Posted by Heather Nyein, CPA
Businesses may receive a research and development (“R&D”) tax credit for qualifying research expenditures incurred when developing and designing new or improved products and processes. While it is a common misconception that the R&D credit mostly applies to large businesses in the scientific and medical industries, the reality is that the credit has a much wider breadth of business niches. The credit can apply to a broad range of industries including (but not limited to) tech, manufacturing, design, and construction companies.
For tax years beginning January 1, 2016, Congress has made several changes to allow more businesses to reap the benefits of the R&D credit.
What are qualified research activities and expenditures, and who may be eligible?
Any activity that falls under the definition of “qualified research” may be eligible for the credit. Essentially, a business’s research activities must be related to a process or product’s new or improved function, performance, reliability, and/or quality. These can include activities conducted to improve or modify techniques or methods in a process. Qualified expenditures include wages, supplies, and contracted research expenses.
Of course, expenses related to “qualified research” encompasses an array of activities, whether it’s finding a new method/technique to print a graphic design on a T-shirt or changing the way a house is built to make it more energy efficient.
As you can see, the ambiguity surrounding what activities could qualify is relatively significant. One key indicator that a business may be eligible for the credit is if it employs product development personnel, engineers, or software developers. Tech startups, especially, must be informed about this credit as there has been an increasing boom in the industry.
How much is the credit?
The credit is based on a percentage of qualified research expenditures, including wages, supplies, and contracted research expenses.
There are three major developments in the Protecting Americans from Tax Hikes (“PATH”) Act of 2015.
- The PATH Act made the credit permanent, prospectively. Since 1981, the credit was only extended from year to year.
- The R&D credit is now considered a general business credit. This allows eligible small businesses or owners of those businesses to apply the credit against their Alternative Minimum Tax (“AMT”). This provision is most helpful to businesses that have an overall net loss, but owe tax due to AMT. Historically, the company would still owe tax, because the R&D credit could not be used to offset AMT.
- Lastly, qualified small businesses with gross receipts of less than $5,000,000 can now apply the credit against the employer’s portion of payroll taxes of up to $250,000 per year. The credit against payroll taxes is especially beneficial for new businesses, since startup companies are inherently prone to incurring losses during their first few years of operations. Previously, startups that sustained losses were unable to utilize the R&D credit because, generally, there wouldn’t be any tax to apply the credit towards. As businesses begin to turn a profit, they can finally utilize the credit and save in taxes.
The R&D tax credit rules are highly complex. If you think you may be eligible for the R&D credit, please consult a tax professional.