Is The Research and Development Tax Credit Right for Your Business?
With the start of the year, businesses continue thinking about potential tax saving strategies. With these discussions comes considering the possibility of any tax credits that could be useful for the business to participate in. This could range from Energy efficiencies, to increasing charitable contributions, to Research and Development. Today we will talk about the Research and Development Tax Credit; what is it, who qualifies for it, the benefits, any changes that have occurred in the last year surrounding the credit, and how is the research and development tax credit calculated.
Research And Development Tax Credit: What Is It?
The Research and Development Tax Credit allows businesses to take a dollar-for-dollar reduction in the company’s income tax liability based on the research and development activities of that company. The company can elect to apply a portion of the research credit as a payroll tax credit against the employer’s share of social security tax. For taxable years beginning after December 31, 2015 and before January 1, 2023, the maximum research credit that can be applied toward payroll taxes was $250,000. Eligible businesses to take a portion of the credit against payroll taxes must have under $5 million in gross receipts in the current year and no more than five years of generating gross receipts including the current year.
An activity qualifies as research and development if is aimed at discovering new knowledge that benefits the development of a new product or service, new process or technique, or the improvement of an existing product. Costs that can be identified with research and development activities are: Materials, equipment, and facilities; personnel; intangible assets; contract services; and indirect costs.
- Materials, equipment, and facilities that are acquired or constructed for the purpose of research and development activities but have a potential future alternative use would still be capitalized as a tangible asset. However, if the materials, equipment, and facilities were consumed or have no alternative future use then these would be considered research and development costs and expensed at the time incurred.
- For personnel, salaries or wages for the employees who actively participated in research and development activities are expensed as a research and development cost.
- Intangible assets that are purchased from third parties for the purpose of use in research and development and have an alternative future use are amortized over the useful life. The amortization of these intangibles that were used in the research and development activities are expensed. However, the intangibles that are purchased for use in research and development and have no alternative future use are expensed in the time incurred.
- Contract services in connection with the research and development and work performed by a third party on behalf of the company would all be included in research and development costs.
- Indirect costs should be reasonably allocated as a research and development cost. However, if there are any indirect costs where it is not clearly identified to be connected to the research and development then it should not be included in those costs.
Research And Development Tax Credit: Who Qualifies to Take the Credit?
Eligible businesses that qualify to take the research and development tax credit are small businesses structured as a partnership, sole proprietorship, or a corporation that has no publicly traded stock. The average annual gross receipts for the three proceeding tax years need to be less than $50 million to take advantage of this tax credit. In order to take advantage of the credit the research must be conducted inside the United States, Puerto Rico, or a U.S. possession. The business must engage in activities considered “qualified research”, which involves work that creates new products, processes, or technology advancements. Accurate record keeping of the research and development activities are required for taking advantage of the credit.
Research And Development Tax Credit: What Are the Benefits?
There are many benefits for a company to conduct research and development activities and taking advantage of this credit.
- Financial incentive: With a dollar-for-dollar reduction in tax liability, the research and development credit allow businesses the freedom to invest their money into improving their products and processes.
- Stimulates Innovation and creates competitive advantage: Research and development is meant for discovering new knowledge and developing innovations, creating new products, improving old products, improving processes, and technological advances. The credit helps companies to invest more money in research and development which ultimately allows for more of a competitive advantage over other companies that are not investing in improvements.
- Job Creation: Typically, when companies invest a lot of time and money into research and development, they have personnel specifically assigned to a part of the research and development process. This creates jobs in areas such as engineering, design, and development.
- Offset development costs: Research and development often requires the investment in a larger labor force, materials used in the development, and new equipment used in research and development. Research and development tax credits allow a company to reduce their tax liability, making these investments more financially feasible.
- Compliance with Federal Regulations: Businesses are required to document their research and development processes in order to take the tax credit which leads to increased regulation compliance. Businesses wishing to take this credit must ensure they fit the criteria for the credit and report with transparency.
Research And Development Tax Credit: What Changes Have Occurred in The Last Year?
In both 2022 and 2023, there have been two major changes to the Research and development tax credit. One regarding applying part of the credit to payroll tax liability, and the other regarding Section 174 capitalization requirements.
- Electing to apply part of the R&D tax credit to payroll tax:
As of 2023, the maximum amount of payroll tax research credit that a qualified small business can elect to apply against payroll tax liability increased to $500,000 for tax years beginning after December 31, 2022. Eligible businesses to take a portion of the credit against payroll taxes must have under $5 million in gross receipts in the current year and no more than five years of generating gross receipts including the current year. As of 2023, the increase to $500,000 will end at the conclusion of the 2023 taxable year, unless the provision is extended by congress.
