Not Sure You Can Claim the R&D Tax Credit? Think Again
June 4, 2021 - If your company does any research and development (R&D), the R&D tax credit can minimize your tax liability. But it's not just for manufacturers and engineers. In fact, you probably do more qualifying R&D work than you think, regardless of your industry.
Even if you've looked into it before, it's time to give the R&D credit another look – it can reduce your current tax liability and even offset future taxes.
What is the R&D Tax Credit and What Counts as R&D?
The R&D tax credit is a dollar-for-dollar credit against the state and federal taxes your company owes (or, in the case of a flow-through entity, the taxes the partners or shareholders owe) for a particular year. Contrary to popular belief, the R&D tax credit is not a deduction on your tax return; it's a reduction in your tax liability.
The R&D tax credit applies to qualified research activities (QRAs), which are defined as activities that develop, improve, or modify existing products or processes. To meet the standard of a QRA, R&D activity needs to meet four main criteria:
- QRAs must be "Technological in Nature". The activity must rely on hard sciences, such as engineering, physics, or computer science.
- QRAs must feature a "New or Improved Business Component". The activity has to prove the intent to develop a new product or process or find a way to improve existing ones. An aesthetic change, for example, may not qualify as "new or improved" – but a process improvement that leads to 30% greater efficiency might.
- QRAs must engage in the "Process of Experimentation". A QRA pursues a new or better thing or way of doing something. Your company must evaluate alternatives to every eligible process through modeling, simulation, testing, and other experimentation methods.
- QRAs must pass the "Technical Uncertainty Test". You must show that you considered alternative methods for doing the work in the way you did. Elimination of uncertainty is an attempt to prove that the qualifying activity was the appropriate way to design a product or achieve a goal.
Here are a few examples of activities that can count as QRAs for the R&D tax credit:
- Developing a new product
- Designing and testing product prototypes
- Improving or modifying existing products
- Conducting certain types of research
- Experimenting or eliminating ideas through trial and error
- Improving or modifying production techniques and processes
In 2015, the PATH Act extended the R&D tax credit and permanently expanded its provisions for American businesses. Two major changes were made to the credit under the PATH Act:
- One of the main ways the PATH Act made the R&D tax credit more accessible was by allowing small businesses or owners of flow-through eligible small businesses to take the R&D tax credit against their alternative minimum tax liability – more on that below.
- Another boost for businesses was the provision allowing start-up companies with no income tax liability to claim the credit as a reduction of their payroll tax liability.
R&D Tax Credit Fast Facts
To really understand how you can leverage your research and development work to reduce your taxes, here are answers to some frequently asked questions about the R&D tax credit:
- Who can claim the R&D tax credit? Any company doing eligible work in the United States can claim the R&D tax credit. In C corporations, it's claimed on the entity tax return. S corporation shareholders and partners claim the R&D credit on their individual tax returns.
- Can I apply the R&D tax credit to work my company did last year? Eligible companies can look back to prior year returns, typically the last three tax years plus the current year, to see if they qualify for potential credits that weren't claimed when they first filed. If your company doesn't owe any income tax in a given year, the credit can be carried forward up to 20 years, reducing future income tax owed.
- What about the alternative minimum tax (AMT)? Eligible small businesses (ESBs) without a current income tax liability, or whose R&D credit exceeds their current tax liability, can use the R&D tax credit to reduce their AMT liability for tax years beginning after Dec. 31, 2015. (Note that for tax years beginning after December 31, 2017, the AMT doesn’t apply to C-corporations). Click this link for the definition of an ESB and information on using R&D credits to offset AMT.
- Partners or shareholders of flow through eligible small businesses can also use the credit to reduce their AMT liability. Although individuals are still subject to AMT (unlike C-corporations), the TCJA increased the AMT exemptions for individuals allowing taxpayers to utilize more of their R&D credit even if the credit is not from an ESB.
- What states offer an R&D tax credit? Thirty-six states currently offer an R&D tax credit on eligible work, including Minnesota, Wisconsin, Iowa, Illinois, and North Dakota. Companies can qualify for both the federal and state incentives at the same time, depending on eligibility. Terms for the R&D credit differ between state and federal programs, so check out this list of states that offer the R&D tax credit to learn more.
Start Claiming the R&D Tax Credit Today
The state and federal R&D tax credit are an incredible opportunity for many corporations, but few realize how much they could be saving simply because they don't realize they're eligible for it. Talk to your CPA or trusted advisor today about how to track the R&D work you do and get rewarded for it on your taxes.