Many business owners can avoid overpaying their taxes by claiming the federal R&D tax credit. In addition to being a major tax-saving opportunity, this credit is meant to incentivize small businesses to innovate and grow. As R&D tax credits can be confusing to understand, this article shall attempt to explain the concept in a simplified manner.
What is the federal R&D tax credit?
Research and Development (R&D) tax credits are an initiative by the federal government to encourage businesses to increase their spending on the research and development of new products. This scheme allows businesses to apply for a reduction in their corporate tax by declaring any expense accrued specifically for research and development projects.
Who is eligible for the R&D tax credit?
Any business that incurs expenditures while trying to develop improved or new products or processes is eligible to claim the R&D tax credit. Four factors are considered to assess whether a business would qualify for the credit:
- Experimentation process- The activities carried out for the project ought to involve some type of experimenting to solve technical uncertainties like simulation, modeling, or other methods.
- Nature of innovation- The research must be technological in nature and performed on hard sciences such as physics, biology, chemistry, engineering, etc.
- Elimination of uncertainty- All research must have been carried out to clear any doubts pertaining to the improvement of a process or a product. Changes for aesthetic or any other purpose will not qualify.
- Qualified purpose- Ultimately, the goal of the activity should be to produce a new or improved product that leads to enhancements in quality, performance, dependability or function.
Businesses that are involved in architecture, construction, engineering, manufacturing, and software are usually eligible for the R&D tax credit. However, certain activities are excluded from this credit. These include surveys, duplication of an existing product, research supported by another individual or government agency, etc.
How to calculate the R&D tax credit?
Two methods are used in R&D tax credit calculation. Form 6765 outlines a series of steps to estimate tax credits using either of these methods. Companies can calculate their credits using both methods and then apply the one which produces a better result.
- Regular Research Credit: Under this method, the credit amount is 20% of a company’s present year qualified research expenditures over a base amount. The base amount is usually the product of a fixed percentage and the average annual gross receipts of the organization over the last four years. Companies that did not claim R&D tax credit in the past or have not been around for the last four years might find it easier to use the second method below.
- Alternative Simplified Credit: This method consists of four steps. First, it involves calculating the company’s qualified research expenses on average over the last three years. Second, the product is multiplied by 50%. Third, the result obtained in step 2 is subtracted from the company’s qualified research expenses for the present year. Lastly, the result of step 3 is multiplied by 14% to arrive at the tax credit amount.
How does the federal R&D tax credit benefit organizations?
The advantage of the R&D tax credit is that it provides businesses of all sizes to develop innovative and revolutionary products and processes without incurring the entire expense. Small businesses can use these credits to offset payroll taxes which reduces staff costs without lowering salaries. Tax credits can also provide funding in addition to other types of financial aid like alternate financing, angel investor loans, etc.
