9 minute read
The credit for increasing research activities — better known as the research and development tax credit — rewards private-sector entities for investing in research and development activities. By returning a percentage of their qualifying R&D expenses as a nonrefundable credit, the government encourages businesses to invest in activities that could “lead to new ideas, discoveries and knowledge that are helpful in supporting a growing economy.”
The R&D tax credit was a temporary measure enacted in 1981, but it was extended again and again until it was made permanent in 2015 with the Protecting Americans From Tax Hikes (PATH) Act. Originally, the R&D credit was created to reward taxpayers in the types of industries that typically have high R&D expenses: pharmaceuticals, biotechnology, aerospace and software, just to name a few. Today, thanks to a few tweaks to the law, the R&D credit is broad enough to benefit almost any business in any industry.
In the current iteration of the tax credit, taxpayers are rewarded when they spend more on qualifying R&D expenses than they had in prior years. There are two methods to calculate the credit:
Under the traditional method, the credit is 20% of the company’s qualified research expenses (QRE) over a base amount. This base amount uses historical data from the 1980s. Most businesses don’t have this data readily available, which is why modern companies tend to favor the alternative simplified credit (ASC) method.
The ASC method rewards taxpayers for increasing their qualified research expenditures (QRE) year over year. The credit is 14% of current year QRE that exceed 50% of the average QRE for the last three tax years. The ASC rate is reduced to 6% if a taxpayer does not have QREs in all of the three preceding tax years. This credit can be calculated using the following four-step process:
To illustrate the credit calculation using the alternative simplified method, let’s look at the following R&D tax credit example.
ABC Business reported the following qualifying R&D expenses:
| Tax Year | Qualified Research Expenses (QRE) |
| 2018 | $20K |
| 2019 | $25K |
| 2020 | $30K |
| 2021 | $40K |
Following the four-step process from above, ABC Business qualifies for an R&D credit of $3.85K in 2021.
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The R&D credit is available to almost any business that performs R&D activities while on US soil. Taxpayers must be able to prove that (1) their activities qualify, and (2) their expenses qualify.
Activities eligible for the R&D credit must meet all four of the following tests:
The activity must seek to innovate or improve upon a business component’s quality, reliability, performance or function. Common activities are those that alter or create new products, processes, techniques, formulas or software.
The activity must be seeking to make a discovery or eliminate uncertainty concerning:
The activity should include a process of experimentation where the outcome is uncertain. When experimenting and evaluating alternatives, you may be able to use:
The activity must rely on principles of hard sciences, like biological science, computer science, chemistry, physics or engineering.
Qualified research expenses (QREs) are direct expenses used in pursuit of R&D. This includes the following in-house or contracted research expenses:
Indirect expenses, like overhead costs and depreciation, are not considered QRE.
The R&D tax credit can be calculated and reported using IRS Form 6765, Credit for Increasing Research Activities. The IRS recently released a memo outlining the information taxpayers include with their R&D claim. This memo is not groundbreaking, but it hints at the fact that the IRS will apply greater scrutiny to R&D credit eligibility. Make sure you can substantiate all expenditures and can prove that your activities were qualifying.
The credit is nonrefundable, so taxpayers may need to carry unused amounts forward to offset future tax liabilities.
By default, the credit will offset income taxes, but startups that have no current year income to offset may be able to apply their R&D credit against payroll tax liabilities instead. Qualified small business startups (QSBs) can apply up to $250K of their credit against their FICA tax liabilities each year for five years. QSBs are entities with current year gross receipts of less than $5M with no gross receipts in any of the past five tax years.
Tax law hasn’t made significant changes to the R&D credit since 2015, but a law change affecting R&D deductions may soon affect whether companies pursue the R&D credit.
But let’s back up a moment. The R&D credit and the R&D expense deduction are two separate tax provisions. The R&D credit is a dollar-for-dollar credit that encourages businesses to increase R&D spending year over year. The R&D deduction reduces taxable income, encouraging companies to sustain R&D activity over time. The Tax Cuts and Jobs Act (TCJA) made a major change to R&D expense deductions, but not to the R&D credit.
Effective January 1, 2022, R&D expenses can no longer be deducted in the current year. R&D expenses must instead be charged to a capital account and amortized (i.e., deducted) over a five-year period. This ultimately means that future R&D expenses will be deducted more slowly.
Although R&D credit amounts shouldn’t change, businesses may find the R&D credit a less appealing pursuit if they cannot immediately deduct R&D expenses. In other words, this tax law change may discourage businesses from investing in R&D activities. The R&D tax credit calculation (and the impending amortization of R&D expenses) can be complex, but estimating the credit can be beneficial when tax planning. This job will be made a lot easier if you work with a robust tax software that helps you with this calculation. If you want to see how our Corvee Tax Planning software helps calculate the R&D credit or the amortization of R&D expenses, reach out to us today for a demo.
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