Nearly almost every business in the United States of America is battling with the effects of the coronavirus outbreak. However, R&D tax credits can be an extremely effective and sustainable way for businesses to recoup funds spent on unique and innovative goods or processes.
R&D Tax Credit: Overview
The R&D tax credit, which was established in 1981 to encourage research and development (R&D) in America, is a dollar-for-dollar adjustment to federal income tax obligation and, in some cases, payroll tax liability. The majority of the states also provide a similar credit, bringing the combined beneficial effect of the federal and state tax credits to between 10% and 20% of qualified spending. Businesses in about every industry reported over $18 billion in R&D tax credits last year.
The tax credit’s statutory, IRC Section 41, is “Credit for Increasing Research Activities,” however it is more commonly referred to in the business as the R&D Credit, Research & Experimentation Credit, or R&E Tax Credit, or merely Research Credit.
The federal income tax code of the United States grants a benefit — a nonrefundable tax credit — to businesses that conduct eligible research and development operations. The Sec. 41 of IRC credit, which is worth up to 20% of the excess of qualifying research expenses for the tax year above a base amount, can generate immediate cash flow via dollar-for-dollar reduction of current year tax liability. While credits are not refundable, they can be carried back one year and forward 20 years under Sec. 39 of the IRC. Additionally, qualifying activities documented in earlier years may be used to generate additional funds in any open tax years by filing an updated tax return.
Any type of business that continuously improves or develops new or enhanced products, methods, or technology may be eligible to claim for the R&D tax credits, one of the most advantageous federal tax credits available. The research and development tax credit is available on both the federal and state levels, with around 70% of states giving it.
The first step is to identify potential revenue streams inside current business operations to take advantage of this tax credit technique.
Activities That Qualify for R&D Tax Credits
The following activities qualify as acceptable research expenses for the purposes of the Sec. 41 R&D tax credits:
- Creating a new or significantly improved product; Inventing a new technology;
- Inventing a new manufacturing process;
- Developing existing processes; Inventing or improving software; or
- Inventing prototypes or models.
Certain activities, including those undertaken outside the United States, research conducted after commercial manufacturing of the product begins, and surveys, are not eligible for the credit.
The R&D tax credit is determined as a proportion of the business’s R&D expenses. Qualified research and development expenditures may include operations expenses such as salaries, supplies, and payments to third-party providers if the expenditure is for a qualified research activity. Thus, while these costs are normally completely deductible when calculating taxable income, many businesses are unaware that they can also be applied toward R&D credits.
Benefits of R&D Tax Credits
- Increased cash inflows
- Earnings per share increase
- Increase of return on investment
- Federal and state tax liabilities lowered
- An effective tax rate reduction
Why are there not more businesses taking advantage of R&D tax credits?
There is no cap on the amount of possible dollars that US taxpayers can claim; nonetheless, the vast majority of our business owners have not previously claimed the tax credits. As businesses gain familiarity with the actions and expenses that qualify, they discover they had previously missed out on valuable possibilities to claim such credits.
Although R&D credits have existed since 1981, they were merely a temporary provision until 2015, when the credit was made permanent by the Protecting Americans From Tax Hikes Act of 2015 or PATH. Prior to that, the credit was usually only extended at the last minute and only retroactively in some years. As a result, many businesses and their advisors considered R&D tax credits to be relatively difficult to claim.
Numerous businesses have also refrained from requesting tax credits due to the complexity of the computations. Tax credit computation was complex when originally adopted, and it required corporations to have in-depth background knowledge regarding their research operations. In 2006, the Alternative Simplified Credit or ASC approach was enacted. It is a less complex method of computing the tax credit. While this more straightforward way of calculating the R&D tax credit provides extra flexibility for businesses, many still do not claim the credit because they are unaware that they have qualifying activities.
The amount of the R&D tax credit can be rather substantial both at the state and federal levels. While the majority of states adhere to the federal credit, many have their own standards, and frequently the state credit terms are less generous.
It is vital for the taxpayer to be able to prove the amount of its research and development expenses. The IRS has established an audit procedures guide to assist its employees in conducting credit claim audits. The guide focuses on research spending substantiation difficulties.
Claiming for R&D Tax Credits
- A taxpayer seeking an R&D tax credit must maintain records in a usable form, and sufficient information to establish that the expenses claimed are creditable.
- Determine and compile evidence in support of the credit to which you are lawfully entitled. Utilize Form 6765 to submit the credit on a timely filed federal tax return (including extensions). If the reporting entity is a pass-through, the shareholder or partner will monetize the credit by filing a Form K-1 with their 1040 returns.
- The credit must be claimed on a timely filed federal income tax return (including extensions) for the year in which the qualifying expenditures were incurred. Additionally, the credit may be claimed by revising an earlier-filed return on or before the date of the statute of limitations to include credits for costs incurred during that time. The statute of limitations normally allows for the amendment of returns three years after the deadline or filing date (whichever one is earlier).