The research and development credit is a tax incentive provided by the U.S. government to encourage businesses to invest in activities within the U.S. that will provide for product and process improvements and/or the introduction of new products or processes.
The credit dates back to 1981, when it first became available to taxpayers on a temporary basis. In 2015, when the Protecting Americans from Tax Hikes (PATH) Act was put in place, the R&D credit became a permanent part of the tax code and with it, revised qualifications that greatly expanded the eligibility for businesses to qualify.
The R&D credit incentivizes certain research activities by reducing a company’s liabilities for spending money on that research. The credit is equal to a certain percentage of a business’ qualified research expense (QRE) in excess of a base amount. Expenses that qualify are more comprehensive than you may think; QREs can include the salaries of employees and supervisors who are conducting research, supplies, and even some of the research that is contracted out. The credit can be taken in any open tax year, which normally includes the last three years filed but can include more if the company had tax losses. Additionally, companies with insufficient tax liability will carry the credit forward to be used against future taxes.
The R&D credit eligibility largely depends on whether the work you are conducting meets the criteria established by the IRS in its four-part test:
- Elimination of Uncertainty: You must demonstrate that you have attempted to eliminate uncertainty about the development or improvement of a product or process. In other words, something that has been changed solely for aesthetic purposes would not qualify.
- Process of Experimentation: You must demonstrate, through modeling, simulation, systematic trial and error, or other methods—that you have evaluated alternatives for achieving the desired result.
- Technological in Nature (The Discovering Technological Information Test): The process of experimentation must rely on the hard sciences, such as engineering, physics, chemistry, biology, or computer science.
- Qualified Purpose (The Business Component Test): The purpose of the research must be to create a new or improved product or process, resulting in increased performance, function, reliability, or quality.
What types of costs qualify for the R&D credit?
The expenditures that may be applied toward the R&D credit include both in-house research expenses and contract research expenses.
The in-house research expenses that can qualify for the R&D credit fall into two categories:
- Wages paid to company employees for conducting, directly supporting, and directly supervising qualified research activities.
- The cost of supplies used or consumed in relation to these research activities.
Contract research expenses are those amounts paid to anyone outside the company performing qualifying research activities on your company’s behalf. The time and effort devoted to conducting research do not necessarily have to be undertaken by your employees. By contracting with outside individuals or companies to conduct these activities on your behalf, provided their contract expenses qualify for the R&D credit, you are improving and advancing your company and, as a result, those expenditures may qualify for the R&D credit.
How does the R&D credit work?
There are two ways to generate the federal credit. The traditional method requires the taxpayer to exceed a base amount generated by multiplying the average gross receipts from the prior four years by a fixed base percentage (developed using one of several methods). This amount is compared against 50% of the current year qualified expenditures. The lower of the two amounts is then used to calculate the current year federal credit.
The alternative method (conveniently named the “alternative simplified credit”) provides a credit for taxpayers with qualified research expenses that exceed 50% of their average spending for the last three tax years.
R&D credit and The Coronavirus Aid, Relief, and Economic Security (CARES) Act
Earlier in 2020, the IRS said expenses paid by Paycheck Protection Program (PPP) loans that were later forgiven would not be deductible. The idea was to prevent businesses from receiving a double tax benefit. It also would have prevented businesses from using certain payroll expenses to calculate their research expenses. The enactment of The Consolidated Appropriations Act (CAA) caused the IRS to reverse its position. Now, businesses can calculate their R&D credits as usual, even if they received PPP loan forgiveness.
The employee retention credit (ERC) is a refundable tax credit that can be applied against certain employment taxes equal to 50% of the qualified wages an eligible employer pays to employees after March 12, 2020, to Dec. 31, 2020, and equal to 70% for the period of Jan. 1, 2021, until Dec. 31, 2021. Per the CAA, employers may not receive a double tax benefit from both the ERC and R&D credit. (You may claim both credits, but you cannot use the same wages for both.) Although the ERC may look more advantageous on paper, it is important to weigh the benefits of each credit. Ideally, you will want to make the best use of your wages where you can. This could mean claiming both credits against different wages.
The R&D credit is a tremendous opportunity to incentivize your development of new products and process improvements and inspire technological growth. The credit also helps businesses recover dollar for dollar tax dollars and reduce future tax liabilities.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Mark Gallegos, CPA, MST, is a tax partner on Porte Brown’s accounting and consulting services team in the Elgin, Ill., office. He has more than 20 years of experience. Since the pandemic started, Gallegos has been entrenched in the intricacies of the Covid-related stimulus programs, such as the Paycheck Protection Program (PPP) and the CARES Act. Gallegos co-hosts a recurring webinar series on the topic and regularly speaks on the stimulus programs and other tax topics.
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