Almost every business in America is wrestling with a painful economic slowdown caused by the coronavirus pandemic. Research and development (R&D) tax credits can be a very effective and controllable way for businesses to replenish valuable dollars spent on new and innovative products or processes.
Overview: R&D tax credit
The U.S. federal tax law provides a benefit — in the form of a nonrefundable tax credit — for companies that engage in qualified research and development activities (see a list below). The Sec. 41 credit, which amounts to as much as 20% of the excess of qualified research expenditures for the tax year over a base amount, can create immediate cash flow by reducing current year tax liability dollar for dollar. While nonrefundable, any credit not used in the current year can be carried back one year and carried forward 20 years under Sec. 39. In addition, qualifying activities that can be documented in prior years can create additional cash flow in any open tax years (currently three years) by filing an amended tax return.
Activities that give rise to qualified research expenditures for purposes of the Sec. 41 R&D credit can include such activities as:
- Developing a new or improved product;
- Developing new technology;
- Creating a new production process;
- Improving current processes;
- Developing or improving software; or
- Developing prototypes or models.
Certain activities do not qualify for the credit, including activities conducted outside the United States, research after commercial production of the product has begun, and surveys (see Sec. 41(d)(4)).
The R&D tax credit is calculated as a percentage of the company's expenses related to R&D activities. Qualified R&D expenditures can include operating expenses such as wages, materials, and payments to third-party contractors if the activity that gives rise to the expenditure is a qualified research activity. So, while these expenses are generally fully deductible when determining taxable income, what many companies do not realize is that they can also count toward the R&D credit.
Why don't more companies take advantage of R&D Tax credits?
There is no limit on the available dollars U.S. taxpayers can claim; however, we can attest that the majority of our clients have not claimed the credits in the past. As companies become familiar with the activities and expenditures that qualify, they now realize that they missed valuable opportunities in the past to claim these credits. Although R&D credits have been around since 1981, the R&D credit was only a temporary provision until 2015 when the Protecting Americans From Tax Hikes Act of 2015 (PATH), P.L. 114-113, made the credit permanent. Before then, the credit was not extended until the last minute for most years, and only retroactively for some years. Because of this, many companies and their advisers viewed R&D credits as somewhat risky to claim.
Many businesses also have shied away from pursuing the credit because the calculations can be complicated. As originally enacted, the credit calculation was complex, and it required companies to have a great deal of historical knowledge about their research activities. In 2006, another a less complex method of calculating the credit was enacted called the alternative simplified credit (ASC) method (Sec. 41(c)(4)). This simplified method of calculating the R&D credit calculations offers companies additional flexibility, but many companies still don't claim the credit, because they are not aware that they have activities that qualify.
The R&D credit amount can be very significant at the state level as well as at the federal level. Most states conform to the federal credit, but many have their own specific rules and often the state credit provisions are less generous. Thirteen states and the District of Columbia have no R&D credit equivalent to the federal incremental R&D credit.
It is important that the taxpayer be able to substantiate the amount of its R&D expenditures. To assist its personnel in conducting auditing credit claims, the IRS has issued an audit techniques guide that focuses on research expenditure substantiation issues.
Is a business more likely to be audited if it takes the R&D credit?
Our firm has not seen any evidence that claiming the credit increases a company's audit risk — if the credit claim is filed correctly and substantiated. However, companies claiming the R&D tax credit must be well documented to withstand an audit. Thus, many CPA firms partner with independent R&D professional service firms that have the expertise to navigate and document proper recordkeeping and testing of activities, and to capture all the qualified expenditures to maximize the benefit.
The IRS will look at the overall size of the credit claimed in relation to the taxpayer's industry averages. Since companies often amend their returns to claim the credits for prior open years, the amended returns often get an additional look by the IRS.
Bottom line: Taxpayers should not attempt to claim the credit without professional help. They should be sure to hire an experienced tax adviser and hire experienced and qualified specialists to help them evaluate, prepare, and defend their R&D tax credit claim.
The R&D credit is not only for pharma, biotech, and technology companies
Even if a company doesn't employ scientists in white lab coats, it may be able to take the R&D credit. Some of the industries frequently overlooked for this credit include architecture firms, engineering design firms, and software development companies. Startup companies that do not have an income tax liability yet (i.e., they're not generating taxable profits) can also take the R&D credit against a portion of their employer payroll taxes.
A small or large business may be eligible for the credit if it engages in activities such as these:
- It develops or designs new products or processes.
- It improves existing products or processes.
- It develops or improves upon existing prototypes and software.
In 2003, the "discovery rule" was removed. That was a big milestone because it meant that a company's research activities no longer had to be "new to the world" (see Regs. Sec. 1.41-4(a)(3)(ii)). The activities only had to be "new to the taxpayer" to qualify for the R&D credit — a standard that is much more favorable to companies.
In 2015, the PATH Act made the R&D tax credit permanent — which motivated many more companies to include the credit in their long-term tax planning strategies. Also, the PATH Act modified the credit for the benefit of small and midsize businesses, including startup companies. Startups and small businesses may qualify for up to $1.25 million (or $250,000 each year for up to five years) of the federal R&D tax credit to offset the Federal Insurance Contributions Act (FICA) portion of their annual payroll taxes (Sec. 41(h)).
Note: Certain stringent criteria, including not having gross receipts before the five-year period ending with the tax year, must be met to be able to claim the credit against payroll taxes, so it is important to plan from the inception of the business.
Additionally, as part of the PATH Act, small businesses (defined as nonpublic companies with less than $50 million in average annual gross receipts for the previous three years) can permanently use research credits generated after Jan. 1, 2016, against both regular tax and alternative minimum tax (AMT) (Sec. 38(c)(4)(B)(ii)).
Don't confuse innovation with 'new and improved'
"New and improved" refers to how new products or new features of an existing product are defined. True innovation generally includes the improved product, but also the process and a solution that may even include the impact on people of the product, process, or solution.
The following is a checklist that a tax practitioner can use to determine the possibility of a client's claiming an R&D tax credit:
Does my business (or client's business) qualify?
Check all criteria below that apply:
- Are you currently, or have you in previous tax years, created or made improvements to any existing products, processes, or technology?
- Is your company in the planning stages for a new or improved product or process?
- Do you foresee current or upcoming tax liabilities?
- Did you have tax liability last year?
- Have you recently received or applied for a patent?
- Have you developed unique internal use software?
- Have you used third-party consultants to create or test new products or processes?
If you have checked off one or more of the criteria above, then you may qualify for the R&D tax credit for past, current, or future years. Don't leave this valuable tax savings opportunity on the table.
Don't overlook the credit
Any business that is currently improving or creating new or improved products, processes, or technology can potentially take advantage of the R&D credit — one of the most beneficial federal tax credits currently offered. The R&D tax credit is both a federal and state incentive, with roughly 70% of states offering it.
The first step to taking advantage of this tax strategy is to determine the areas of opportunity within current business operations.
— Karen J. Koch, CPA, MT, is a partner of Bedford Cost Segregation, located in Louisville, Ky. She is a recognized professional in tax treatment of fixed assets for commercial real estate, tax incentives for energy efficient buildings, and research and development tax credits. To comment on this article or to suggest an idea for another article, contact Sally Schreiber, a Tax Adviser senior editor, at Sally.Schreiber@aicpa-cima.com.