R&D Tax Credit: Everything You Need to Know

Does your business engage in process improvement or innovative research in emerging industries? If so, you may be entitled to take the Research and Development Tax Credit to offset a portion of your tax liability for expenses you are already incurring. Understanding the basics, limitations, filing requirements, and top tips of the R&D Tax Credit should be a priority to maximize accurate filings and minimize your tax liability.

What is the R&D Tax Credit?

The Research and Development Tax Credit, known as the R&D Tax Credit, is a dollar-for-dollar reduction of tax liability when businesses engage in the research of new technologies and the development of innovative procedures. The requirements for this tax credit are broad, giving businesses in every industry the ability to qualify. Common qualifying activities include:

·         Developing a new process

·         Creating an innovative product

·         Improving existing products or processes

·         Generating prototypes, software, or patents

·         Hiring engineers and designers

Most businesses are constantly trying to find ways to become more productive in their operations. The costs associated with these improvements are qualifying expenditures for the R&D Tax Credit.

What are the Credit Limitations?

One of the key aspects of the R&D Tax Credit is no limitations on credit claiming ability. This means that companies are able to take as much of the credit as they can qualify for. However, there are limitations depending on how much tax the individual or entity is subject to. This tax credit is nonrefundable, meaning the amount taken cannot exceed the taxable income and create a refund. Individuals and corporations are able to carry forward this credit for 20 years at the Federal level.

Each state imposes slightly different credit computations and limitations. There are currently 35 states that offer the R&D Tax Credit in some capacity. Unlike Federal tax returns, some states allow a portion of the credit to be refundable. For example, the R&D Tax Credit may wipe out the entire tax liability and create a refund of around 10% of the total credit.

Special R&D Credit for Startups

Startups must follow special credit claiming rules, which generally include meeting a four-part test:

1.      Permitted Purpose – Is your startup working on designing a new processing method or product? How about boosting the functionality and quality of an existing product? If so, you meet the permitted purpose test.

2.      Technological in Nature – Are the activities of your startup primarily related to engineering, biology, or computer sciences? These areas qualify your startup for the R&D Tax Credit.

3.      Technological Uncertainty – When you started your activities, did you know for certain that you would be successful? Qualifying R&D activities often involve a degree of uncertainty, including the risk of loss.

4.      Process of Experimentation – Is there more than one alternative to solve any uncertainty? Finding innovative procedures and products relies on being able to effectively offset the risk of technological uncertainty.

If your startup meets those requirements, you can claim the R&D Tax Credit. Supplies, computer leasing, consultants, and employee wages are all qualifying expenses for startups. The IRS does specify that the third-party consultant costs need to be from consultants working within the United States. This means that consultants overseas would not be a qualifying R&D expense, but you can claim it as a general business expense on the tax return.

Startups receive expanded claiming opportunities according to provisions in the Inflation Reduction Act of 2022. Startups were capped at a credit of $250,000, but are now able to claim up to $500,000. This additional credit is applied toward a business’s payroll tax liability. In order to claim this additional credit, the startup must have under $5 million in gross receipts and have not earned interest income for more than 5 years before the applicable tax year.

Who Can Take This Credit?

Any business that incurs qualifying expenses can take this credit. Qualifying expenses most commonly include direct labor, supplies, and materials. In addition, most business types are able to take this credit. For, Partnerships, S-Corporations, and Multi-Member LLCs, the credit will be passed down to the individual shareholders where they will claim the credit. Since C-Corporations report and pay all taxes at the Federal level, the credit will be claimed directly on Form 1120.

Even though the business is able to claim the credit, there is no guarantee that you will be able to utilize the credit. For example, let’s say that the business passes a $20,000 credit to you through Schedule K-1 and your tax liability is only $10,000. This means that $10,000 of the credit will be carried forward and used to offset future income. The same situation applies to C-Corporations depending on the tax liability.

What are the Benefits of Taking the R&D Tax Credit?

The first benefit of taking the R&D tax credit is a reduction of your tax liability. Whether taxes are paid at the corporate level or passed down to shareholders, the credit received offsets the tax liability dollar-for-dollar. Furthermore, your business can receive tax benefits for activities you may already be doing. Manufacturers, developers, and construction companies are constantly looking for ways to improve their current processes. Why not get rewarded for the money you are already spending?

What are the Documentation Requirements?

The R&D Tax Credit has been around since 1981 when it was first introduced as a part of the Economic Recovery Act of 1981. Throughout the years, the credit has undergone major changes with the most recent alterations being in 2021 with the IRS expanding the filing requirements. The new guidelines require businesses to include the following information:

·         Identification of each business component that the credit applies to.

·         Identification of the research activities performed within each component including who performed the activity and the information that the individual was looking for.

·         Provide the total of qualified wages, supplies, and other expenses.

