One of the largest annual tax credits available to U.S. companies is also one of the most misunderstood and untapped – the R&D tax credit. In an environment where businesses are struggling with the financial impact of Covid-19, many businesses are anxious to see the next wave of economic stimulus make its way through Congress. With agreement on the Hill uncertain, the R&D tax credit can serve as a potential lifeline for businesses looking to improve their cash flow.
Introduced in 1981 as a way to incentivize companies to keep high-paying jobs in the U.S., R&D tax credits originally required that a company create or produce a new product or process to qualify, limiting its reach to a few cutting-edge companies. However, new regulations and the elimination of the Discovery Rule have paved the way for more companies—and more industries—to qualify for the credit.
Today, activities that once needed to be “new to the world,” now only have to be “new to the taxpayer.” Nonetheless, many businesses are unaware they qualify under the revised guidelines. In fact, according to the most recent available IRS data, between 1990-2013 only 260,000 corporate taxpayers claimed R&D tax credits during that time period.
Why R&D Tax Credits Matter, Especially Now
Simply put, money from R&D tax credits is instant cash. For many small and mid-sized companies, the R&D tax credit is money you can re-invest right away because it’s a dollar-for-dollar credit against taxes you owe or taxes you already paid.
With so much current economic uncertainty in today’s market, companies can reduce their current and future state and federal tax liabilities, providing greater financial stability. Not only can credits carry back one year and forward 20 years, companies are able to take the credit for all open tax years—usually the last three or four years. Furthermore, even if a company is in its early stages and operating with losses, it can use the R&D tax credit to offset payroll taxes.
Most recently, a provision in the Coronavirus Aid, Relief, and Economic Security (CARES) Act allows businesses to carry back net operating losses (NOLs) for up to five years for taxes incurred between incurred 2018 and 2020, thus reducing taxes owed. This legislation helps cash-strapped businesses claim refunds, which they can in turn reinvest into their companies.
Not Just for Medical Labs and Tech Incubators
Despite the immediate benefits of the R&D tax credit, the lack of corporate taxpayers claiming the credit suggests that many businesses aren’t aware that they don’t need a scientific lab or a leading engineering team to qualify for R&D tax credits.
From life sciences to craft beers, any company that develops or designs new products, improves existing products or processes, develops patents or intellectual property, or conducts research that could lead to new knowledge all qualify for R&D tax credits.
A qualifying activity only must meet four simple criteria:
- Attempt to develop a new or improved product, process, software, technique, invention, or formula: The effort must only attempt to increase performance, function, reliability, or quality. Even if the efforts fail, the company can still qualify.
- Rely on hard science: Hard science refers to engineering, architecture, chemistry, biology, or computer science.
- Eliminate uncertainty: The activities must be meant to eliminate uncertainty as to capability, methodology, or design.
- Require Experimentation: Activities must go through some experimentation, whether iterative or trial-and-error, to eliminate or resolve the technical uncertainty.
For example, small brick-and-mortar retailers that were forced to implement a brand new e-commerce strategy as their state went into lockdown during the pandemic may be able to take advantage of R&D tax credits. Think for example of an independent bookstore that needed to develop an e-commerce platform to compensate for the shift to online business interactions, which brings an added need for cybersecurity and upgrading legacy systems for capacity during the pandemic. The development and testing of these types of internally used software systems can qualify for the R&D tax credit.
Elements to Consider When Applying
For many companies, qualifying for R&D tax credits isn’t the biggest hurdle—it’s documenting the activities that qualify. Companies must show the nexus between qualified expenses and qualified activities, which means gathering critical sources of data, including:
- Payroll records
- General ledgers
- Project requirements
- Meeting notes
- Design specifications
- Tax returns
- Employee rosters
- Customer agreements
- Testing reports
- Wireframe drafts
R&D tax credit qualifications vary based on jurisdiction and continuously evolve. Companies need to be on top of those requirements—and adhere to them—wherever they are innovating. Leveraging technology and AI-backed solutions can help alleviate much of the time burden companies face when tracking these changes. Looking at 2020 and beyond, it will be imperative that taxpayers understand all the laws surrounding deductibility and allocation of expenses in order to maximize benefits and defend claims under any IRS or State tax examination.
As a permanent part of the tax code, the benefits of R&D tax credits far outweigh the hurdles. Implementing an annual R&D tax credit strategy can be a powerful tax minimization and planning tool that increases a company’s competitive advantage, provides additional funding, and allows for future growth and innovation.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Rahim Walji is the Director of R&D Tax Incentives at CrossBorder Solutions. He is a licensed attorney with over 10 years of experience in government compliance matters, primarily focused on various domestic and international tax incentives.
CrossBorder Solutions’ AI-powered tax suite provides a bespoke software platform solution that overcomes the shortfalls of traditional accounting firms and makes claiming and documenting R&D tax incentives more efficient and accurate. The world’s leading AI tax expert, Fiona, keeps track of R&D tax incentive calculations and regulations for over 75 international jurisdictions while offering real-time information plus strategic insights with just a few clicks.