There have been many updates to the Research and Development (R&D) tax credit. And with that comes more internet articles, more R&D Tax Credit marketing and more just plain wrong Tic-Toc-Tax advice. Our clients are not immune to this noise, so we put together this R&D tax credit post to provide the real information.
First, an Overview
Qualified research expenses (QREs) are central to the federal research and development (R&D) tax credit. Businesses that can identify which of their costs meet the qualifying criteria may be able to take advantage of a dollar-for-dollar in the FICA (employer) taxes bill vs just a deduction for the QREs. Remember the value of a deduction depends on the tax rate. A C-Corp tax rate is 21%. So a deduction, of say $10,000 is worth $2,100 whereas a $10,000 tax credit is worth $10,000.
A taxpayer can’t both deduct research costs and claim a research credit for the same expenditure; there is no double tax benefit. A taxpayer must reduce the research expenditure deduction otherwise allowable by the amount of the research credit claimed which increases the taxable profit. But using the example above, paying $2,100 more in income tax is offset by the potential $10,000 tax credit.
There is another consideration and that the tax treatment of R&D expenditures shifts from immediately expensing R&D costs to requiring amortization over a specified period starting in 2022. Instead of deducting these costs in full in the year they are incurred, businesses must now spread (amortize) the deduction over five years for domestic R&D expenditures and 15 years for foreign research and development expenditures. So to get a $10,000 credit, that means you may have spent $50,000 this year but you then forgo a deduction of $50,000 this year to get the credit. Over the five years, you will come out ahead however.
What is qualified research?
What exactly qualifies as research?
It's not all white coats and labs. According to the IRS, it's all about meeting a four-part test. Essentially, if your activities involve improving or developing a business component (like a product, process, or software), have a technological aspect, face uncertainty, and are experimental in nature, you're likely on the right track.
What expenses qualify for the R&D credit?
Employee wages and contract expenses may be eligible for the R&D tax credit if the labor is performed in the United States. Supplies, defined as tangible raw materials used in the R&D process that were not initially capitalized or depreciated, may qualify, as well. General and administrative costs, on the other hand, typically are not eligible. This is true for activities that were wholly or partially conducted in support of qualified research.
1. Qualified R&D employee wages
For wages to qualify for the R&D tax credit, employees must perform qualified research activities, such as:
- Conducting or executing the qualified research (e.g., testing a manufacturing prototype)
- Directly supervising the qualified research (e.g., managing a team of software developers)
- Directly supporting qualified research (e.g., organizing test results on formulation trials)
Only the time attributable to these specific activities may be claimed as part of the credit. Documentation is key here, so keep those payroll records handy like W2s and time cards handy.
2. Qualified R&D supply expenses
Qualified supply expenses are defined as tangible properties directly used in research activities that were not capitalized or depreciated. For example, raw materials used to fabricate and test prototypes would be eligible, but the research facility itself, depreciable equipment or general office materials would not.
3. Qualified contract research expenses
Much like qualified wage expenses, qualified contract research expenses include time spent conducting or executing qualified research. The difference, however, is that these activities are performed by a third party, not the business entity itself. And up to 65% of the expenses - 75% in some cases) are allowed. According to IRS guidelines for contract research, businesses must maintain substantial rights to the research performed by the contractor AND bear the economic risk of the contractor’s development even if the research was not successful.
Navigating the world of R&D tax credits might seem daunting, remember, we're here to help you every step of the way. We’ve teamed up with R&D tax experts to walk you through the process since this is a very specialized tax area with little room for error. Don't hesitate to reach out if you have any questions or need assistance. Together, we'll make sure you're maximizing your benefits and minimizing the headache.
