How to Qualify and Claim the R&D Tax Credit

Broad statements rarely fit everyone, but we’ve never met anyone eager to pay more than what is required when it comes to paying taxes. That’s where tax credits come in handy. Like research and development, certain activities can qualify businesses or individuals to offset a portion of their tax liability, effectively paying less in taxes.

The key is to make sure that you understand the tax credits available and meet all eligibility requirements. Taking a credit when you don’t qualify can result in back taxes and penalties that undermine any potential savings that you might see. So, let’s talk about the R&D tax credit and who qualifies.

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What is the R&D Tax Credit?

The research and development (R&D) tax credit is available to businesses who engage in the development or improvement of products, services, software, techniques, technologies, formulas, or inventions. The key is that developing a new business component must improve the performance, quality, reliability, or functionality of the existing business. So, essentially, it’s a broad definition that covers a lot of activities as long as the outcome is working towards improving a business.

A start-up may even be able to claim the R&D tax credit on its payroll for up to five years. Other common business activities that qualify for the R&D tax credit include:

  • Companies who spend time or allocate resources towards creating a new or innovative product that enhances their industry. For example, a commercial cleaning company invents a new mobile vacuum system with innovative technology could claim the tax credit.
  • Companies that devote resources to improving existing products. For example, a commercial food company that reformulates its frozen pizza recipe could claim the tax credit.
  • Companies that develop processes, patents, software, or prototypes can claim the R&D tax credit. For example, a global hotel chain that develops a proprietary database software for managing guest reservations could claim the tax credit.
  • Companies that employ engineers, designers, or scientists can generally claim the R&D tax credit. For example, a pharmaceutical company that handles drug trials can claim the R&D tax credit.

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How Companies Benefit from Claiming the R&D Tax Credit

The R&D tax credit is very popular because it is a dollar-for-dollar credit that reduces tax liability for a broad range of activities that most businesses actively engage in to gain a competitive advantage in their industries. And, there is no limit or cap on the amount of R&D-related expenses that can be claimed in a given tax year. Even better–these credits can typically be taken retroactively for up to three years or more. 

Why Companies Often Miss this Tax Credit

Some companies mistakenly assume that they will not qualify for the R&D tax credit, especially when they are not in a position to pay federal income taxes. For example, a start-up company often takes several years to become profitable, netting losses that exceed their revenues. This negative balance situation means they will not owe any income tax for the first few years, at least until the business begins to profit. However, that does not mean they don’t qualify for the R&D tax credit. Many start-ups can take the credit on their payroll for up to five years, netting up to $1.25 million in tax-liability savings. 

Some companies are profitable and pay taxes, but they miss this credit because they are not actively focused on research and development. Perhaps they do not employ anyone who routinely engages in R&D as part of their job description, and certainly, they don’t have a recognizable R&D department. But that doesn’t mean they aren’t spending time and money on activities that might qualify.

If your production supervisors have a meeting to retool work processes and improve efficiency, that’s an eligible R&D expense. And, if your livestock managers have a simple lab set up to test DNA and improve your breeding programs, that’s an eligible R&D expense.

Your employees don’t have to be degree-holding experts to make meaningful contributions to research and development. And your innovations don’t have to be entirely novel. The only requirements are improving your business, being new to your business, and passing the basic litmus test for true R&D.

Determining Eligibility for the R&D Tax Credit

Qualifying for the R&D tax credit requires that you meet four criteria. Take a closer look at what your business does every day. You might be surprised to learn that you qualify for this tax credit.

Purpose

Research must support the creation or improvement of a business component. It can be a product, process, software, or other invention as long as it improves the business’s function, reliability, or quality. 

Elimination of Uncertainty

A company must identify its objectives and show a clear relationship between the R&D activities and the innovation they are working towards. While this sounds simple enough, it isn’t always clear at the beginning of a research project.

Defined Process of Experimentation

A company must articulate its method of experimentation detailing how it has tested one or more possible solutions. This could include modeling, simulation, trial, and error, among other methods.

Science-Backed Processes

Companies are required to rely on hard science to conduct R&D experimentation. This could include engineering, chemistry, physics, computer science/technology, biological sciences, or similar principles. 

The R&D tax credit is not exclusively limited to the well-recognized leaders and innovators in the industry. Newcomers and small businesses can all make meaningful contributions that qualify for this credit. These steps can be applied to many different activities in many different industries.

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Monetizing the claimed R&D tax credit

The R&D tax credits offer various avenues for offsetting financial obligations:

  • They can reduce income taxes for entities with taxable income.
  • Businesses with average annual gross receipts of $50 million or less over the past three years and current-year AMT liabilities can be applied against the Alternative Minimum Tax (AMT).
  • Qualified small businesses can offset the employer portion of Social Security taxes up to $250,000 per fiscal year. This payroll tax benefit enables small businesses to gain from their R&D efforts, irrespective of their profit status.

What Happens If My Company Lacks Tax Liability?

Suppose your business is not liable for taxes at present. In that case, it can still benefit from taking advantage of the R&D tax credit if they are engaged in eligible research and development activities. Unutilized credits obtained through this method could be carried forward to cope with future tax responsibilities for nearly two decades. Companies may also claim the R&D tax credit on previous returns retroactively by submitting amended ones.

Can I offset payroll tax?

If a startup qualifies for the R&D tax credit, you may apply up to $250,000 yearly against your payroll taxes. This benefit enables eligible startups to lessen their quarterly federal payroll tax filings and offset all five years’ worth of such expenses – even up to $1.25 million! As long as a startup has revenue below $5 million annually and is within its first five years since earning its initial income stream, it can avail of this perk regardless of profitability status. However, the claim must be made in the original tax filing to benefit from this payroll tax offset.

How Does This Affect the Alternative Minimum Tax?

The R&D tax credit can now directly decrease a company’s immediate tax obligations, thereby increasing available capital for reinvestment. For businesses previously constrained by the Alternative Minimum Tax (AMT), the R&D tax credit can completely offset the AMT, bypassing the tentative minimum tax requirement. This opportunity extends to small businesses structured as sole proprietorships, partnerships, and private corporations with average annual gross receipts of $50 million or less over the last three years. TaxRobot’s team of experts stands ready to assist businesses in claiming and maximizing their R&D tax credit benefits.

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How to Claim the R&D Tax Credit

Claiming the credit requires diligent documentation. The IRS is well-known for its detailed, record-loving requirements. Companies should keep track of appropriate expenses using payroll records, general ledger entries, lab inventories, project notes, email correspondence, and similar types of documentation. In addition to keeping track of the documentation, you’ll also need to keep a running total of expenses so that you can enter the dollar amount when filing your annual taxes.

Final Thoughts on Claiming the R&D Tax Credit

Many businesses are surprised to learn that the requirements for R&D tax credit eligibility are broad and cover a wide range of activities in many different types of businesses. There is a simple four-part checklist to check eligibility, but generally, any activity that focuses on improving your business could qualify for this dollar-for-dollar credit. 

TaxRobot is an AI-powered R&D tax software that can help you keep track of your expenses to maximize your tax credit. Learn more today.

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