Everything You Need To Know About R&D Tax Credits
Business owners often consider taxes an inconvenient but necessary part of everyday
operations. However, a better understanding of taxes can save you money by taking
advantage of various credits, such as the R&D tax credit. How does the R&D tax credit work?
Get an in-depth look into everything you need to know, including what it is, how to claim it,
and how it’s calculated.
What Is the R&D Tax Credit?
The Research and Development tax credit is a federal tax liability reduction companies can
take for approved domestic expenses. The rate of reduction is dollar for dollar. You also get
back approximately 13 cents for every dollar spent on research that meets the eligibility
requirements. Qualifying research and development expenses include the development,
improvement, or design of a product, technique, process, or software.
This credit can lead to significant savings that free up cash for further R&D, hiring new
employees, and more. For companies that meet the criteria of a Qualified Small Business, the
R&D credit can be used to offset quarterly payroll taxes. For tax years 2016 through 2022, the
maximum R&D tax credit for payroll tax was $250,000. The credit doubled to $500,000
beginning January 1, 2023. Many states have also enacted an R&D credit.
Who Qualifies for the R&D Tax Credit?
This lucrative credit is available for more than established researchers and scientists. Small
businesses can also reduce tax liability for eligible expenses tied to innovation. Any
company working within the United States to develop or improve a process or a product can
claim the credit, no matter what industry it is in.
How Is R&D Different from R&E?
The Research and Development tax credit is also known as the Research and
Experimentation (R&E) tax credit. These two terms refer to the federal benefit outlined in
Section 41 of the Internal Revenue Code.
What Are the 4 Pillars of R&D?
Knowing the 4 part test R&D tax credit is a simple way to identify qualified research activities:
1. Permitted purpose: Qualified activities work to improve a new or existing product
or process’s functionality, reliability, quality, or performance.
2. Technological nature: The activities rely on the principles of physical science,
computer science, biological science, or engineering.
3. Eliminate uncertainty: The activities make improvements that lead to eliminating
technical uncertainties regarding a product’s capabilities, design, or method.
4. Experimentation: The activities involve experimenting through processes like
testing, simulating, and trial and error of hypotheses.
If your proposed activity meets the above criteria, it likely qualifies for the R&D credit.
What Are the IRS Rules for R&D Tax Credit?
What activities qualify for the credit, according to the IRS? Businesses can claim R&D credit
for activities that fall into two categories:
1. Qualified research activities or qualified research expenses
2. Basic research payments
While many large businesses take advantage of this credit, smaller businesses often forego
extensive tax savings because they aren’t aware they qualify. In fact, many small business
expenses qualify under the QRA category. Work with a professional firm knowledgeable in
the R&D tax credit to get advice and make sure you aren’t failing to claim eligible expenses.
How Do R&D Tax Credits Work?
The tax code for this credit works in two ways, by allowing a company to deduct R&D
expenses in the first year or to get a tax credit for qualifying expenses.
Claiming the R+D tax credit requires that you submit certain documentation to prove your
eligibility. Some examples are payroll records for your R&D employees and expense
accounts with receipts, blueprints, prototypes, and notes from project meetings.
How Do You Fill Out Form 6765?
Form 6765 instructions on the IRS website guide you through figuring out and claiming the
credit. You will find information on eligibility, qualified research, and line-by-line instructions
for completing the form. Collect the following to help you work through the form more easily:
● Profit and loss statements
● Expense receipts for activities related to research and development
● Invoices
● Balance sheets
Having your information together will make it easier to get through the form more quickly and
ensure accuracy.
How Are R&D Credits Calculated?
The IRS provides several formulas for businesses to calculate the correct R & D tax credit.
One method called the Alternative Simplified Credit method, involves the following five steps:
1. Calculate your business’s qualified research expenses going back three years.
2. Calculate the average of the three totals.
3. Multiply the average by 50% to get your credit base.
4. Subtract your calculated credit base from the year’s total R&D expenses.
5. Multiply this number by 14% to calculate your R&D credit.
New businesses that don’t have three years of expenses to calculate a credit base can
multiply the year’s R&D expenses by 6%. The process is simple but requires you to
understand which expenses qualify and to have documentation to submit as proof.
It’s a good idea to consult a tax specialist to ensure you take full advantage of the credit and
calculate it correctly. You can also estimate your R&D credit using an online calculator.
What Is R&D Tax Credit Amortization?
