How Can My Business Use the R&D Tax Credit?

Every year, businesses that are eligible for the federal research and development (R&D) tax credit let this valuable opportunity slip by. One reason is likely that they don’t understand how they can use the credit to their benefit. For example, they might mistakenly believe they can’t use the credit because they don’t owe any income taxes. But income tax is only one way the credit can pay off for your business. Here’s what you need to know about all of your options. 

What is the federal R&D tax credit?

Also known as the Sec. 41 credit, the federal R&D tax credit was created to encourage 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 its tax liability on a dollar-for-dollar basis—even if the research didn’t produce the desired results.

You can apply the credits against your income tax, alternative minimum tax (AMT), or payroll tax. The option to use some or all of the credit against your payroll tax liability means you can benefit from the credit even if your business doesn’t have any income tax liability. As described below, different rules apply depending on the type of tax liability.

The credit is nonrefundable, but unused credits can be carried forward for 20 years or back one year to offset tax liability in those years.

Do I qualify for the credit?

The IRS has a four-part test for qualifying research activities:

1. The research is performed to eliminate technical uncertainty about the development or improvement of a product or process, including computer software, techniques, formulas, and inventions,

2. The research is undertaken to discover information that’s technological in nature (that is, it relies on physical, biological, engineering, or computer science principles),

3. The research is intended for use in developing a new or improved business product or process, and

4. Substantially all (generally, at least 80 percent) of the research activities are elements of a process of experimentation relating to a new or improved function, performance, reliability, or quality.

If your business has pursued such research, you probably qualify for the R&D tax credit.

How do I claim the credit against my income taxes?

First, you’ll need to calculate your credit using IRS Form 6765, “Credit for Increasing Research Activities.” It provides two options for the calculation[BN1] : You can claim the “regular credit” in Section A or elect to claim the “alternative simplified credit” (ASC) in Section B.

Partnerships and S corporations must file Form 6765 to claim the credit. Other kinds of taxpayers generally can report the credit directly on their Form 3800, “General Business Credit,” and file it with their income tax return.

Note: The IRS limits the amount of general business credits, including the R&D tax credit, that a taxpayer can use each tax year. The credits can’t exceed the excess of the net income tax (net regular tax plus AMT) over the greater of:

• The tentative minimum tax for the year, or
• 25 percent of the excess of net regular tax liability over $25,000.

In practice, business credits generally can offset no more than 75 percent of your tax liability.

Can I apply the R&D tax credit against my AMT liability?

Since 2016, eligible small businesses can have been allowed to use their credits against their AMT. Your business is eligible if it:

• Is a partnership, sole proprietorship, or corporation without publicly traded stock, and
• Has average annual gross receipts of less than $50 million in the three preceding tax years.

How can I apply the credit to my payroll taxes?

For tax years from 2016 to 2022, qualified small businesses (more information below) can elect to apply as much as $250,000 of their federal R&D tax credit against the employer portion of Social Security taxes. (That is, 6.2 percent of the wage base, up to the annual wage cap; for 2022, the wage base limit is $147,000 per employee).

If you qualify, you can apply the smallest of:

• The current-year credit,
• An elected amount no greater than $250,000, and
• Your general business credit carryforward for the tax year (before applying the payroll tax credit).

Note: The general business credit carryforward limit doesn’t apply to partnerships or S corporations.

Beginning in 2023, eligible businesses can apply up to an additional $250,000 of their federal R&D credit against their 1.45 percent Medicare tax liability; the same eligibility criteria apply (see below). Although that makes the maximum payroll tax credit amount $500,000, you cannot apply more than $250,000 to each type of tax. You can’t, for example, apply $300,000 of a $500,000 credit to Social Security taxes and reduce your Medicare credit to $200,000 to make up for it.

Related

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

Finances and Taxes

Is my business a “qualified small business” for the payroll tax election?

A qualified small business for purposes of the election has:

• 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 ending with the tax year.

The second requirement often limits the payroll tax option to start-up companies, but some larger businesses may qualify.

What counts as gross receipts?

Gross receipts include total sales (less returns and allowances) and all amounts received for services. They also include income from investments and incidental or outside sources — for example, interest, dividends, rents, royalties, and annuities.

You must aggregate the gross receipts for all businesses under common control. And you must also include the gross receipts of any predecessor businesses.

What if my business had a tax year that was less than 12 months?

In that case, you’ll need to annualize your gross receipts. Multiply the gross receipts for the shortened period by 12 and divide the result by the number of months in the period.

How do I take advantage of the payroll tax option?

It takes a few steps. First, you must make the formal election on or before the due date for the originally filed income tax return (including extensions). You do that by completing Section D on Form 6765 and submitting the form with your income tax return.

Then you’ll claim the credit against your payroll liability on Form 941 for the first quarter immediately after you’ve filed the income tax return with the election.

For example, you must file your first quarter income tax returns by March 30 to apply the payroll credit to the second quarter employment tax filing. If you extend your income tax deadline to June 30, you can first apply the credit to your third quarter Form 941 filing.

What kind of documentation should I keep when I claim the R&D tax credit?

Whether you claim the credit against income tax, AMT, or payroll liability, you must be able to substantiate the credit if the IRS ever comes calling. You’ll need documentation of your R&D-related expenses — employee wages, contract research services, supplies, and amounts paid to lease computers to conduct research (including cloud computing).

Appropriate documentation might include:

• Payroll records (including Forms W-2s, Forms 1099, and time records),
• Service contracts,
• Purchase orders, invoices, and receipts,
• General ledgers,
• Project notes,
• Status reports,
• Meeting minutes, and
• Lab reports and results.

It sounds like I could have used the credit in earlier tax years. Is it too late to claim it?

You can amend previously filed returns to claim the federal R&D credit as long as the statute of limitations period hasn’t expired. The limitations period generally ends three years after the original deadline or the filing date, whichever is earlier..

Note that the IRS has tightened the requirements to claim a refund or credit for the R&D credit. Your claim must:

1. Identify all the business products and processes to which the credit claim relates for the relevant tax year.

2. For each business product and process, identify all research activities performed, all individuals who performed each research activity, and all of the information each individual sought to discover.

3. Provide the total qualified employee wage expenses, total qualified supply expenses, and total qualified contract research expenses for the claim year (you can do this using Form 6765).

You must submit these so-called “five items of information” when you file the refund claim, along with a declaration signed under penalty of perjury verifying their accuracy.