Common Questions About the R&D Tax Credit

The R&D tax credit is a powerful federal tax incentive that helps businesses of all types and sizes keep competitive while significantly reducing their tax burden. Unfortunately, misconceptions about the credit keep many qualifying businesses from pursuing it, leaving thousands or even hundreds of thousands of dollars on the table.

Here are answers to the most common questions about the R&D tax credit.

Research and Development Tax Credit FAQ

1. What is the R&D tax credit? What is its purpose?

The Research & Experimentation Tax Credit (“R&D tax credit”) was created in 1981 to encourage businesses to innovate and invest in R&D. Also known as the “credit for increasing research activities,” it incentivizes the development of new or improved products or processes. The ultimate goal of the R&D tax credit is to create and keep tech jobs in the U.S. and increase global competitiveness through technological advancement.

The R&D tax credit was originally intended as a temporary two-year incentive. However, it proved so successful that it remained on the books. The 2015 PATH Act made the credit permanent. It also addressed some of the credit’s limitations, allowing more startups and small businesses to take advantage of the incentive. We’ll cover those changes later on in the Q&A.

The R&D tax credit is found in IRC Code Section 41.

2. Is the credit only for R&D companies like pharmaceutical researchers and tech developers?

No! That’s one of the biggest misconceptions about the R&D tax credit. As a result, many companies that might reap the benefits of the credit don’t pursue it.

Yes, the R&D credit applies when developing a new drug or inventing a new high-tech product. However, it can also apply to manufacturers improving their processes or engineers developing new systems. All types of companies in a variety of industries successfully utilize R&D tax credits.

Qualification for the R&D tax credit isn’t based on the industry or type of business but rather on the activities that a company performs. Potentially any company that performs “qualified research activities” (QRAs) on U.S. soil can take advantage of the credit.

3. Do only large corporations qualify?

No! That’s another common misconception about the R&D credit. The credit is available to qualifying businesses of ALL sizes. Even qualifying startups and small businesses with little or no federal income tax burden may use the tax credit to offset their payroll tax or AMT. We’ll cover that later on.

Many small and medium sized businesses don’t pursue the credit due to a lack of internal resources. R&D tax credit studies, as well as compiling the supporting documentation, take time and effort. Thankfully, there are other options, such as working with a specialty tax partner like Tri-Merit.

4. What types of activities are considered qualified research (QRA)?

The IRS uses a four-part test to determine if a business activity meets the standard of “qualified research.” The activity must meet all four requirements.

1. Qualified Business Component

The activity must include a new or improved product, process, formula, computer software, program, technique or invention.

2. Technological in Nature

The activity being performed must fundamentally rely on the principles of physical science, biological science, chemistry, computer science or engineering.

3. Eliminate the Uncertainty

The activity must be intended to discover information to eliminate uncertainty concerning the capability or method for developing or improving a product or process or the appropriateness of the product or process design.

4. Process of Experimentation

The experimentation process needs to include the evaluation of alternatives. Examples of acceptable process include systematic trial and error, prototype creation and testing, computer aided modeling, and simulation in an effort to resolve the technical uncertainty.

Download our whitepaper for a list of common QRAs by industry.

5. Are there specific types of research activities that don’t qualify?

Yes. There are several types of research activities that are specifically excluded from the tax credit. These include:

• R&D activities conducted outside the U.S.
• Funded research
• Research in non-scientific areas including the social sciences, arts or humanities
• Market and consumer research
• Ordinary quality control testing
• Routine data collection
• Internal business process development
• Management studies and surveys
• Adaptation or duplication of existing business components (products, inventions, formulas, software, processes or techniques)
• R&D activities conducted solely to improve product aesthetics
• Research conducted after the start of commercial production or implementation of the new business component (some exceptions apply)
• Locating and evaluating mineral deposits, including oil and gas

6. What kinds of research expenses qualify for the credit?

Expenses that qualify for the R&D tax credit are known as qualified research expenses (QREs). They are certain expenses incurred by a business in conducting the qualifying research activities described above.

QREs include:

• Wages paid to employees who engage in QRAs
• Supplies used and consumed in the R&D process
• Contract research expenses paid to a third party to perform QRAs (allowed at 65% of the actual cost incurred)
• Basic research payments made to qualified educational institutions and scientific research organizations (allowed at 75% of the actual cost incurred)

QREs do NOT include (among others):

• Commercial production costs
• Advertising and promotional expenses
• Acquisition and improvement of land used in research
• General managerial and admin duties, including supervisory functions not related to R&D
• HR and personnel duties, including recruiting
• Accounting duties, including bookkeeping, payroll and budgeting
• Customer service support
• Employee training, including attending conferences
• Routine status meetings
• Charitable fundraising

7. What if the project failed? Can the QREs still count towards the credit?

Yes. R&D involves risk and uncertain results, and the credit takes that into account. QREs up to the point of termination can count towards the credit.

