The research and development tax credit (R&D tax credit) can help many startups and small businesses save on tax time. However, many business owners don’t claim it because they don’t think it applies to them or isn’t aware that it exists.
When you think about R&D, lab coats and test tubes might come to mind, but there are many activities that qualify a company for this tax credit.
We’ll discuss everything you need to know about the R&D tax credit, including how to calculate it.
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R&D Tax Credit Calculator
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About the R&D Tax Credit
The research and development tax credit is an incentive for US companies to increase their spending on R&D in the country. It’s a tax credit that can reduce your amount owed or increase your tax refund.
If your company qualifies for the R&D tax credit, you’ll need to know the two methods of calculating it:
1. Calculating the R&D Tax Credit: Regular Method
With the traditional method, your company receives 20% of its qualified research expenses for the current year over a base amount.
Calculating your R&D tax credit with this method can be complicated—it’s the product of your company’s annual gross receipts over four years and a fixed-base percentage.
Here’s how to do it (when you perform these calculations, the fixed-base percentage cannot exceed 16%, and your base amount must be 50% or more of your current year’s qualified research expenses):
- Total up your qualified expenses for the current year.
- Determine the aggregate expenses over a base period.
- Divide that number by the aggregate gross receipts you have during the same period (this is your fixed-base percentage).
- Take the lesser of your fixed-base percentage or 16%.
- Multiply that fixed-base percentage by your average annual gross receipts over the previous four years (this is your base amount).
- Choose the greater of your base amount of 50% of your current year’s expenses.
- Subtract the minimum base amount from your current year’s expenses.
- Multiply that result by 20%.
Other than being complicated, companies that haven’t claimed the credit in the past or don’t have data from the previous four years will have trouble calculating their R&D credit using this method. However, you can make it easier by using the alternative simplified credit method.
2. Calculating the R&D Tax Credit: Alternative Simplified Method
This method is typically easier and involves a four-step process:
- Find the average of your company’s qualified research expenses for the past three years.
- Multiply the average by 50%.
- Subtract that number from your current year’s expenses.
- Multiply that number by 14%.
Let’s look at an example:
Say that your business’s qualified expenses over the past three years were $50,000, $45,000, and $60,000, and your current year’s expenses are $70,000.
- Step 1: Your average expenses for the past three years would equal $48,333.
- Step 2: 50% of $48,333 is $24,167.
- Step 3: $70,000 minus $24,167 is $45,833
- Step 4: $45,833 multiplied by 14% is $6,417—this is your R&D tax credit amount.
Related: How to Easily Calculate CAC
However, if your company didn’t have research expenses over the past three years, your tax savings would be 6% of the qualified expenses for the current year.
Many states have R&D tax credit programs, too. These programs come with different rules and limits than the federal credit—it’s a good idea to work with a tax professional to determine if you can file for both a state and federal R&D credit.
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What Businesses Can Claim the R&D Tax Credit?
Any business that incurs expenses while developing or improving a product or process in the US can claim this tax credit.
There’s a four-part test to determine whether or not a business qualifies:
- Does it eliminate uncertainty? Your research must eliminate uncertainty about the improvement or development of a product—aesthetic changes do not qualify.
- Does it include a process of experimentation? Your activities must include a process designed to evaluate one or more alternatives to resolve uncertainties like modeling, trial and error, simulation, etc.
- Is it technological in nature? Your research must rely on hard sciences, including physics, biology, chemistry, engineering, and computer science.
- Does it have a qualified purpose? Your activities must focus on creating or improving a product or process that results in better performance, quality, or reliability.
In addition, the tax code excludes specific activities from qualifying for the R&D tax credit:
- Research started after the beginning of commercial production
- The duplication of an existing process or product
- Research for internal-use software
- Research for humanities, arts, or social sciences
- Research that adapts an existing process or product for a particular customer
- Studies and surveys
- Research conducted outside of the US or US territory
- Research funded by the government or another person
What Expenses Qualify?
When calculating your R&D tax credit, you’ll have to document all of your qualified research expenses, which include:
- Wages you paid to anyone working on, supporting, or supervising the development process
- Supplies that you used for research and development
- Expenses paid to third parties for performing research on your company’s behalf
- The cost of leasing hardware or using cloud services for your research activities
Even if your research doesn’t lead to a successful process or product, your expenses can still count toward the credit—if your research or project failed, you could still claim these qualified expenses.
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