In 2017, Congress created a tax bill that required amortization of R&D costs beginning
January 1, 2022. This change means businesses can no longer immediately expense R&D,
which may result in higher tax bills. You can find the new rules in Section 174, capitalization
and amortization.
The backlash for R&D section 174 is widespread, with businesses facing problems, confusion,
and high costs under the new law. A bipartisan group of members of Congress have
recognized this as a problem and have introduced legislation to repeal amortization. No
decision has yet been made, but support for repeal is growing.
What Types of Expenses Qualify for the Credit?
A variety of expenses qualify for the tax credit:
● Wages to research and development employees
● Third-party costs, such as expenses paid out to contractors you hire to perform
qualified activities that contribute to the research
● Research payments to a qualified scientific organization or educational institution
● Supplies required for the research and development of new products and
technologies
The R&D tax credit is flexible and can include quite a few expenses. However, some are
excluded:
● Research started after the commercial production process began
● Costs associated with fixed assets that keep your business operational
● Duplication of an existing product
● Market research, such as surveys
● Research done outside of the United States
● Research regarding software used for internal purposes
● Research already funded by a person, grant, organization, or the government
● Research into any discipline involving the arts, humanities, or social sciences
Sometimes, an expense may qualify for more than one tax credit. If this happens, you need to
understand the benefits of each so you can make an informed decision on which credit to
take.
What Are Examples of R&D Tax Credits?
There are nearly endless ways for a business to qualify for the credit. Here are a few
examples:
● Designing cloud-based software solutions
● Developing new products
● Improving or enhancing an existing product
● Developing or improving an existing process
● Testing a product or process
● Beta testing
● Conducting research and documenting the results
Is R&D Tax Offset Taxable Income?
The R and D tax credit reduces your federal taxable income by giving you a dollar-for-dollar
credit on qualified expenses. You can also still deduct certain R&D expenses on your tax
return.
What Happens to Unused R&D Credits?
If your business lacks tax liability, you first must carry the credits back one year (if there was
tax liability). Then any remaining credits can carry forward for a maximum of 20 years. The
extended time frame was put into effect by 2015’s Protecting Americans from Tax Hikes
(PATH) Act.
How Far Back Can You Claim R&D Tax Credits?
One of the great things about R&D credit is that you can claim it for any open tax years by
filing an amended return. Typically, this is about three years, although it may be longer if you
sustain losses.
If Our Company Has Had Losses but Incurred Qualified Research Expenses, Can
We Utilize the R&D Credit Benefit?
One of the most common questions is, “Can you take R&D credit if you have a loss?” The
simple answer is yes, you can. Your company mustn’t be profitable to take advantage of the
R&D tax credit. Companies that have a loss also benefit. As a loss-making company, you
could potentially claim back a more significant percentage of your R&D expenditure than
those that make a profit. Also, you could receive a cash credit instead of reducing your tax
bill.
What Is the Timeline To Complete an R&D Study?
Knowing how and when to claim the R&D tax credit for an ongoing research and
development project is essential. Understand that you can only claim the stages that involve
technological uncertainty, such as product research, development, and testing. It’s crucial to
keep detailed records to claim the appropriate expenses for work done during each tax
period.
If you have not yet made a claim for prior years of an ongoing project, you may claim
expenses for two years after the end of an accounting period.
If I Claim the R&D Credit, Will I Be Audited?
Claiming the R&D tax credit on an original return filed on time does not trigger an audit
automatically, and R&D clients do not have a higher rate of audits than standard income tax
returns for those claiming the credit on an original return. However, there is always the
possibility of an audit, so you should have supporting documents available to prove your
claim.
Final Thoughts: Can I Claim the R&D Tax Credit?
The R&D tax credit has many benefits, like creating a dollar-for-dollar tax liability reduction
and improving cash flow. However, it can be a challenge to understand the complex tax
system well enough to get the most value for your business. Taking advantage of available
money-saving opportunities often requires help from professionals. To discover which tax
programs can best benefit your business, contact KBKG to learn more about the valuable
solutions available to save you money. Our experts are knowledgeable, experienced, and
ready to work with you to identify the tax credits and deductions for which your business
qualifies.
What are the Potential Benefits of the R&D Tax Credit?