Due to the significant burden these requirements place on businesses, the IRS has set up a grace period for businesses to “perfect” a claim. A “perfect” claim is one that includes all of the required information to substantiate the claim. The transition period allows businesses to supply this information within 45 days after the R&D Tax Credit is claimed through January 10, 2024. This means that this grace period is effective for the 2023 filing season.

How is the R&D Credit Claimed?

Businesses will need to file Form 6765, Credit for Increasing Research Activities, with their annual tax return to claim this credit. On this form, you will outline the qualifying labor, supplies, contract research expenses, and the cost of rented or leased computers. The actual computation of the credit relies on the prior 3 years of research credits. If this is your first year claiming the credit, you will work solely based on current year expenses. Startups claiming the payroll reduction portion of the R&D Credit will also need to file Form 8974.

There are two credit computation methods: the regular method and the alternative simplified credit. The regular method takes 20% of the qualified R&D expenses, but you do need to have the prior four years of gross R&D receipts to use this method. On the other hand, the alternative simplified credit takes 14% of the current year’s research expenses that are above 50% of the average three prior years of research expenses. This means you will first need to have the prior 3 years of qualifying expenses. For the specifics of which method works best for your business, reach out to Tandy Consulting.

Cost Deductibility Changes Going Into 2022

The R&D Tax Credit claiming process begins to get complicated going into 2022. Not only will businesses need to follow the additional documentation regulations, but they will also be required to amortize qualifying costs over 5 years. Prior to tax year 2021, businesses were able to immediately expense all qualifying R&D costs. This resulted in lower taxable income while simultaneously receiving a tax credit.

According to Bloomberg Tax, to avoid double counting, businesses must now amortize the costs over 5 years, starting with the midpoint of when the expense was paid. The amortization expense will start in the following tax year. For example, if you claim the R&D Tax Credit in 2022, you will start amortizing those costs in 2023.

Businesses are only able to amortize up to 90% of the R&D costs taken. This means in the long run, your business might lose out on 10% of the expenses you paid. Although that might seem immaterial, if you have $200,000 in R&D expenses, you are unable to use $20,000 of that to offset taxable income. The first 4 years of amortization will be at 20% while the 5th year will be at 10%.

This change most notably impacts startups since they incur a majority of their R&D expenses in the first year. It will be difficult to recoup those costs in the first year, leading to years before startups are able to use those expenses against taxable income.

How Can You Implement the R&D Tax Credit?

The expanded guidelines on substantiating R&D expenses make it a little more difficult to implement the credit. However, if you develop the proper tracking measures in your accounting system and file Form 6765 timely, you will have minimal issues from implementing this tax credit. The first year of claiming the credit will most likely be more time intensive as you work out changes in your accounting system to track expenses. 

Top Tips to Efficiently Track Expenses

Since the IRS requires an abundance of information to be submitted for each project, businesses see the most success with implementing expense tracking throughout the year. Keep these top tips in mind going forward:

·         Have project managers fill out a sheet for each qualifying project that includes who’s working on the project and the purpose.

·         Employees should track their time on the project on a daily basis. This will not only help with billings to clients, but it is also a required documentation component.

·         Set up separate categories in your general ledger for research wages, supplies, and materials.

·         Allocate qualifying materials, supplies, and wage amounts to the R&D general ledger accounts on a regular basis, such as weekly or monthly.

·         Designate a separate location for storing R&D information. This could be done electronically or in a file folder.

·         Hold frequent discussions with project managers and employees to make sure everyone is on the same page.

The tips and tricks your business finds most useful will vary, making it important to evaluate your strategies on a regular basis. If you are unsure what qualifies for the credit, reach out to a professional who can guide you on the regulations.

What are the Benefits of Working with a Professional on the R&D Tax Credit?

Working with a professional to take the R&D Tax Credit might be in your business’s best interest. A qualified accountant, like Tandy Consulting, can not only guide you through which expenses need to be tracked, but they can also ensure the timely filing of credit claims. The new rules going into 2022 make it increasingly more difficult for businesses to claim the credit, meaning you want to be sure you are filing the accurate information. If the IRS does not receive a complete claim, they might nix your entire credit, costing your business thousands.

Businesses, especially startups, can’t forgo expert guidance when taxable losses and carryovers are involved. Carrying over the wrong number directly impacts future tax returns. Instead of receiving an IRS inquiry for just one tax year, you might be on the hook for multiple tax periods, requiring you to amend years of returns.

A professional that specializes in the R&D Tax Credit can also help you maximize your deduction. From uncovering business segments that are producing qualifying expenses to choosing the right computation method, you want to be sure you are taking the proper credit amounts.

Summary

The Research and Development Tax Credit presents an opportunity for business owners to reduce their tax liability for expenses that may already be incurring. The IRS and state agencies are constantly adjusting the credit requirements and filing instructions, so be sure you watch for any changes going into the next few months. For more information or to talk through the R&D Tax Credit with an expert, reach out to Tandy Consulting today.