As a small business owner, you can save a significant amount of money each year with tax credits. The trick is to know which you qualify for and how to claim them. Here, we’ll walk you through the Research and Development tax credit (also known as the R&D tax credit), which helps small businesses offset R&D costs.
Here’s how it works.
What is the R&D Tax Credit?
This is a dollar for dollar federal tax credit—up to $1.25M—that is available to companies to help offset the cost of developing new or improved business elements, including:
- Processes
- Products
- Technologies
- Innovations (like new formulas, techniques, and/or inventions)
Any activity or expense that can improve quality, performance, reliability, or functionality may be a cost that qualifies for the R&D tax credit, including software development, quality enhancements to products or techniques, and/or updated manufacturing processes.
This tax credit is available at both the federal and the state level (although only 36 states offer it), and the credit is typically applied against income taxes, but start-up organizations that have no income may be able to apply the R&D tax credit against payroll taxes for up to five years.
Already a Gustomer? Log in to your account to easily automate the process of determining eligibility and calculating your R&D tax credit.
To do this, in the side nav click on “Taxes & Compliance” and then “Overview” > click on “Go to Gusto R&D“
How to determine if your business is eligible for the R&D tax credit
How to Make an Operating Budget for Your Business
Finances and TaxesNot sure if your business is eligible? There is a four-part test that can help you figure this out—in order to be eligible you must meet all four of the following criteria:
Qualified purpose: The purpose of your research must be to create either a new business component or improve an existing one. As mentioned above, the research must help improve the quality, performance, reliability, or functionality of the business component.
Process of experimentation: Any activities that qualify for the credit must include an experimental process like testing, trial and error, simulation, and/or modeling. One or more alternatives must be evaluated to achieve the final result.
Technological in nature: The process of development or improvement of the business component must rely on scientific principles and must use hard science to achieve the final result. Hard sciences include chemistry, biology, physics, computer science, and engineering.
Eliminate uncertainty: You must demonstrate that your company has established methods and activities to eliminate uncertainty about the development or creation of the business component. This means that your team must be confident in their ability to achieve the desired results and/or should have an established process or design for achieving that result.
Which costs qualify for the R&D tax credit?
Here’s how to think about it:
Any qualified expense that is used for a qualified activity, process, or product (all qualified activities, processes, and products must meet the four-part criteria listed above) may be a cost that qualifies for the R&D tax credit.
Got it? Let’s try this another way: qualified expenses for qualified activities, processes, and/or products are qualified costs.
Qualified expenses include:
| Qualified activities, processes, and products must pass the four-part test. These activities must:
|
These qualified costs are eligible for the R&D tax credit.
Which costs do not qualify for the R&D tax credit?
There are certain costs that will not qualify; some of these are:
- Research conducted outside of the U.S.
- Research that is being done by a third party for which the taxpayer has no rights, and/or has not paid for.
- Market research
- Training
- Troubleshooting
- Customizing products or components for specific customers
How can my company claim the R&D tax credit?
Be sure to maintain and continue to document meticulous records of all R&D activities performed at your company.
Documentation may include:
- Expense details
- Payroll records
- Project notes
- Lab results
- Emails and communications about the research and development
In order to claim the credit:
- Complete Form 6765, Credit for Increasing Research Activities.
- For small businesses you must also file Form 8974, Qualified Small Business Payroll Tax Credit for Increasing Research Activities; this will be filed once the IRS has approved your credit.
- Also, for small businesses: Form 8974 is attached to Form 941 when you file it.
How is the R&D tax credit relevant to start-up companies and small businesses?
In 2015, legislation was passed called the Protecting Americans from Tax Hikes (PATH) Act; this expanded the R&D tax credit to start-up companies that were not yet profitable and therefore, did not pay any federal income tax.
Any company that produces less than $5 million in gross receipts for the year and has no gross receipts dating back further than five years is eligible to apply for up to $250,000 in R&D credit per year. Of course, the company must also meet the criteria laid out in the four-part test above.
For start-up companies, the R&D tax credit is set against the FICA portion of payroll taxes.
Misconceptions about the R&D tax credit
There are some common misconceptions about the R&D tax credit, so let’s clear them up!
Myth: Your company must be paying income taxes to claim the R&D tax credit
Truth: Nope! In certain cases, startup organizations may be able to offset a portion (up to $250,000) of their payroll tax liability with the R&D tax credit Also, certain states provide the credit regardless of income tax status.
Myth: Your company must be doing cutting edge, groundbreaking scientific work to qualify for the credit.
Truth: Nope! You just need to meet the qualifying credit criteria and the four-part test.
Myth: Your company must employ an R&D department to qualify for the credit.
Truth: Nope! You just need to meet the qualifying credit criteria and the four-part test.
Myth: Your company can’t qualify for the R&D tax credit because you are (or your shareholders are) subject to the Alternative Minimum Tax (AMT).
Truth: Nope! Since the start of 2016, certain small businesses (that are not publicly traded and have less than an average revenue of $50M) can offset AMT and other taxes with the R&D tax credit. You just need to meet the qualifying credit criteria and the four-part test.
Risks associated with claiming the R&D tax credit
Like any tax credit, the R&D tax credit is subject to IRS audits and scrutiny. When the IRS examines a tax return that includes an R&D tax credit claim, if the claim is found to be unsupported, the IRS may disallow the tax credit (which means that they will deny the credit or reduce the credit amount and take the money back).
In certain cases, the IRS may impose a penalty and or interest on tax credits that have already been received but determined (in an audit) to be unsupported.
Commonly asked questions about the R&D tax credit
Understanding if you are eligible for the R&D Tax Credit may be confusing, so here are some frequently asked questions to clear things up.
I realize that I qualified for the R&D tax credit in previous years, but never claimed it. Is it retroactive?
Yes. At the federal level, you can claim the R&D tax credit for up to three years prior. Certain states allow you to go back even further.
Does a company have to be profitable to claim the R&D tax credit?
A company must be profitable to utilize the credit, but fortunately, the federal credit can be carried over for 20 years, so you can claim the credit when your company is not profitable and utilize it once you are. State R&D tax credits have their own specific carryover laws.
Also, as mentioned above, certain start-up companies may be able to claim the credit against payroll taxes.
If my company fails in its research and/or development, are we still eligible for the R&D tax credit?
Yes. As long as you meet the other criteria, you are not required to be successful in your research and/or development. The tax credit is for the effort not necessarily the result.
Is the R&D tax credit a federal tax credit or a state tax credit?
Both. In addition to the federal R&D tax credit programs, 36 states offer the R&D tax credit:
- Alaska
- Arizona
- Arkansas
- California
- Colorado
- Connecticut
- Delaware
- Florida
- Georgia
- Hawaii
- Idaho
- Illinois
- Indiana
- Iowa
- Kansas
- Kentucky
- Louisiana
- Maine
- Maryland
- Massachusetts
- Minnesota
- Nebraska
- New Hampshire
- New Jersey
- New Mexico
- New York
- North Dakota
- Ohio
- Pennsylvania
- Rhode Island
- South Carolina
- Texas
- Utah
- Vermont
- Virginia
- Wisconsin
Do the business components developed or improved by the company have to be new to the industry in order to qualify for the R&D tax credit?
No, but they must be new to the company.
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