How to Know If Your Small Business Qualifies for the R&D Credit

The Research and Development (R&D) tax credit is a tax incentive for companies that perform qualified research in the U.S. Let's take a closer look at this tax credit and see how it can help your business.

The Research and Development (R&D) tax credit is a tax incentive for companies that perform qualified research in the U.S. While the term R&D tends to conjure visions of research labs and test tubes, a wide range of businesses and activities qualify for the credit.

Overview of the R&D Credit

The R&D credit is available to companies that spend money in an attempt to develop new or improved products, processes, software, techniques, or formulas.

If your activity qualifies, the federal tax credit is worth 11% to 15.8% of Qualified Research Expenditures (QRE) above a base amount (often about half the current QRE), which includes:

●    Wages of employees directly conducting or supporting the innovation and first-line supervisors

●    Supply costs, including tangible property and prototypes

●    Contract research expenses paid to third-party vendors, consultants, contractors, and temporary employees (at 65%)

●    Patent development costs

●    Costs to rent or lease computers or cloud services used in the research and development process

Over 35 states in the U.S. have enacted their own R&D tax credits, making this an extremely valuable tax incentive for companies that can claim it.

What business activities qualify for the R&D credit?

The IRS has a four-part test to help small businesses decide whether their activities qualify for the R&D credit:

1. Permitted purpose. The purpose of the research or development must be to create a new or improved product or process that the business intends to sell, lease, license, or use in its business operations.
2. Technological in nature. The experimentation process must rely on the hard sciences, including engineering, computer science, physics, chemistry, or biology.
3. Technical uncertainty. The business must perform research to eliminate technical uncertainty about the development or improvement of a product. In other words, purely aesthetic changes don’t qualify.
4. Process of experimentation. The activities must include experimentation via modeling, simulation, systematic trial, and error, or other methods.

Internal-use software, that is software used for general and administrative purposes of the taxpayer, must pass an additional three-part test:

1.   it must be innovative;

2.   It must involve significant economic risk, and

3.   It must not be commercially available without mpdofocati0ons that involve innovation and significant economic risk.

Any company in any industry that devotes resources toward research and development may qualify for the R&D credit. However, a few common examples include software and tech companies, construction contractors, manufacturers, food processors, and healthcare companies.

Some of the activities that qualify include:

●    Developing new or improved products or manufacturing processes

●    Developing new or improved software applications for sale, lease, or license

●    Building and enhancing interactive software-as-a-service (SaaS) platforms and web applications

●    Creating algorithms to automate tasks resulting in increased performance

●    Writing code to add functionality and capabilities to improve existing applications

●    Programming mobile apps for iOS and Android platforms

●    Developing code for new technologies such as artificial intelligence, blockchain, and machine learning

It’s also useful to note that the research doesn’t have to be successful for the expenses to count for the credit.

Benefits of an R&D study

If you believe your business may qualify for the R&D credit, an R&D Tax Credit Study can help alleviate complexity and ambiguity by analyzing your company’s research and development activities and determining which costs qualify for the credit.

These studies offer three primary benefits:

1.   Improved cash flow

The R&D tax credit can offset your current year’s federal (and possibly state) income tax liability. If the available credit is greater than the tax due, any unused credit can be carried back one year or carried forward 20 years. We may also be able to identify prior year returns that may be amended to claim the credit retroactively.

New small businesses also have the option of applying up to $250,000 of their federal R&D credit to their payroll tax liability for up to five years.

2.   Financial statements

Claiming the R&D tax credit can reduce the tax provision on your books, resulting in increased net income and higher earnings per share (EPS).

3.   Defense

Analyzing and documenting your business’s research and development activities is essential to ensuring the credit will hold up under audit scrutiny from the IRS and state tax authorities.

For many companies, most qualifying R&D expenses stem from employee and wages and contractor fees, so it’s important to document exactly how much time employees and contractors spend working on qualifying activities. A quality R&D tax credit study is the best offense in sustaining the credit.

Don’t leave money on the table! Decimal is in your corner, helping your business take advantage of available tax incentives. Our professionals can help you navigate your finances, from accounting for daily transactions to improving your tech stack. Talk to us to learn more! 

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