Research & Development Tax Credit (Section 41)

Do you own a business and does your business find ways to improve upon use of technology and equipment? If your answer is yes, then you could qualify to reduce your tax liability with Research & Development (R&D) credits. Many businesses do not realize that they can take advantage of this credit, thinking it only applies to businesses with microscopes and lab coats. However, that is no longer the case. The federal government has loosened its’ requirements to include more businesses and keep the innovative juices flowing within the U.S.

So what is it and who does it apply to exactly?

R&D expenses are the costs incurred for a business to analyze how they are utilizing their technology and what kind of improvements can be made to operate more efficiently. Expenses may include wages paid to employees, supplies used and consumed during research, contract expense paid to a third party (allowable at 65% of the actual cost), and payments made to qualified research institutions (allowable at 75% of the actual cost).

To be eligible for the credits, a company must pass ALL of the Four-Part test listed below:

Four-Part test for Eligibility

  1. The Elimination of Uncertainty Test (Section 174 Test) – A company must demonstrate that the expenditures incurred were directly related to the business and represent R&D cost in the experimental or laboratory sense. In other words, you must be improving upon technology, not just changing design.
  1. The Discovering Technology Information Test –A company must demonstrate that the experimentation is based on hard-sciences, such as engineering, physics, chemistry, biology or computer science. Simply put, it must be technological in nature.
  1. The Business Component Test – A company must demonstrate that the research was undertaken to eliminate uncertainty concerning the development or improvement of a business component.
  1. The Process of Experimentation Test – A company must demonstrate that all of the research constitutes elements of a process of experimentation for a qualified purpose, showing that they have evaluated alternatives for achieving the desired result.

Who is Eligible:

  • A corporation (must not be publicly traded)
  • A partnership
  • A sole proprietorship

All of these entities must meet the additional requirement of having not exceeded $50 million in gross receipts for three years preceding the application for the tax credits.

How is it Calculated:

Regular Research Credit. According to the Journal of Accountancy, the R&D credit is an “incremental credit that equals 20% of a taxpayer’s current-year research expenditures that exceed a base amount, which is determined by applying the taxpayer’s historical percentage of gross receipts spent on qualified research expenditures to the four most recent years’ average gross receipts. For taxpayers that had QREs in calendar years 1984 through 1988, that is the historical period for determining the fixed-base percentage (FBP). For those that had fewer than three tax years with QREs and gross receipts during that period or began having them subsequently, the fixed-base percentage starts at 3% during the first five years (beginning after 1993) and over each of the next five years successively approximates the actual percentage by an increasing fraction”.

Alternative Simplified Credit. “Since 2007, taxpayers have been able to elect the ASC, which equals 14% (for tax years beginning on or after Jan. 1, 2009, and 12% previously) of the QREs for the taxable year that exceed 50% of the average QREs for the three taxable years preceding the credit determination year. If the taxpayer has no QREs in any one of the three preceding tax years, the ASC rate equals 6% of the QREs for the credit determination year. The election to claim the ASC must be made on the original tax return and cannot be made retroactively”. (For examples, please see link below)

Payroll Tax Credit:

The Payroll Tax credit is the election that a qualified small business may elect to apply the R&D credit against employer portion of payroll taxes by specifying the amount of research credit (not to exceed $250,000) that may be used. The payroll tax credit benefits small startups that may be operating at a loss but incurred R&D expenses. The credit is the smaller of the research credit or the business R&D credit carryforward for the tax year. The following criteria applies:

  • The election can only be made for 5 tax years.
  • The election made by a partnership or S corporation must be made at the entity level.
  • The election must be made on or before the due date of the originally filed income tax return on Form 8974, Qualified Small Business Payroll Tax Credit for Increasing Research Activities, and submitted with the return.
  • The credit is claimed against payroll taxes on the taxpayer’s Form 941, Employer’s Quarterly Federal Tax Return, for the first quarter that begins after the income tax return making the election was filed.

Who is eligible:

  • A qualified small business whose gross receipts are less than $5 million for the tax year, and
  • No gross receipts for any tax year before the 5-tax-year period ending with the tax year.

R&D costs can range through a broad spectrum of expenses and these costs are often difficult to diagnose. If you are unsure if this credit is something your business can take advantage of, please contact us with any questions or concerns. We are here and happy to help!

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