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Research and Development Tax Credit: A Comprehensive Guide

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How the Research and Development Tax Credit Works

The Research and Development Tax Credit is a federal tax credit that incentivizes businesses to conduct qualified technical activities in the United States to improve products and processes. Businesses engaged in technical activities can document income tax credits for their qualified research expenses, which generally include employee wages, third-party costs, offsite data hosting costs, and project-related supplies. R&D tax credits can be more valuable than deductions because credits directly offset income tax liability.

R&D Tax Credit Qualifications

Which Industries Qualify for R&D Tax Credits?

Established businesses and startups in these industries are typically eligible for the R&D Tax Credit:

  • Manufacturing & Processing
  • Software & Technology
  • Engineering & Product Design
  • Biotech & Life Sciences
  • Aerospace
  • Pharmaceutical & Medical Devices 
  • Oil & Gas

Many industries beyond this list may qualify for the R&D credit. In fact, businesses in any industry may be eligible if they engage in technical activities to develop new products or processes.

Small business owners often overlook the R&D Tax Credit because of the misconception that it only applies to companies conducting laboratory research. The truth is that businesses that perform a broad range of technical activities can qualify.

R&D Tax Credit Qualified Activities

A business must conduct qualified technical activities to be eligible for the R&D Tax Credit. To identify if your business qualifies, an R&D credit expert can use the Four-Part Test to evaluate your technical activities. Omega’s tax credit experts can work with you to apply the Four-Part test to your own activities and determine which expenses can qualify.

R&D Tax Credit Requirements: The Four-Part Test

To qualify for the R&D Credit, your technical activities must satisfy four requirements:

1. Permitted Purpose

Develop or improve products, processes, or techniques

The activity must develop or improve business components such as tangible products, operational or production processes, formulae, software, or methods. The qualified activity must also seek to improve the component’s performance, functionality, quality, or reliability.

2. Elimination of Uncertainty

The desired solution must be unclear before testing

There must be uncertainty regarding the design, capability, or method of the business component being tested. 

3. Process of Experimentation

The qualified activity should include a trial-and-error process

The qualified activity should involve an iterative trial and error process wherein results are evaluated and compared to the intended outcome. 

4. Must Be Technical in Nature

Qualified activity must involve traditional sciences.

Technical activities must leverage a scientific skillset, such as computer science, engineering, physics, chemistry, or biology. Activities that utilize social or managerial sciences like behavioral psychology, sociology, economics, or political science are not eligible. Market research such as evaluating price points from vendors is also excluded.

Types of Qualified Research Activities

Qualified research activities are more common than many people think. Your business does not have to create patentable products to qualify for the credit. Your technical project could simply make an effort to catch up with your competitors’ products or find the best way to integrate an existing technology into your production process.

Some examples of qualified research activities include:

  • Developing new consumer products
  • Developing software, even as a service provider, for web, desktop, smartphones, and product controllers
  • Developing new manufacturing processes and techniques
  • Improving the performance, functionality, quality, or reliability of existing processes
  • Testing alternatives and evaluating prototypes of new or improved products
  • Research intended to speed up time-to-market
  • Implementing new automation processes
  • Process improvements aimed at waste reduction, cost reduction, and increased efficiency
  • Experiments developing or functionally improving formulas for food, beverage, or chemicals (i.e. shelf life, chemical content, packaging functionality) 
  • Research creating patentable products or processes
A man and a woman work on a technical prototype in a research and development laboratory, performing qualified research activities while seated at a desk.

How To Claim the R&D Tax Credit

A few steps must be taken to claim the Research and Development Tax Credit.

Generally, businesses must first determine if their technical activities are eligible for the credit before calculating their qualified research expenses. Companies must keep records of those expenses and document how those technical activities meet the R&D tax credit qualifications in Section 41 of the Internal Revenue Code.

Once eligibility and qualifying expenses have been documented, businesses must file IRS Form 6765, the Credit for Increasing Research Activities; and Form 3800, the General Business Credit.

IRS Form 6765: Credit for Increasing Research Activities

Businesses must submit IRS Form 6765, the Credit for Increasing Research Activities, to the IRS as an attachment to business income tax returns for each year they wish to claim the R&D tax credit.
There are four sections on Form 6765 which can be used to report qualified research expenses:

Section A: Regular Credit

The Regular Credit in Section A allows companies to compare their R&D expenses to their revenue.  The company develops a historical base using its first 10 years of qualified activities and compares that base to recent years’ revenue and the current year’s expenses.

Section B: Alternative Simplified Credit

The Alternative Simplified Credit in Section B allows companies to review a more recent period of activity and only focuses on expenses (as opposed to expenses vs revenue).. 

Section C: Current Year Credit

The Current Year Credit in Section C identifies other tax forms or adjustments that may need to be completed depending on the business’s structure.

Section D: Qualified Small Business Payroll Tax Election and Payroll Tax Credit

Section D applies to qualified small businesses that wish to claim their R&D credit against payroll tax liabilities. This payroll tax election allows startups and businesses without income tax liability to benefit from the credit on payroll taxes.

The R&D tax credit specialists at Omega Accounting Solutions can help you complete Form 6765 while providing expert insights on maximizing your credit benefits and ensuring your R&D credit claim complies with IRS regulations.

IRS Form 3800: General Business Credit

IRS Form 3800 is used to list and calculate the accumulated tax credits a business is claiming. Form 3800 must be filed to claim any of the general business tax credits. After Form 6765 is complete, companies transfer their calculated R&D credit amounts to Form 3800, along with any other tax credits the business is claiming.

