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The Fundamentals Of The R&D Tax Credit

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Tax planning and claiming tax credits make a good business better. One tax credit that needs further investigation, particularly by startups, is the R&D Tax Credit. Do you know if your business is eligible for a dollar-for-dollar R&D tax credit both at the federal and state levels? It’s definitely worth your time finding out!

Word Bank data suggests globally 2.203% of GDP is spent on R&D – which is good news. In the USA it’s higher i.e. over 3% of GDP and two-thirds of all R&D investment comes from business – your business may be one of them. 

R&D investment growth since Covid is mostly in ICT and Health Sciences however not exclusively so in this business blog, we look at the R&D Tax Credit including:

  • What is an R&D Tax Credit?
  • What qualifies as R&D?
  • Eligibility
  • Claims

R&D Tax Credit Explained

Research and Development (R&D) Tax Credit: What is it and How Does it Work?

The R&D Tax Credit (26 USC 41), allocated by the United States, was created in 1981 to promote US innovation and development. It is a federal benefit, and also most states offer it as a state-level benefit. The R&D tax credit is provided to companies developing new or enhanced business components, such as goods, processes, techniques, computer software, formulas, or ideas.

At the state level, out of the 50 states, 12 currently don’t provide the R&D Tax Credit – which deters the startup of new businesses dependent on innovation and creativity.

How does it work?

Corporations get dollar-for-dollar tax reductions for operations linked to the design, development, or improvement of goods, processes, formulas, as well as software.

The tax credit essentially helps companies divert revenue into other business areas, including hiring more people, improving systems and processes, R&D, and business expansion.

Guidelines

Employees in the engineering, software development, or hard sciences departments may qualify for the credit. Ideally, these individuals have formal technical training or a long professional experience in their job.

Products and processes are the most prevalent business components. Techniques, formulas, innovations, and software can also be other essential business components.

Many businesses are unaware that R&D credits can be claimed for activities and operations such as new manufacturing processes, quality improvements, and software development. Startups can deduct R&D tax credits from their payroll taxes for up to five years.

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Taxpayers may be allowed to claim R&D credits in three prior accessible tax years. Businesses running in loss may be able to return even longer; certain jurisdictions allow claims back more than three years.

Eligibility for R&D Tax Credits

tech innovation

The good news is qualifying for the tax credit is far-reaching and includes commercial entities involved with:

  • Tech – SAAS, Big data, AI, AR & VR, Cryptocurrency
  • Manufacturing
  • Pharma & Health
  • Agriculture
  • Oil & Gas

Working with an R&D tax credit consultant can help establish a company’s credit eligibility. The company must indulge in thorough research to qualify for the R&D tax credit. Qualified research is a commercially driven development format aiming to produce a scientific or technological breakthrough.

4 Part Criteria

The four-part criteria below decide whether an activity qualifies for the R&D tax credit.

Process of Experimentation

The taxpayer must go through a systematic procedure to evaluate one or even more options to attain a result. The capacity, method, or design is unknown at the start of the taxpayer’s research efforts. The Treasury Regulations specify this from the formal scientific approach to a systematic hit and trial technique.

Permitted Purpose

The activity or project must be designed to enhance a business product’s performance, functionality, reliability, or quality. Unused business components are described as commodities that the taxpayer plans to hold for future sale, lease, or license.

Technological in Nature

Experimentation must be based on physics, biology, engineering, and computer science concepts. To meet this requirement, a taxpayer may use current technologies or principles from the biological or physical sciences, computer science, or engineering. Tax credits for R&D must be undertaken in the US.

Any of the following can help qualify a company for an R&D tax credit:

  • Design and development of new products or processes
  • Improvements to existing commodities or procedures
  • New and updated prototypes or software
Elimination of Uncertainty

The taxpayer must seek facts to dispel doubts about the company component’s growth or improvement. Uncertainties remain if the taxpayer’s information does not establish the business component’s design competence, approach, or suitability.

Claiming the Tax Credit for R&D

Several elements go into getting the R&D tax credit. Companies can claim the credit for ongoing and earlier tax years by demonstrating their R&D activity.

Businesses must constantly review and document current research operations to prove their costs. Although some estimations may be used, the assumptions utilized to derive such estimates must be genuine.

Examples of such documentation include:

  • General ledger expense detail
  • Payroll records
  • Project notes
  • Project lists
  • Associated records

Conclusion

Paying less tax is called tax planning and it’s legal! R&D Tax Credits are offered to encourage and support investment in innovation and development. Reducing the complexity of eligibility and claims is a core priority at a federal and state level, so businesses of all sizes, new and mature, can do their bit for the economy and country.

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