What is the R&D Tax Credit?
Written by Amanda Bower | Published: June 24, 2022
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Many businesses assume that only large companies with sophisticated research labs can qualify for the R&D tax credit. However, any business can qualify for R&D tax credits if it meets the requirements, regardless of its size or status. Notably, this credit is one of the easiest ways for startups to make substantial savings on their taxes and operations.
Do you think that your company may qualify for the R&D tax credit? Here is a comprehensive overview of how this credit works, which businesses qualify, and how to claim it.
What is the R&D Tax Credit & Who Qualifies?
R&D stands for Research and Development. The Research and Development (R&D) tax credit is a financial incentive designed to motivate businesses to invest in innovation. Essentially, it is a dollar-for-dollar offset based on the income and payroll taxes of the employees involved in doing the R&D project (not necessarily everyone in the company), making it the most valuable tax credit for businesses.
Ideally, every business that designs, develops, or improves processes, formulas, products, or software qualifies for the R&D tax credit. Contrary to the popular assumption, you don’t have to develop something entirely new to qualify for this tax credit. The federal government originally introduced the R&D tax credit, but 35 states also offer it as a financial incentive.
Besides taxes on employees’ wages, businesses can also claim R&D tax credits for various costs incurred when doing the R&D project, including:
Staff costs primarily include employees’ wages. They also include employees’ financial benefits, including bonuses, reimbursed expenses, and contributions to their insurance policies and pension funds.
Subcontractors & Externally Provided Workers (EPWs)
Externally provided workers (EPWs) and subcontractors are temporary employees hired only to work on the R&D project. For example, hiring an accounting team or opting for outsourced accounting to calculate the project’s cost qualifies.
Ideally, businesses can claim up to 65% of the money paid to EPWs and subcontractors for their contribution to the R&D-related work. You can also claim 100% of the subcontractors’ wages if they are affiliated with the company in other ways.
You can also claim some or all of the costs incurred when using computer software for your R&D projects. Notably, you can only claim a fraction of the costs if you also use the software for other activities not related to the R&D projects.
Consumable items are all items used to develop the R&D project. They include raw materials and utilities such as energy and water.
You can also claim the cost of designing and constructing a prototype if you intend to use it to resolve a technological or scientific uncertainty. However, your claim doesn’t qualify if you use the prototype for commercial purposes, such as demonstrating it at a trade show or selling it to a third party.
Research contributions are payments made to external researchers to conduct research on the R&D project on your behalf. It is worth noting that only large companies usually qualify for this claim.
Benefits of the R&D Tax Credit
R&D tax credits have proven effective in encouraging innovation. They have also been beneficial for everyone involved, including the economy, society, and the businesses driving this innovation.
Most notably, businesses stand to benefit financially from R&D tax credits. Overall, the federal government and state governments pay out billions of dollars per year in R&D tax credits, saving the qualifying businesses a lot of money. Some of the ways how businesses can save money through the R&D tax credit include:
- Companies can claim up to 16 cents of R&D tax credits for every qualifying dollar, saving up to 16% of their overall costs.
- Some startups can claim up to $250,000 per year on payroll taxes, while most other businesses can claim up to $1.25 million on their quarterly federal payroll tax returns.
- Companies can claim a dollar-for-dollar reduction in their federal and state income tax liabilities.
The money you save via R&D tax credits can help boost your company’s cash flow to support its operations and facilitate its growth. You can also claim R&D tax credits on previous projects for previous tax years.
Example of a Company That Applied for the R&D Tax Credit
Businesses can claim R&D tax credits for a wide scope of activities, and the examples are numerous. Beam, the world’s first company dedicated to helping the homeless via crowd-funding, is an excellent example of how companies can qualify for R&D tax credits just by going about their everyday activities.
Beam uses a crowd-funding platform to generate money to get homeless people stable housing and employment. The company relies on social networking to find donors for its crowd-funding campaigns. It also incorporates advanced cybersecurity solutions, financial technology (Fintech), and gamification to facilitate its campaigns and transactions.
Beam’s R&D Tax Credit Claim
Beam’s work is based on social innovation – it is the first campaign to use social networking and crowd-funding to help house the homeless. Unfortunately, the company cannot claim R&D tax credits for social innovation. However, it can claim the tax credit for the technological aspects of its operations.
Beam faced some technological uncertainties in its operations and had to improve on some of the social networks and other computer software it uses. The company is transparent in how it improves its tech solutions, and it maintains an updated database on its progress. Its work qualifies as innovative, and it has helped other charitable organizations advance their Fintech capabilities.
Claiming the R&D Tax Credit
Calculating and claiming your R&D tax credit can be a bit complicated. However, the process is relatively straightforward, and it entails doing the following three things:
Prove That You Qualify
You must prove that your work qualifies for R&D tax credits. Ideally, you can do this by providing the following documents:
- The payroll records of the employees involved in the qualifying R&D projects
- The project and meeting notes related to the research
- The expenses, receipts, and accounts related to the equipment and supplies used for the qualifying R&D project
- Invoices and contracts related to third parties involved in the qualifying R&D project, such as outsourced business tax services
- The qualifying R&D project’s blueprints, designs, drawings, patents, and prototypes
It is crucial to maintain good bookkeeping and meticulous records on your R&D projects if you plan to claim R&D tax credits. It is also worth noting that you can claim R&D tax credits for previous tax years if you have the necessary paperwork.
Pass the Four-Part Test
The qualifying R&D project must also pass the following four-part test:
This is the main requirement for qualifying for R&D tax credits. Ideally, you must undertake the project for the purpose of designing, developing, or improving processes, formulas, products, or software.
The project must also be technological in nature. Ideally, it should be based on biology, physics, computer science, or engineering principles.
The project must also eliminate uncertainty about a technological process or product. This generally entails developing a new product or improving an existing product’s or process’s functionality.
The R&D project must also involve an experimentation process. The experimentation process may involve systematic trials, testing, simulating, and modeling.
Fill Out Form 6765
You must also document your qualified R&D expenses by filling out Form 6765. The form contains four sections:
- Section A – Claiming regular credit
- Section B – Claiming alternative simplified credit
- Section C – Identifying additional schedules and forms
- Section D – Claiming payroll tax credits
It is worth noting that Section D is only applicable to qualifying startups. The IRS will consider your claim and accept or reject it, depending on your proof.
Let hiline Help You Claim Your R&D Tax Credit!
Are you engaged in research and development projects that qualify for R&D tax credits? hiline can help you navigate whether an R&D Credit Study makes sense for you, connect you with our partners and assist throughout the entire process. Get in touch today to learn more about how we can help.
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