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Your Guide to the R&D Tax Credit
November 15, 2022 •TaxPlanIQ Support team
The Research and Development (R&D) tax credit is a government-sponsored program that encourages businesses to invest in innovation and improve their competitiveness. The program provides tax relief for companies that incur expenses on R&D activities.
These tax instruments had minimal changes from their introduction in 2000 until recently, in 2021, when the government announced some proposed changes that were seen as an effort to support modern research needs by expanding qualifying expenditures such as data and cloud costs.
As a proactive accountant or tax planner, it is important to provide tax-saving opportunities that your clients may not know about.
And the R&D tax credit is one of those opportunities that up to 90% of small businesses and startups fail to utilize. Therefore, familiarizing yourself with this tax credit and its benefits is essential if you truly want to deliver value to your clients.
Here is a quick overview of what you need to know about the R&D tax credit:
R&D Qualification And Eligibility
The R&D tax credit is a dollar-for-dollar reduction of a company's tax liability that can be used to offset income tax liability, payroll tax liability, or alternative minimum tax liability.
The R&D tax credit can be claimed by companies of all sizes that incur eligible expenses on R&D activities. Unlike other tax incentives, the R&D tax credit does not require the company to be profitable or to have generated any revenue. This makes it a great option for early-stage startups and small businesses.
This credit spreads across many industries, including technology, manufacturing, architecture and engineering, and even medical and scientific research. As long as the company is engaged in an activity that seeks to make an advancement in its field or industry, it may be eligible for the credit.
According to the IRS, for an activity to qualify as an R&D, it must:
- Be technological in nature
- Seek to resolve a technical uncertainty
- Should use experimentation
- Related to a business component, new product, technique
- Have Eligible W2 Qualifying expenses
Qualifying research expenses (QREs) are those incurred in experimental or laboratory situations. This includes W-2 employee wages, contract research expenses, and certain supplies used in the research process. These expenses must be incurred in the United States in order for the company to claim the credit.
R&D for internal software has three more criteria to meet:
- The software must be innovative as measured by cost reduction, speed improvement, or other improvements.
- The software development must involve some level of economic risk in that the project's success is not certain.
- The software cannot be purchased commercially without significant modifications or enhancements to meet the company's needs.
Activities that may be considered for the R&D tax credit include:
- Developing or improving products, processes, or software
- Developing prototypes
- Conducting scientific or technical experimentation
And really, the research doesn't have to be related to a new product or novel service. Even improving an existing product or process can qualify. Fortunately, even if the research is unsuccessful, the company can still claim a tax credit for its expenses.
There are specific types of research activities that are excluded from receiving R&D credit, including:
- R&D activities conducted outside the US
- Research in nonscientific areas such as social sciences, arts, and humanities
- Management studies and surveys
- R&D studies to improve aesthetics
- Market and consumer research
- Routine data collection
- Internal business process development
How To Claim The R&D Tax Credit
The R&D tax credit can be claimed on a company's federal income tax return. The credit is claimed as general business credit, which can offset both regular and alternative minimum tax (AMT) liability. Any unused credit can be carried forward for up to 20 years.
To claim the credit, the company needs to file IRS Form 6765 with its tax return. The form must include a description of the qualified research activities and the expenses incurred. The company will also need to attach IRS Form 3468, which is used to calculate the credit.
New IRS Documentation Requirements When Filing For R&D Tax Credit
The IRS now wants more documentation to support R&D claims. While not officially approved, a proactive accountant must be prepared to provide the following:
- Identification of all business components that form the factual basis for the Research and Development claim
- A description of all research activities performed by all identified business components
- A list of individuals who worked on the R&D project
- A description of the information each individual sought to fix or discover and the challenges experienced thereof
- Total qualified research expenses, including the employee wages, supply expenses, payments for outsourced services, and contract research expenses
Calculating R&D Tax Credit
To calculate the credit, the company will need to determine its qualified research expenses (QREs) for the year, such as W-2 employee wages, contract research expenses, certain supplies used in the research process, and qualifying contractor research expenses. These expenses must be incurred in the United States in order for the company to claim the credit.