There are several benefits to realizing the R&D tax credit. These benefits can include the following:
● Receive up to 12-16 cents of federal and state R&D tax credits for every qualified dollar
● Create a dollar-for-dollar reduction in your federal and state income tax liability
● Increase earnings-per-share
● Reduce your effective tax rate
● Improve cash flow
● Carry forward the credit up to 20 years
● Perform look back studies to recognize unclaimed credits for open tax years (generally 3
or 4 years)
● Utilize the federal R&D tax credit against payroll tax (applicable to certain startup
companies)
What is the Research and Development (R&D) Tax
Credit?
The R&D Tax Credit (26 U.S. Code §41), also known as the Research and Experimentation (R&E)
tax credit, is a federal benefit that provides companies dollar-for-dollar cash savings for performing
activities related to the development, design, or improvement of products, processes, formulas, or
software. This credit provides much needed cash to hire additional employees, increase R&D,
expand facilities, and more. The credit was enacted in 1981 to stimulate innovation and encourage
investment in development in the US. Since then, many states have also passed the R&D Tax
Credit. As such, this benefit is available across a wide variety of industries. Some of the common
industries that qualify include, but are not limited to:
● Aerospace
● Agriculture
● Architecture & Engineering
● Automobile
● Brewery
● Cannabis
● Chemical & Formula
● Fabrication
● Food & Beverage
● Foundry
● Life Science
● Machining
● Manufacturing
● Software Development
● Tool & Die Casting
● Winery & Vineyard
[Link]
earch-tax-credit-irc-ss-41-qualified-research-expenses
Audit Techniques Guide: Credit for Increasing Research Activities (i.e.
Research Tax Credit) IRC § 41* - Qualified Research Expenses
Publication Date - June, 2005
* Unless otherwise indicated, all section references are to the Internal Revenue Code of
1986, as amended, and the Treasury Regulations.
NOTE: This guide is current through the publication date. Since changes may have
occurred after the publication date that would affect the accuracy of this document, no
guarantees are made concerning the technical accuracy after the publication date.
Chapter 3 | Table of Contents | Chapter 5
4. QUALIFIED RESEARCH EXPENSES (“QREs”)
Section 41(b)(1) defines QREs as the sum of (1) "in-house research expenses" and (2)
"contract research expenses”.
Section 41(b)(2) defines in-house research expenses as:
1. any "wages" paid or incurred to an employee for "qualified services" performed
by such employee;
2. any amount paid or incurred for "supplies" used in the conduct of "qualified
research”;
3. under regulations prescribed by the Secretary, any amount paid or incurred to
another person for the right to use computers in the conduct of qualified
research.
Section 41(b)(3) defines "contract research expenses" as 65 percent of any amount
paid or incurred by the taxpayer to any person (other than an employee of the taxpayer)
for qualified research. If an expense is not set forth in section 41(b), a taxpayer may not
claim the expense as a QRE.
a. Wages
The first category of in-house research expenditures eligible for the research credit
consists of amounts paid or incurred for wages. Wages paid to an employee constitute
in-house research expenses only to the extent the wages were paid or incurred for
"qualified services" performed by the employee. For purposes of section 41, the term
“wages” means wages as defined in section 3401(a). This means all taxable wages as
reported on Form W-2, including bonuses and stock option redemptions. It does not
include amounts that are not subject to withholding, such as certain fringe benefits or
non-taxed income, even if paid for research services performed by an employee.
Stock options that are exercised and then included in wages subject to withholding, may
or may not be included as wages in the research credit computation.5 The option is
generally granted as compensation for work performed and is subject to withholding
upon grant. In such situations, the type of work done will determine if the option spread
(wage) is included in the computation. For example, if an option is granted in 1997 and
exercised in 2003, you would look to see if the work performed in 1997 would qualify as
a qualified service. If it would qualify, then the spread is included in wages in the year
the option is exercised. In other words, look to the grant year to determine if it is a
qualified service but include the spread amount the computation in the year it is
exercised.
Section 41(b)(2)(B) identifies three types of qualified services:
1. Engaging in qualified research,
2. Directly supervising qualified research; or
3. Directly supporting qualified research .
Treasury Regulation section 1.41-2(c) provides further guidance.
The term "engaging in qualified research" means the actual conduct of qualified
research, as in the case of a scientist conducting laboratory experiments.
The term "direct supervision" means the immediate supervision (first-line management)
of qualified research (as in the case of a research scientist who directly supervises
laboratory experiments, but who may not actually perform experiments). "Direct
supervision" does not include supervision by a higher-level manager to whom first-line
managers report, even if that manager is a "qualified research scientist“. Specific
attention should be paid to individuals who do not "directly" supervise qualified research
activities (i.e., management levels higher than first line supervisors). In some cases,
higher level research managers may perform some qualified research or direct
supervision of qualified research due to their technical background and expertise, but
this is usually only a minor fraction of their overall work activities. In addition,
companies generally have a certain number of employees that work within traditional
"research" departments who do not perform qualified services.