8. How is the R&D tax credit calculated?

The R&D credit is based not on the total amount a business spends on QREs, but on increases in spending. To calculate the credit, a business must determine its QREs in excess of a certain “base amount.”

There are three different base period calculation methods available, based on a business’ date of incorporation, initiation of qualified research, and ability to collect required contemporaneous documentation.

The three calculation methods are:

• Traditional Credit Calculation
  • Base amount is calculated by multiplying the taxpayer’s “fixed base percentage” and the average annual gross receipts for the four preceding taxable years
    • The “fixed base percentage” is the ratio of QREs to gross receipts for the 1984–1988 period. There is a modified rule available for businesses not in existence during that time.
  • Credit rate is 20% of QREs that exceed the calculated base amount
• Alternative Simplified Credit Calculation (ASC)
  • Base amount is 50% of the average QREs for the three preceding taxable years
  • Credit rate is 14% of QREs that exceed the calculated base amount; rate is reduced to 6% if there are no QREs in any of the three preceding taxable years
• Start-Up Credit Calculation
  • Base amount is calculated by multiplying the taxpayer’s “fixed base percentage” and the average annual gross receipts for the four preceding taxable years
    • The “fixed base percentage” calculation is quite complex and can be found here
  • Credit rate is 20% of QRE that exceed the calculated base amount

For the traditional and start-up calculation methods, the base amount can’t be less than 50% of the current year QREs.

9. Is it a dollar for dollar credit?

Yes. It reduces the taxpayer’s tax bill by a full dollar for each credit dollar.

However, the IRS wants to make sure that companies don’t benefit twice by using QREs for both the R&D tax credit and for business tax deductions.

If a company wants to claim the expenses as a credit, they must either reduce the amount of their deduction by the amount of the R&D credit claimed, or choose to take a smaller credit. This “reduced” credit decreases the credit rate from 20% to 13% under the traditional calculation and from 14% to 9.1% under the ASC.

10. How is the R&D tax credit claimed?

Corporations and pass-through entities claim the R&D credit on IRS Form 6765, Credit for Increasing Research Activities.

11. What if the credit offsets all tax liability? Is the credit refundable?

No, but the excess credit isn’t lost. Any R&D credit that isn’t used to offset a company’s tax liability for the year in which the QREs were incurred or paid may be carried back to the prior tax year or carried forward for up to 20 years!

12. Can startups that don’t have federal income tax liability utilize the credit?

Yes! The 2015 PATH Act expanded the R&D tax credit to benefit startups with low or no income tax burden. Qualified Small Businesses (QSB) with less than $5 million in gross receipts may use the credit to offset the FICA portion of their payroll tax—not just their income tax. The credit is capped at $250,000 for up to five years.

13. Can small businesses subject to the AMT utilize the credit?

Yes! This was another important expansion of the credit under the 2015 PATH Act. Eligible Small Businesses (ESB) with $50 million or less in average gross receipts in the past three years may use the credit to offset the Alternative Minimum Tax (AMT).

14. Are R&D tax credits available at the state level, or only federal?

Currently, 37 states offer R&D tax credits. Most follow the federal guidelines for determining QRAs and QREs, so businesses in those states can claim both without too much additional effort.

15. Does claiming the R&D tax credit increase audit risk?

If you are taking an incentive for the first time on a timely filed return, the odds of being audited are really no higher than if your weren’t taking the incentive. The audit rate goes up if you’re amending a return to claim credits you didn’t previously realize you qualified for. This is logical as you are essentially asking the Treasury for a refund.

When done properly through an R&D tax credit study from an expert specialty tax partner like Tri-Merit, you can feel confident your claim will hold up under IRS scrutiny.

16. Is pursuing the R&D tax credit worth it?

Yes! The R&D tax credit is one of the most important and valuable incentives offered by the government for businesses to innovate, improve and compete. It can significantly reduce your tax burden, freeing up capital to invest in operations and growth.

While the R&D tax credit is complex, it isn’t something you have to handle on your own as a business owner or CPA. Tri-Merit’s team of engineers, attorneys and CPAs make the process easier by taking a customizable, flexible and thoughtful approach to produce the best possible outcome. We engage clients in the most efficient and effective way possible, requiring minimal time and effort that results in a refreshingly simple process.

Tri-Merit helps companies determine the size of their potential credit, the usability of those credits, and the appropriate way to support their credit claims.

17. How can I find out if my company or client qualifies?

Any company can qualify. Determining if you actually do requires an evaluation of the facts and circumstances of your activities.

Tri-Merit will do much of the upfront work to determine if you qualify, at no cost. This is our standard phase one feasibility analysis. We examine your company’s ability to capitalize on the credit. A feasibility analysis saves valuable time by identifying potential problem areas before committing to a full tax study.

There’s no risk in exploring the possibilities. Call (847) 637-5677 for more information or to set up a consultation.