The Research and Development (R&D) Tax Credit is a means by which the United States government incentivizes American businesses to continue innovating and expanding their abilities to research and develop better products. As technology evolves and provides a wider range of capabilities in every industry, companies must keep pace with that growth. That can prove difficult as many companies, big and small, face adversity in creating new products or improving existing ones. Even seamlessly integrating new products with those that currently exist is another hurdle that is often tough to overcome.
That's why R&D is so vital to the strength of American businesses. When companies can increase their technical acumen to navigate past the barriers that limit innovation, it provides a stable foundation for our economy. It stimulates competition and the result is a healthier, more robust marketplace However, innovation can be expensive in both financial cost and manpower. There are many variables involved in coming up with new ideas and the methods to implement those ideas into tangible value. More often than not, the trial and error that comes with R&D takes up significant time and money without the return on investment to show for it.
The R&D Tax Credit is Born
First created in 1981, the credit went by the slightly different name of the Research and Experimentation (R&E) Tax Credit and has been a component of the United States tax code to this day. The goal is to encourage American business owners to continue making substantial investments into their research and development departments for the purposes of conceiving, designing, and producing new products or trade processes, and building upon pre-existing products or trade processes to make them more reliable, more efficient, or higher quality. Consider it a monetary incentive to think bigger and better.
Now, some three decades on, the R&D Tax Credit has not only remained part of the tax code but expanded to make certain provisions permanent. Under the Obama Administration, the Protecting Americans from Tax Hikes (PATH) Act was passed to give taxpayers more accessibility to the credit while renewing certain provisions on a retroactive basis and implementing a series of provisions that had expired as permanent components of the credit.
How Taxpayers Might Benefit from the R&D Tax Credit
These apply to both individuals and businesses and the changes eliminated many of the eligibility criteria that made it difficult for small businesses and startups to benefit from the credit. Under the PATH Act, eligible small business owners may now claim the R&D Tax Credit based on their Alternative Minimum Tax (AMT) for the tax year. This was once restricted under the previous version of the law.
Eligible small businesses are allowed to apply the credit as a way to offset their AMT. There are some stipulations as to the eligibility criteria of a small business seeking the credit. As per the expanded language, an eligible small business must not be a publicly traded company, nor a partnership or sole proprietorship that has an average annual gross over $50 million over the three previous taxable years to the tax year in which the business is claiming the R&D Tax Credit.
In addition, startup companies are now eligible to claim the R&D Tax Credit but the expanded legislation now makes it a refundable credit for startups that have no federal tax liability and can prove gross receipts totaling under $5 million. The Credit is taken against payroll taxes with a maximum of $250,000 over a period of five years. As of January 2016, small businesses that qualify may apply the R&D Tax Credit against their employers' FICA payroll taxes. But in order for the business to be eligible, it must have less than $5 million in annual gross receipts for under five years.
Most companies are often allowed to claim anywhere from 7% to 10% of their qualifying expenses under the federal R&D Tax Credit. Consider a qualified employee earning $100,000 a year on a W2, he or she may equal a tax savings of as much as $10,000 for an eligible employer.
Qualifying Activities
The list of activities that make a business eligible to claim the R&D Tax Credit are as follows. All of these practices have a role in the progress and growth of the business:
- Designing and applying an improvement on an existing product, process, methodology, software, formula/blueprint, or internal manufacturing process
- Developing a tool, a fixture, a mold, or some other similar apparatus
- Developing a data center or data mining tool or similar apparatus
- Integrating new equipment into your business
- Integrating an Application Programming Interface or similar technology
- Developing new or updated pricing models
- Manufacturing new products or manufacturing products that have been improved in some capacity
- Developing prototypes, models, or initial versions of a product or service
- Developing a simulator
- Developing a risk management apparatus
- Researching and evaluating alternative materials for products
- Developing firmware
- Exploring ways to integrate new research
- Making a current manufacturing process more efficient or effective
Common Challenges When Claiming R&D Tax Credits
Although claiming this credit can offer considerable benefits for companies engaged in R&D efforts, the process can be challenging.
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What Happens to Unused R&D Tax Credits?
What happens if you don’t use all your credits in a single year? Don’t worry! The US tax code has you covered.