The federal R&D tax credit is a tax incentive from which small and large companies in nearly every industry can benefit. If you want to know how your business can take advantage of this tax incentive, we’ve outlined some common questions and answers related to it and the R&D tax credit software.
Q: What is the R&D tax credit?
The R&D tax credit was created in 1981 to encourage companies to pursue research and development (R&D) projects in the US. The R&D credit is a dollar-for-dollar offset of federal income and even payroll tax liability. Many states provide a similar credit, which makes the average potential benefit to federal and state credit at around 10-20% of qualified spending. In 2021, businesses in different industries reported around $18 billion in R&D credits.
Q: What Documents Do You Need to Claim the R&D Tax Credit?
Like anything else included on the tax return, you must provide documents and records proving the expenses you claim.
This includes financial records showing you paid money for particular expenses, business records showing money spent for a qualified purpose, and other records showing a breakdown of qualified vs. non-qualified activities when a total expense was done for multiple business purposes.
Q: What if You Don’t Have Income Tax Liability?
The R&D tax credit is non-refundable, meaning if you don’t owe any income tax or the credit value is more than what you own, then the IRS won’t be granting you a check.
Businesses will usually use the 20-year carryforward to use their unused credit for taxes in the future. Small businesses that qualify can also apply credit to their payroll taxes.
Q: What are the benefits of the R&D tax credit?
There are several benefits to the R&D tax credit, such as:
- Increases cash flow
- Increases earnings per share
- Increases return on investment (ROI)
- Reduces federal and state tax liability
- Reduces effective tax rate
Q: What Activities Qualify for the R&D Credit?
R&D activities qualify if they satisfy the conditions of a “four-part test.”
The Four-Part Test
- Qualified purpose – is the activity intended to improve the function, performance, quality, and reliability of a product, process, technique, software, invention, or formula used in the taxpayer’s business or is sold, leased, or licensed.
- Technological uncertainty –taxpayers experience uncertainties regarding whether it can or how it should develop the product or the product’s appropriate design.
- Process of Experimentation –to eliminate uncertainty encountered by the taxpayer, they evaluate alternatives through means of modelling, simulation, trial and error, and other methods.
- Technological in nature – the success or failure of the evaluative process can be determined by the principles of physics, chemistry, biology, engineering, computer science, or other similar natural or “hard” science, unlike the principle of social sciences and the arts.
Q: What is the R&D Tax Credit Software?
It is software designed to help qualified businesses calculate how much credit they can claim. Many tax software providers specialize in R&D tax credit services. It’s all just a matter of choosing which offers the best service and can explain the process correctly. An R&D tax credit software can use the standard credit method and the alternative simplified credit method to calculate the amount of federal R&D tax credit.
Q: Do You Need to Achieve a Major Scientific Breakthrough or Research to Qualify for the R&D Credit?
The answer is NO.
One of the biggest misconceptions about the R&D tax credit is that you must conduct successful research to qualify. Some poorly enforced administrative guidance has spread this misconception. Fortunately, this misconception has been corrected over the years.
R&D activities do not always have to succeed in order to qualify for the incentive. In general, activities only have to attempt to discover technological information a taxpayer needs to develop or improve a business’s performance, function, reliability, and quality.
Q: What Kind of Activities Do Not Qualify?
Not all R&D activities qualify for the credit because not all satisfy the four-part test conditions. Some activities are excluded from incentives because they did not encourage or stimulate an increase in the kind of R&D it was designed to stimulate.
Excluded activities are as follows:
- Research performed outside the US.
- Market research
- Consumer preference testing
- Routine data collection
- Ordinary testing for quality control
- Research funded by an unrelated third party
These activities don’t qualify because they didn’t pass the four-part test:
- Repairs and maintenance
- Trial production runs
- Tooling-up for production
- Pre-production planning for a finished concept
- Collecting data related to production processes
- Activities that rely on social sciences, arts, or humanities
- Research done after commercialization
- Modifying existing components to meet a particular customer’s need
- Copying or duplicating an existing component through reverse engineering
Note: If a research activity meets the four-part test, it will likely qualify for the R&D credit. But if the IRS examines the activity, it may be subject to an even more extensive investigation. But the important thing is whether it passes the four-part test.
Q: Can Software Development Activities Qualify for the Credit?
The answer is YES. Software development activities to be held for sale, lease, or license that pass the four-part test can qualify. Activities to develop software meant for “internal use” must meet more requirements before they can be eligible.
Q: What expenses qualify?
Below are the expenses that qualify for R&D:
- Taxable wages – these are for employees that carry out or directly supervise the said qualified activities.
- Cost of supplies – this is used in qualified activities such as extraordinary utilities, except for capital items or general administrative supplies.
- Rental or lease expenses of computers –this refers to computers used in qualified activities, for example, payments to cloud service providers (CSPs) for renting service space to create, develop, or improve a product or service.
- 65%–100% of contract research expenses – this is meant for qualified activities, as long as the taxpayer maintains substantial rights to the activity’s results and has to pay the contractor regardless of whether the activity succeeds or fails.