- New Section 174 capitalization requirements:
Beginning tax years on or after January 1, 2022, R&D expenditures under section 174 can no longer be deducted. Businesses are now required to capitalize costs identified a research and development and amortized over a five-year period for any domestic research. The R&D expenditures do not currently need to be capitalized on the company’s balance sheet; however, the expenditures do need to be capitalized in terms of the business’s tax return.
Research And Development Tax Credit: How is the Credit Calculated?
The research and development tax credit can be calculated using one of two methods: the Traditional Method and the Alternative Simplified Credit Method.
- Traditional Method
The traditional method is typically used for businesses who have already claimed the research and development tax credit in the past. Under the traditional method, the credit is 20% of the company’s current year qualified research expenses that exceed a base amount. The base amount is the product of a fixed base percentage and the average annual gross receipts of the taxpayer for the four tax years preceding the tax year for which the credit is being determined. However, the base amount can never be less than 50% of the qualified research expenses for the credit year. Additionally, the base amount cannot exceed 16%.
A huge part of the traditional method is the company having historical qualified research expense data to determine the fixed-base percentage. The fixed-based percentage is computed as the aggregate qualified research expenses for tax years beginning after Dec. 31, 1983 and before Jan. 1, 1989 (base period), divided by the aggregate gross receipts for the same period. For companies defined as start-up companies, meaning any company whose first tax year with both gross receipts and qualified research expenses begins after Dec. 31, 1983, or any company that has fewer than three tax years between Dec. 31, 1983 and Jan. 1, 1989, the fixed base percentage is 3% for the first five years where qualified research expenses exist and then a moving average formula of gross receipts to qualifies research expenses. Below is an example of the traditional method calculation:
|
Traditional Method: 21% Corporate Tax Rate |
|
|
Current Year Qualified Research Expenses |
2,500,000 |
| Fixed Base Percentage |
16% |
| Average Annual Gross Receipts for Prior Four Tax Years |
10,000,000 |
| Base Amount (10,000,000*16%) |
1,600,000 |
| Excess of Qualified Research Expenses over Base Amount (2,500,000-1,600,000) |
900,000 |
| Smaller of Excess Qualified Research Expenses or 50% of Qualified Research Expenses (900,000 < (2,500,000*50%=1,250,000)) |
900,000 |
| Gross Credit (900,000*20%) |
180,000 |
| Reduced Credit Under Section 280C (180,000*21%=37,800, 180,000-37,800=142,200) |
142,200 |
For companies who have not claimed the research and development tax credit in the past or do not have the data necessary to determine their historical qualifies research expenses will most likely use the second method.
- Alternative Simplified Credit Method
The Alternative Simplified Credit Method is equal to 14% of the excess of qualified research expenses for the current tax year over 50% of the average qualified research expenses for the three preceding tax years, also known as the taxpayer’s “base period”. If the company had no qualified research expenses in any of the three preceding tax years, the Alternative Simplified Credit equals 6% of the qualified research expenses for the tax year for which the credit is being determined. Despite the difference in the tax credit rates, the Alternative Simplified Credit Method can be a less complicated methodology to compute the credit when historical data is an issue.
There is a four-step process involved in calculating the Alternative Simplified Credit:
- Figure out the company’s average qualified research expenses for the past 3 years
- Multiply that average by 50%
- Subtract the result of step 2 from the company’s current year qualified research expenses
- Calculate the credit by multiplying the result of step 3 by 14%
Below is an example of the Alternative Simplified Credit Method calculation:
|
Alternative Simplified Credit: 21% Corporate Tax Rate |
|
| Current Year Qualified Research Expenses |
2,500,000 |
| Sum of Prior 3 Years Qualified Research Expenses |
7,500,000 |
| Average of Prior Years Qualified Research Expenses (7,500,000/3=2,500,000 (Average)) (2,500,000*50%=1,250,000) |
1,250,000 |
| Excess Qualified Research Expenses (2,500,000-1,250,000=1,250,000) |
1,250,000 |
| Gross Credit (1,250,000*14%=175,000) |
175,000 |
| Reduced Credit Under Section 280C (175,000*21%=36,750, 175,000-36,750=138,250) |
138,250 |
If the company had no qualified research expenses in the three preceding tax years and use the 6% of the qualified research expenses for the credit:
|
Alternative Simplified Credit: No QRE in 3 preceding years, 21% Corporate Tax Rate |
|
| Current Year Qualified Research Expenses |
2,500,000 |
| Gross Credit (2,500,000*6%= 150,000) |
150,000 |
| Reduced Credit Under Section 280C (150,000*21%=31,500, 150,000-31,500=118,500) |
118,500 |
Whether you are currently taking part in research and development or you are considering if this would benefit your company, keep in mind the requirements for taking the credit, qualifications required to determine if the expenditures are research and development costs, how any updates to the credit can affect your business, and which credit calculation method would be best for your business. Please let us know if you have any questions regarding the research and development tax credit or any other tax compliance or planning issues, we can be reached at (480) 980-3977.