The tax credit experts at Omega Accounting Solutions can provide your CPA with the information needed to complete Form 3800 as it relates to your R&D Credit claim.

Three research and development team members work together at a meeting table inside an automotive manufacturing plant.

How to Calculate the R&D Tax Credit

The R&D tax credit is calculated by first totaling the business’s qualified wages, supplies, third-party costs, and cloud computing costs. The taxpayer must then evaluate the Regular Credit and Alternative Simplified Credit to determine which calculation path to utilize.

The Regular Credit compares qualified expenditures to revenue from a given “base period” and applies that ratio to recent years’ revenue in comparison with the current year’s qualified costs.
The Alternative Simplified Credit compares the prior three years’ qualified costs to the current year’s qualified costs and does not consider revenue as a factor.
Both the Regular Credit and Alternative Simplified Credit methods have “start-up” calculations for younger businesses that have not yet fulfilled prescribed timelines.

How Much Money Can You Save With the R&D Credit?

There is no ceiling on the amount of credit your business can save by claiming the R&D tax credit. The amount of your business’ R&D credits is determined by the scale and expense of your qualifying technical activities — the more you spend on R&D, the more money you can save. Most businesses save roughly 10% of their eligible R&D costs, and many large corporations save millions of dollars every year.

R&D Tax Credit Qualified Research Expenses

Qualified expenses for the R&D tax credit include employee wages, contractor/consultant fees, supply costs, and leased equipment including offsite server space. Only expenses that apply directly to technical projects conducted in the USA are considered qualified research expenses. Expenditures made in foreign countries cannot qualify.

The following expenses typically qualify for the R&D tax credit:

  • Material costs, such as supplies, components, or specialized tooling for prototypes
  • Employee wages, such as the salaries of engineers and project managers 
  • Contractor wages, such as the fees of outside consultants who assist, direct, or conduct the actual technical activities
  • Rented cloud server space for dedicated testing environments (the server space cannot be used to host live consumer software or website data)

How Is the R&D Credit Monetized?

The Federal R&D credit is typically used to offset income taxes. If the credit is not fully utilized in the tax year it was generated, R&D credits can be carried backward one year to generate a tax refund. If there is still excess credit, it can then be carried forward for up to 20 years. State credits, when available, have their own rules about carryforwards.

The IRS recently released new guidance regarding updates to the mandatory capitalization and amortization of research expenditures.

The Payroll Tax Offset for Qualified Small Businesses

Small businesses and startups that have low or negligible income tax liabilities may qualify to monetize a portion, or all, of their R&D tax credits on payroll taxes, rather than income taxes. This allows businesses that may not currently be profitable to utilize the Research and Development Tax Credit. To qualify for the payroll tax offset as a Qualified Small Business, the company must have less than $5 million in revenue and five or fewer years since recognizing gross receipts.

R&D Tax Credits for Startups or “Startup Provision”

Qualified Small Businesses can utilize their credits to offset payroll taxes up to $500,000 every year for up to five years, or a total of $2.5 million. Any excess credits can be claimed on income taxes.

To benefit from the credit as a Qualified Small Business, your business must:

  • Qualify for the R&D tax credit
  • Have payroll tax liability
  • Have less than $5 million in revenue the year they claim the credit
  • Have five years or fewer since recognizing gross receipts

If your business does not meet the criteria of a Qualified Small Business, you can still monetize the R&D credit on income taxes and carry any excess credits forward for up to 20 years.

The Deadline to Claim the R&D Tax Credit

Businesses can claim the R&D tax credit by submitting IRS Form 6765 attached to their tax return on or before the business tax deadline on April 18 of each year. Businesses can also claim the credit retroactively by filing a tax amendment up to three years from the date the original tax return was timely filed.

How Far Back Can You Claim the R&D Credit?

Businesses can claim the credit in previous tax years by retroactively amending their taxes up to three years from the date their tax return was originally filed. This allows businesses to perform retroactive studies to document their credits for research activities conducted up to three years prior. Businesses can receive a tax refund for these retroactive credits or choose to take the credit against the next quarter’s tax liabilities.

Claim the Research and Development Tax Credit with Trusted Experts

R&D tax credits are easier to access than many business owners think. Businesses do not have to employ white-coat scientists in cutting-edge laboratories to qualify. Technical activities related to process improvements for manufacturing facilities or new apps for software companies may qualify.

If you believe your company may conduct eligible research activities, contact Omega Accounting Solutions to determine your eligibility and claim the R&D tax credit with experts trusted by businesses nationwide. Omega’s team of Research and Development Tax Credit professionals can quickly determine if your business is eligible for research credits, calculate your credit amounts, and help you claim the maximum, valid credit.


 

A Brief History of the Research Tax Credit

The Credit for Increasing Research Activities was first created by the federal government in 1981 with the passing of the Economic Recovery Act (ERTA) as a temporary incentive to encourage new research initiatives.

Congress designed the new credit to incentivize businesses to spend more money each year on research and development. It was initially created as a two-year credit to temporarily jumpstart new research, but the R&D credit proved effective in its purpose and has been extended 16 times since 1981.

In 2003, the R&D Discovery Rule was modified to expand eligibility for the credit and incentivize more businesses to invest in innovative technical activities. To qualify, businesses now only need to make developments that are new to their own company.

While many businesses were able to utilize the credit while building successful R&D departments, some were hesitant to make long-term investments in research activities because the future of the credit was uncertain. Finally, in 2015, the Protecting Americans from Tax Hikes Act (PATH Act) permanently wrote the research and development tax credit into the U.S. tax code. Businesses can now invest heavily in R&D in the United States without fear that the credit could expire.