The term "direct support" means services in the direct support of either persons
engaging in the actual conduct of qualified research, or persons who are directly
supervising persons engaging in the actual conduct of qualified research. This would
include the services of a machinist for machining a part of an experimental model used
in qualified research.6 Direct support of research does not include general and
administrative services, or other services only indirectly of benefit to research activities.7
This is true whether general and administrative personnel are part of the research
department or in a separate department.
Treasury Regulation section 1.41-2(d)(2) provides that if substantially all 8 of the
services performed by an employee during the taxable year consist of qualified
services, then the term “qualified services” means all of the services performed by the
employee for the taxpayer during the taxable year. The ‘substantially all’ rule for wages
is analyzed on an employee-by-employee basis, and, in general, is determined by
multiplying total wages by the following fraction: Hours spent in the conduct of qualified
services over total hours spent in the conduct of all services (sick leave, for example,
would not be included in the fraction). See Treasury Regulation section 1.41-2(d) for
the methodology applicable to this rule. If the ratio is less than 80%, the actual amount
of qualified services should be used
Identifying the employees whose wages are claimed as QREs and determining the
services they perform is perhaps the most important phase of auditing the research
credit. Payroll records, employee job descriptions, performance evaluations, calendars
and appointment books are good sources of information. The goal is to determine what
the employee did and how much time they spent doing it.
If the employee pool is large, and it is impractical to achieve complete coverage,
consider using statistical sampling techniques. Audit resources should focus on those
employees whose job descriptions suggest they are engaging in administrative,
manufacturing, marketing, and other non-qualifying activities. When appropriate,
interviews should be considered to supplement and corroborate information obtained
from the review of existing records.
An important caveat: Determinations as to whether an employee is (or is not) engaged
in qualified services, should not be based solely on job descriptions or titles. Credit
eligibility is based solely upon what an employee actually does, or does not, do during a
specific time period. It is important to note the technical and educational qualification of
a researcher, but this is not conclusive evidence that the individual engaged (or did not
engage) in the performance of qualified services.
b. Supplies
A taxpayer may claim the research credit for amounts it paid or incurred for supplies
used in the conduct of qualified research. Section 41(b)(2)(C) defines the term "supply"
to mean any tangible property other than (1) land or improvements to land, and (2)
property of a character subject to the allowance for depreciation. For example,
overhead, license fees and costs for leasing assets are not tangible property and,
therefore, not supplies. Supplies are used in the conduct of qualified research if they
are used in the performance of "qualified services" by an employee of the taxpayer (or
person acting in the capacity of an employee). To be a QRE, a supply must be directly
related to the performance of "qualified services”. Expenses for property used in
general and administrative activities are not QREs. Accordingly, for the purposes of
section 41, a "supply" is non depreciable tangible property acquired by the taxpayer that
is used in the performance of "qualified services". 9
The examiner should request that the taxpayer produce documents to support its
claimed supply expense to ensure that the amount only includes non depreciable
tangible property acquired by the taxpayer that was used in the performance of
"qualified services".
There has been a trend to include a myriad of non-qualified research related costs in
the credit computation by claiming such costs are "supplies”. When reviewing the
supplies claimed as qualified, focus on the statutory and regulatory definition of
supplies. For example, taxpayers often improperly treat as a supply expense, the
general and administrative costs related to "self constructed" supplies. Additionally, the
examiner should carefully scrutinize "prototype" 10 expenditures to determine whether
the "prototype" is (or contains) property of a character subject to an allowance for
depreciation. Other examples of costs that are not supply QREs are:
● travel, meals or entertainment
● telephone expenses of researchers
● relocation or rental/lease expense
● professional dues or royalty/license expenses substantial
Supply QREs, in general, should represent a small portion of total QREs. When supply
QREs are substantial, you should be alerted to the possible inclusion of capital or other
ineligible expenses being claimed as QREs.
c. Contract Research Expenses
A contract research expense is 65 percent of any expense paid or incurred in carrying
on a trade or business to any person, other than an employee of the taxpayer, for the
performance on behalf of the taxpayer of qualified research, or services which, if
performed by employees of the taxpayer, would constitute qualified services within the
meaning of section 41(b)(2)(B). Treas. Reg. § 1.41-2(e)(1). If any contract research
expense is attributable to qualified research to be conducted after the close of the
taxable year, it shall be treated as paid or incurred when the qualified research is
conducted. I.R.C. § 41(b)(3)(B). Thus, prepaid research expenditures are not eligible
for the credit until the services are performed.
