If you’ve never claimed the US R&D tax credit previously either because you didn’t think you qualified or you couldn’t use the credits, it’s a great time to re-consider. The changes to the R&D tax credit have opened it up to far more small and midsize companies.
How much of my R&D costs can I recover?
Let’s look at California as an example.
- Federal portion – 6% of eligible expenditures or 14% of half of the average R&D expenditures over the past three years – this may yield a much higher credit (if expenditures remain constant over a three year period it results in a 10% credit)
- State portion – 15% of eligible expenditures, calculated as 15% of half of the average R&D expenditures over the past three years