How to Claim the Research and Development (R&D) Tax Credit in the US: A Simple Guide

If you are a small business owner or a researcher, you may be eligible for a very valuable tax credit called the Research and Development (R&D) Tax Credit. This credit can significantly reduce your tax burden, but it may seem complicated at first. Don't worry — this guide will break it down into simple steps, using examples to help you understand how to claim it.

What is the R&D Tax Credit?

The R&D Tax Credit is a federal tax incentive for research and development activities. It has been designed to encourage companies to invest in creating new products, processes, or software, thus promoting the improvement of existing ones. The credit can offset some costs of conducting R&D, such as the wages paid to employees, supplies, and contract research.

To qualify for the R&D Tax Credit, you first must understand what constitutes "research." Basically, research must be:

1. Technological in Nature: It should employ technology to solve a problem or make products better.

2. Innovative: It must seek to develop something new or make something already in existence better or work in a new way.

3. Experimental: There must be some element of experimentation — trying things to see what works.

What counts as Qualified Research?

• Creating a new software application.
• A new formula for a food product.
• Making processes of manufacture more efficient.

What Doesn't Count?

• Post-commercial launch product research.
• Minor product improvements to meet the requirements of a particular customer.
• Market or consumer research or surveys.

How to calculate the Credit?

There are two methods to compute for the credit. They are: Regular Credit or Alternative Simplified Credit (ASC). The ASC is easier to calculate and the more popular of the two. Try both, however, and see which gives you the higher credit.

Regular Credit:

The Regular Credit method calculates the R&D tax credit by comparing your current year's qualified research expenses (QREs) to a historical base amount, which is a percentage of your average gross receipts over the past 4 years. The credit is 20% of the difference between current-year QREs and the base amount. This method can lead to a larger credit if your R&D spending has increased, but it's more complex and requires detailed historical data. Many businesses prefer the Alternative Simplified Credit (ASC) for its ease.

Example:

Company XYZ has operated for several years. Here are their data: Gross receipts for the last 4 years have been: Year 1 $2,000,000 Year 2 $2,200,000 Year 3 $2,400,000 and Year 4 $2,500,000 QREs in the current year equal $400,000, and their FB has averaged 3% based on prior years' R&D spending.

We calculate the base amount as the average gross receipts over the last 4 years, which is $2,275,000. The base amount is then 3% of this average, which equals $68,250.

We then compare the current year's QREs of $400,000 to the base amount of $68,250. The excess of the current year's QREs over the base amount is $331,750.

Finally, the R&D credit is 20% of this excess amount, which works out to be $66,350.

Thus, Company XYZ would be eligible for an R&D tax credit of $66,350 for the current year.

ASC:

The Alternative Simplified Credit (ASC) method is the less complicated way of computing the R&D tax credit. Businesses need to determine 14% of excess current-year R&D expenses over a base amount, which is 50% of the average of the prior 3 years' R&D expenses. You may use zero as the base for your first year of claiming the credit to maximize benefit. This method is faster and easier than the Regular Credit, with fewer data requirements. However, the ASC offers a lower credit rate, 14%, compared to the Regular Credit's 20%, so businesses with significant growth in R&D spending may find the Regular Credit more beneficial. It is ideal for smaller companies or those just starting to claim the credit.

Example:

Let’s say Company ABC has $500,000 in current-year R&D expenses and an average of $300,000 in R&D expenses from the past 3 years. The base amount would be 50% of $300,000, which equals $150,000. The excess of current-year expenses over the base is $500,000 - $150,000 = $350,000. The credit would be 14% of $350,000, or $49,000.

Payroll Tax Credit Election (If Eligible)

If your business is small - under $5 million in revenue and in operation for 5 years or less, you can make a payroll tax credit election. This lets you use up to $500,000 of your R&D credit against your social security payroll taxes instead of your income taxes.

Example: Assume your business has enough qualified research expenditures to claim a $400,000 R&D credit. For the payroll tax election, you can use the $400,000 to pay against the employer's portion of social security taxes-that is, 6.2% of your employees' wages. This is especially advantageous if you do not have enough income taxes due to take full advantage of the credit.

Which forms do you fill out?

Form 6765 should be filed as part of your tax return if you want to claim the R&D tax credit. Although often utilized in the calculation and submission of the Regular Credit or ASC method, it also depends on the nature of QREs detailing information about wages, supplies, and costs of contract research. Form 6765 also asks for information about your company’s gross receipts, historical expenses, and other relevant data. For businesses using the Regular Credit method, the form will require more detailed historical information to calculate the base amount, whereas the ASC method simplifies this step by using just the average R&D expenses from the previous 3 years.

If you decide to pay the credit against your payroll taxes instead of income taxes, you will need to report on Form 8974. It is specifically used in claiming the R&D credit as an offset against payroll tax and it's basically for small businesses which are eligible to benefit from the credit but may not have any income taxes to pay. Form 8974 calculates the amount of the R&D credit that can be used to reduce your payroll tax liability. The credit can offset payroll taxes on wages paid to employees, providing immediate relief to companies that may not have large taxable income but have significant R&D activities.

When to File Your Form 6765 & 8974?

To claim the R&D tax credit, you will need to file Form 6765 and Form 8974 with your business's tax return. File them with Form 1120(corporate return) by the 15th day of the 4th month after the end of your fiscal year, or with Form 1065 (partnership return) by the 15th day of the 3rd month. If you need an extension, you can file for one but be sure to include the forms with the return or extension.

It is essential to keep good records of all your R&D activities and expenses. The IRS might ask you to provide documentation to support your claim, such as receipts, project notes, and employee time sheets.

Conclusion