Q: What’s the Research and Development Tax Credit?

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 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 37 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

The IRS created a four-part qualification test (details below) to help determine eligibility. Keep in mind that for each activity listed, it cannot pertain to the marketing or advertising of your business’s goods or services and the R&D activity must take place within the U.S.

If your company meets all four parts, it’s likely to qualify for the R&D tax credit.

Part 1: The purpose of your research 

The purpose of your research and development activity must create a new or improved function,  performance, reliability, or quality for a business component. According to the IRS, a business component can be a process, product, formula, science, technology, or anything else that directly relates to what your company offers to customers and uses to generate revenue. 

The business component doesn’t need to be tangible, your results don’t have to be perfect, and you don’t have to offer a new or innovative product to market. For example, a business component could be a unique blend of chemicals created by a pharmaceutical company for over-the-counter medicine.

Part 2: Eliminate uncertainty 

Businesses that qualify for the R&D tax credit must encounter a problem with a high degree of technical uncertainty and try to solve it using their own procedures. Any activity your business does to try to address, improve, or develop a product, a product’s design, or a process—whether or not the work is successful—is one of the four ways to qualify for R&D taxes. If your business follows established guidelines or processes to eliminate the uncertainty in question, the activity most likely doesn’t qualify. For example, if a makeup company develops all new products made out of fruits, vegetables, and grains only, testing out the right combo of produce for their products eliminates uncertainty.

Part 3: Technology

The research must be technical in nature—and to be considered technical in nature, an activity must heavily rely on a hard science. Research and development in machine learning, physics, chemistry, biology, software, and/or electrical engineering must be conducted for the research to be considered technological in nature. 

Note that businesses don’t need to define themselves as tech companies. Gusto has secured credits for beauty companies that create their own sustainable packaging, fashion industries that create their own environmentally-friendly threads, and marketing agencies that developed their own analytical software. The development of software must be innovative, resulting in reduced cost and/or improved speed, involve economic risk, and require the use of resources where the recovery of these resources is uncertain. The software cannot be commercially available.

Part 4: Experimentation

According to the IRS, the process of experimentation must include simulation, evaluation of alternatives, systematic trial and error, testing, modeling, and refining. The activity of testing, failing, and tinkering in hopes of finding a solution, even if you don’t  find a workable one, after all, is the process of experimentation. Take the case of Heckler Design, a product design and manufacturing company that focuses on exacting standards for function and aesthetics with their hardware. They developed, tested and improved their specialty software for manufacturing and shipping locally and achieved more than $380,000 in R&D tax credits.

Remember, the federal R&D tax credit is meant to incentivize innovation; it is not merely reward the successful. While your company must meet all four parts of the IRS R&D test, it doesn’t have to succeed in all of its goals to qualify.

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:

  • Salary and wages (for employees who perform, support, or supervise R&D activities)
  • Supplies
  • Cloud services (to host any software that is under development)

Qualified activities, processes, and products must pass the four-part test. These activities must:

  • Have a qualified purpose
  • Include a process of experimentation
  • Be technological in nature
  • Eliminate uncertainty

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
  • Attorney fees, including for filing patents

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
  • Contractors doing R&D within the United States

In order to claim the credit: 

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, 37 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
  • Mississippi
  • 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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