How to Calculate R&D Expenses?

R&D Tax Credit

small business

Deborah Roth, CPA
August 1, 2023

The calculation of the Research Tax Credit offers two main approaches: the Regular Research Credit (RRC) Method and the Alternative Simplified Credit (ASC) Method. These methods are outlined in detail within IRS Form 6765, also known as the Credit for Increasing Research Activities form.

When filing their tax return on time, taxpayers have the freedom to choose either of the two methods. However, it is crucial to grasp the nuances of each computation approach since once a method is elected, it cannot be altered when submitting an amended return. Considering that each method comes with its own set of benefits and drawbacks, understanding them thoroughly is essential in making the most suitable decision for claiming the Research Tax Credit.

Regular Research Credit (RRC) Method for R&D Tax Credit

The RRC method allows businesses to claim a credit of 20% of their current year qualified research expenses (QREs) over a base amount. To calculate the credit, companies need to consider the average annual gross R&D receipts over the previous four tax years. Additional information may be required for companies with operations dating back to the 1980s or earlier.

Alternative Simplified Credit (ASC) Method

An alternative to the RRC method is the Alternative Simplified Credit (ASC) method, which offers a simplified approach for companies to calculate their R&D tax credit. Unlike the RRC method, the ASC method does not require gross receipts as a component of the calculation. Instead, it focuses on QREs over the preceding three-year period.

Step-by-Step Calculation Using the Alternative Simplified Credit Method

The ASC is calculated as 14% of QREs incurred in the current tax year, above 50% of the average QREs in the previous three years. If a taxpayer had no QREs during any of those three prior years, the credit is calculated as 6% of the QREs in the current tax year. The simplified four-step calculation process is as follows:

  • Determine the current tax year's qualified research expenses (QREs).
  • Calculate the average QREs for the previous three tax years.
  • Multiply the average QREs for the three-year period by 50%.
  • Subtract half of the three-year average from the current year's QREs.
  • Apply a credit rate of 14% to the resulting amount to determine the R&D tax credit.

Qualifying Activities for the R&D Tax Credit

Numerous activities are eligible for the R&D tax credit, all of which contribute to the growth and development of businesses. Some of these activities include:

  • Creating improved products, processes, formulas, software, and techniques.
  • Automating or improving internal manufacturing processes.
  • Designing tools, jigs, fixtures, and molds.
  • Integrating new equipment and technologies.
  • Development of data center, big data, and data mining tools
  • Integrating APIs and other technologies.
  • Developing financial or pricing models.
  • Hiring outside consultants for qualified research activities.
  • Manufacturing new or improved products.
  • Developing prototypes, first articles, and models.
  • Evaluating alternative materials.
  • Developing firmware.
  • Network hardware and software development and optimization.
  • Developing simulators.
  • Development of risk management systems.

Understanding Qualification Rules and Documentation

Knowing the rules for qualification is an essential initial step in claiming the R&D tax credit, typically carried out during a feasibility analysis or Phase 1. During this phase, R&D activities and related qualified research expenses (QREs) are identified at a high level. This information is used to estimate both federal and state R&D tax credits accurately. Educating oneself about qualified activities and QREs is essential for more precise benefit estimation.

The expenses that are eligible for research activities within a company usually include employee compensation, materials, and contracted services. Sufficient documentation, such as payroll records, financial records indicating supply or contract research expenses, and vendor invoices, can support these qualified expenses.

On average, companies can typically claim 7-10% of their qualified expenses as a federal R&D tax credit. For instance, a single software developer, engineer, or lab technician earning a W2 of $100,000 annually may generate tax savings of up to $10,000.

To illustrate the successful claiming of the R&D tax credit, consider the case of a brewery:

Established in 1995, this $70M brewing company produces over 260,000 barrels of beer annually and operates in over 40 U.S. states plus Washington D.C. Additionally, they have added a restaurant and an Inn to offer customers an opportunity to explore the brewpub and production brewery.

While a brewery may not immediately come to mind when thinking about "R&D," this brewery faced the challenge of differentiating research activities from regular brewing production. After some uncertainty, the company identified its R&D efforts, which primarily involved creating new brews with a focus on gluten-free beers. Unlike typical gluten-free beers that are generic white lagers, the brewery aimed to cater to the preferences of gluten-free beer enthusiasts by experimenting and testing various new formulations and brewing processes.

In order to qualify for the R&D Tax Credit, the brewery required a dedicated team to invest time and resources in understanding the complexities of the brewing process to maximize its R&D Tax Credit potential. Selecting the GOAT. tax credit team, known for their extensive experience in conducting over 2,200 R&D studies resulting in federal & state tax savings of over $1 billion for their clients, was an obvious choice.

Remarkable Results began conducting these studies for the brewery when its revenues were $10 million, and for almost a decade, the company has benefited from an average of $65,000 in annual R&D credits. This tax offset has allowed the company to invest in developing additional brews and grow its sales to reach $70 million. The success of their new products has significantly contributed to the company's rapid growth.

continue reading

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.

read on

No Profits, No Problem: R&D Tax Credits Can Help Your Startup

Running a startup is all about innovation and making the most of your resources. But what if you're not yet turning a profit?

read on

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.

read on