How To Calculate the R&D Tax Credit

The Sec. 41 research and development (R&D) federal tax credit can help eligible businesses significantly offset their federal tax liability, whether for income or payroll taxes. If your business has incurred costs to develop new products or processes—even if they didn’t pan out—here’s what you need to know about the R&D tax credit calculation.

What is the R&D credit?

The Sec. 41 credit is designed to incentivize domestic businesses to conduct R&D work in the United States. It generally allows a business doing “qualifying research” to apply a percentage of its qualifying expenses to offset, on a dollar-for-dollar basis, its federal income tax or payroll tax liability.

Unused credits can be carried forward for 20 years or back one year to offset income tax liability in those years. And the option to apply some or all of the credit against your payroll tax liability means you can benefit even if your business isn’t profitable and hasn’t yet incurred income tax liability. (See below for information on limits on applying the credit to payroll taxes.) The reduced payroll tax obligation could significantly boost your cash flow.

Is there more than one way to calculate my credit amount?

Yes. IRS Form 6765, “Credit for Increasing Research Activities,” provides two options. You can claim the “regular credit” in Section A or elect to claim the “alternative simplified credit” (ASC) in Section B. It’s best to calculate your credit under both methods to determine which produces the higher credit amount.

How does the regular credit formula work?

The regular credit generally equals 20 percent of the smaller of the:

• Current-year qualified research expenses (QRE) that exceed a base amount, or
• 50 percent of the current-year QREs.

The base amount is determined by applying a fixed-based percentage to the average gross receipts (less returns and allowances) for the four most recent years. 

The fixed-based percentage depends on whether you’re a startup or an established company. For purposes of the credit, though, “startup” is defined broadly, to say the least. If you had both gross receipts and QREs for the first time in a tax year beginning after 1983, you’re a startup.

The fixed-based percentage for a startup is three percent for the first five years after 1993 for which it has QREs. For later years, the calculation of the fixed-base percentage is more complicated, but it never exceeds 16 percent.

Let’s assume your business qualifies for the three percent fixed-base percentage. Here’s an illustration of how the calculation could work out:

Note: You may take a reduced credit rather than the full amount. See below for more information on this option.

Related

IRS Form 6765 for R&D Tax Credits: What It Is, How to File, and More

Finances and Taxes

How does the ASC formula work?

The ASC generally equals 14 percent of current-year QREs that exceed 50 percent of the average QREs for the three previous tax years. If you had no QREs for those years, the ASC rate is 6 percent of the current-year QREs.

Here’s an example for a company with the following QREs:

• 2019: $100,000
• 2020: $110,000
• 2021: $120,000
• 2022: $130,000

And the following steps to calculate: 

1. Calculate the three-year average QRE: $110,000 ($330,000/3)
2. Calculate 50 percent of the three-year average QRE (aka, the base amount): $55,000 ($110,000 x .50)
3. Deduct the base amount from current-year QREs: $75,000 ($130,000 – $55,000)
4. Calculate the 2022 credit amount by multiplying that figure by 14 percent: $10,500 ($75,000 x .14)

If the company had no QREs until 2022, the full credit would be $7,800 ($130,000 x .06).

As explained below, you might prefer to take a reduced credit instead of the total amount.

Which method is better?

It depends—there’s no one-size-fits-all answer to this question. Because the ASC doesn’t account for historical gross receipts, it can help businesses that don’t have the necessary records nonetheless claim the credit.

On the other hand, the regular credit amount often weighs in at more than the ASC, especially when the base amount is low. It’s likely to be higher for new companies or other companies that have only recently begun performing R&D.

You should never assume that the method that produces the larger tax credit in one tax year is the optimal method going forward. Circumstances change, so you should go through the exercise of determining your credit under both methods every year.

Can I change my mind after electing the ASC?

Once you make the election, it applies to the current tax year and all later years. You can’t revoke the election for the current year, but you can for a later tax year. You’ll need to complete Section A on Form 6765 and attach the form to your original tax return for the year for which the revocation will apply.

Note: You can make an ASC election on an amended return only if you haven’t already claimed the research credit for that year. 

Can I apply the entire credit amount against my payroll tax liability?

Eligible businesses can elect to apply up to $250,000 of the credit against their 6.2% share of the Social Security taxes for their employees. You’re eligible if you have:

• Gross receipts of less than $5 million for the tax year, and
• No gross receipts for any tax year in the preceding five-year period (including the current tax year).

Beginning in 2023, you can apply an additional $250,000 of your R&D credit against your 1.45% Medicare tax liability for a maximum payroll tax credit of $500,000 (the same eligibility requirements apply). The amount is bifurcated, though. So you can apply no more than $250,000 against each type of payroll tax liability — Social Security and Medicare. You can’t, for example, use $300,000 against Social Security and $200,000 against Medicare.

If you elect to apply part or all of your credit to payroll taxes (by completing Section D on Form 6765), you must attach Form 8974, “Qualified Small Business Payroll Tax Credit for Increasing Research Activities,” to your employment tax return. You can apply the credits to offset payroll taxes no earlier than the first quarter after you file the tax return with your payroll tax election.

Note: According to the IRS, QREs incurred during 2023 will be eligible for the increased $500,000 threshold after the annual tax return is filed.

Why would I take a reduced credit?

Whether you opt for regular credit or the ASC, Form 6765 allows you to take a reduced credit. Your instinct may be to always claim the full amount, but that choice might work against you. For example,  if you take the full credit, you must reduce your otherwise allowable Sec. 174 deduction for qualified research expenses by the amount of the credit.

In other words, you have to add the full credit amount to your taxable income before you apply the credit, and this could land you in a higher tax bracket. If you take the reduced credit, you don’t need to add the reduced credit amount to your taxable income.

Adding to the credit could have other tax consequences, as well. Talk to your CPA about the best course for your circumstances.