● Examining contract research expenses is one of the most straightforward, yet
most often overlooked, research credit issues. An important audit step is to
request a list of all contracts, along with the dollar amount of the claimed contract
research expense (by contract). From this list, select the contracts that should
be requested and reviewed. When there are only a few material contracts, all the
contracts should be requested. The contracts should be reviewed to determine
whether all the above legal requirements have been met.
Assistance of local counsel can be helpful in securing these agreements, as well as
assisting with their interpretation. If requested contracts are not provided, and the
taxpayer fails to represent (preferably in writing) that such contracts do not exist, we
recommend the use of summons. This will ensure that the examiner has had the
opportunity to review all of the taxpayer’s documentation, and if the case is unagreed,
helps to ensure that no new documentation will be provided at an Appeals conference.
Treasury Regulation section 1.41-2(e) provides a three-part test for determining if the
payment is for the performance of qualified research where a third party performs the
research for the taxpayer. An expense is paid or incurred for the performance of
qualified research only to the extent that it is paid or incurred pursuant to an agreement
(usually in writing, but not required) that:
1. is entered into prior to the performance of the qualified research,
2. provides that research be performed on behalf of the taxpayer, and
3. requires the taxpayer to bear the expense even if the research is not successful.
Qualified research is performed on behalf of the taxpayer if the taxpayer has a right to
the research results. Qualified research can be performed on behalf of the taxpayer
notwithstanding the fact that the taxpayer does not have exclusive rights to the results.
Also, if the expense is paid or incurred pursuant to an agreement under which payment
is contingent on the success of the research, then the expense is considered paid for
the product or result, rather than the performance of research, and the payment is not a
qualified contract research expense.
Under Treasury Regulation section 1.41-2(e), a contract research expense is 65 percent
of any expense paid or incurred in carrying on a trade or business to any person other
than an employee of the taxpayer for the performance on behalf of the taxpayer of (i)
qualified research, or (ii) services which, if performed by employees of the taxpayer,
would constitute qualified services within the meaning of section 41(b)(2)(B). Where the
contract calls for services other than services described above, only 65 percent of the
portion of the amount paid or incurred, that is attributable to the services described
above is a contract research expense.
Sometimes the activities to be performed by the contractor are more clearly defined in
contractually-referenced work orders or statements of work rather than the body of the
main contract. Such documents should be secured and reviewed.
A service contract differs from a research contract in calculating what amounts will be
allowable contract research expenses. For example, in a service contract, the vendor
may be paid by the hour and the research is not specified. In this case, you must look
at the work done. Only the amounts paid for qualified research work would be included
in QREs (subject to the 65% limitation). In a research contract where there is an agreed
fixed price amount to perform qualified research, the entire amount would be subject to
the 65% limitation and included as a QRE.
5 See Apple Computer, Inc. v. Commissioner, 98 T.C. 232 (1992), acq., 1992-2 C.B. 1
(rtf, 31kb). and Sun Microsystems v. Commissioner, T.C. Memo 1995-69, acq., 1997-2
C.B. 1 (rtf, 25kb) for treatment of stock options.
6 Other examples of direct support of research would include the services of (1) a
secretary typing reports describing laboratory results derived from qualified research;
(2) a laboratory worker for cleaning equipment used in qualified research; and (3) a
clerk for compiling research data. Treas. Reg. § 1.41-2(c)(3).
7 Services of payroll personnel in preparing salary checks of laboratory scientists, of an
accountant for accounting for research expenses, of a janitor for general cleaning of a
research laboratory, or of officers engaged in supervising financial or personnel matters
do not qualify as direct support. Treas. Reg. § 1.41-2(c)(3).
8 The “substantially all” for wages differs from the “substantially all rule” for Process of
Experimentation.
9For more information on the definition of a supply, see Lockheed Martin Corp. v.
United States, 87 A.F.T.R.2d, ¶ 2001 812 (Ct. Cl. 2001). The only exception to the
general rule is for certain "extraordinary utilities" expenditures. See Treas. Reg. §
1.41-2(b)(2).
10 Taxpayer labels are not controlling.