Here's what you'll need to know about your client's QREs:
- Salaries and wages (Box 1 wages) attributable to qualified research
- Supply cost used or consumed during research and development, i.e., any tangible property other than land or land improvements and property of a character subject to the allowance for depreciation. Supplies are not overheads, cost of leasing assets, meals, entertainment, telephone expenses, or professional dues.
- 65% of qualifying US-based contractor research costs
Calculating R&D Tax Credit Using The Alternative Simplified Credit (ASC)
The federal R&D credit allows for an Alternative Simplified Credit (ASC), which is easier to calculate. It only uses the prior three years of historical R&D expenses.
Savvy accountants can combine workflow solutions with software such as RectroacDev and TaxPlanIQ to streamline their clients' R&D tax credit filing process and make it super easy to generate file Form 6765.
To calculate ASC:
ASC = (Current years QREs - (Avg QREs for the past 3 years X 50%))X14%
If the client has no QREs within the 3 years preceding the tax year, the ASC rate is 6% of the QREs for the credit determination year
Opportunities And Risks For The R&D Credit Strategy
- Unused credit can be carried backwards for one year or forward 20 years.
- The credit is designed to incentivize technological advances and the hiring of qualified R&D professionals in the US
- The Alternative Simplified Credit (ASC) allows a 14% credit but is much more straightforward to calculate than the traditional method
- The traditional method allows a 20% credit of a taxpayer's current year QREs.
- Qualified small businesses and startups with less than 5 years or 5M in gross receipts can claim tax credits to offset some of their payroll taxes, even when they don't have an income tax.
- Use existing solutions such as TaxPlanIQ and RectroacDev to position yourself as a valuable resource to your clients.
- RectroacDev offers 15% off for TaxPlanIQ clients, allowing you to deliver more value at a fraction of the cost.
- There are new IRS changes that may change how businesses claim the R&D credit
- The IRS continues to actively challenge claims with large supply expenditures
- The IRS may audit your client if they have large R&D tax credits
Leveraging Technology to Streamline the R&D Tax Credit Filing Process
Technology can help you streamline your clients' R&D tax credit filing process, making it super easy to generate file Form 6765.
Software solutions such as RectroacDev and TaxPlanIQ can help automate repetitive tasks, saving you time and money. These solutions can also help you manage multiple clients more efficiently by providing a centralized platform to track deadlines, manage workflows, and generate reports.
In particular, TaxPlanIQ has a comprehensive R&D strategy template that allows you to customize and optimize the credit by running multiple "what if" scenarios. This is a great way to help your clients maximize their R&D tax credit.
Client 1 is a tech startup.
- R&D credit: $15,000
- Accountant fee (20% fee) = $3,000
- Total hours spent = 4.5
Sample 2 (using software such as RectroacDev and TaxPlanIQ)
Client 2 is a tech startup.
- R&D credit: $45,000
- Accountant fee (Approx. 10%) = $3,450
- Total hours spent= 3
As you can see, the idea is to offer faster, more competitive services by leveraging technology. This is a great way to differentiate your firm and attract new clients.
The R&D tax credit is a great way for companies to offset the costs of their research and development activities. However, it's important to understand the rules and regulations around credit to maximize your clients' value.
If you want to stay ahead of the curve, deliver more value to your clients, and become indispensable, leverage technology to make the R&D tax credit filing process as seamless and painless as possible. Utilizing solutions such as TaxPlanIQ and RectroacDev can help streamline the R&D tax credit filing process, saving you time and money.
These solutions can also help you manage multiple clients more efficiently by providing a centralized platform to track deadlines, manage workflows, and generate comprehensive reports that will help you optimize the credit for your clients. And what's better, RectroacDev offers 15% off for TaxPlanIQ clients, allowing you to deliver more value at a fraction of the cost.