Claiming the Section 41 R&D Tax Credit

The Credit for Increasing Research Activities, defined in Internal Revenue Code (IRC) Section 41, is a federal tax incentive for businesses that engage in research and development in the United States. The credit provides a dollar-for-dollar reduction of tax liability, rewarding companies for investing in new technologies and processes. This incentive is incremental, encouraging companies to expand their research efforts year after year.

The credit was made a permanent part of the tax code by the Protecting Americans from Tax Hikes (PATH) Act of 2015. This permanency allows businesses to reliably incorporate the credit into their long-term financial strategies. The PATH Act also expanded the credit’s utility for smaller companies.

Determining Eligibility for the Credit

To qualify for the R&D tax credit, a company’s research activities must satisfy the Four-Part Test. These requirements apply to each business component, which is a product, process, software, technique, or formula a company intends to hold for sale, lease, license, or use in its business.

The first requirement is the permitted purpose test, where research must aim to create a new or improve an existing business component’s functionality, performance, reliability, or quality. For example, a manufacturer developing a pacemaker with a longer battery life meets this test by improving the product’s performance.

The activity must be technological in nature, with its principles grounded in the physical or biological sciences, engineering, or computer science. A company can use existing scientific principles to satisfy this requirement. An example is a software company applying computer science principles to develop a more efficient data compression algorithm.

The third part is the elimination of uncertainty. At the project’s outset, the company must face uncertainty about the capability, method, or appropriate design for developing or improving the business component. The research is undertaken to discover information that resolves this uncertainty. For example, a food manufacturer experimenting with protein combinations to achieve a specific texture is eliminating uncertainty about the formulation.

Finally, the research must involve a process of experimentation to eliminate the identified uncertainty. This process involves evaluating one or more alternatives and can include modeling, simulation, developing prototypes, and systematic trial and error. A manufacturing firm testing different robotic arm configurations to find the most efficient setup is engaging in this process.

Identifying Qualified Research Expenses

Once an activity meets the Four-Part Test, the associated Qualified Research Expenses (QREs) must be identified. QREs are the sum of in-house and contract research expenses incurred in the course of business.

In-house research expenses include wages for qualified services and the cost of supplies. Qualified services include engaging in, directly supervising, or directly supporting the research. Supplies are tangible property used and consumed during research, but costs for land or depreciable property do not qualify.

Contract research expenses are payments to a third party for qualified research. Generally, 65% of the amount paid is eligible as a QRE. An agreement must be in place before research begins, and the business must retain substantial rights to the results while bearing the economic risk of the project.

Expenses for quality control testing, advertising, consumer surveys, and efficiency studies are excluded. Research conducted after commercial production begins or related to adapting an existing product for a specific customer’s need does not qualify. Documentation is necessary to separate these non-qualifying costs from QREs.

A change in tax law requires businesses to capitalize and amortize all specified research expenditures. Costs for research in the U.S. are amortized over five years, while costs for research outside the U.S. are amortized over 15 years. This is a separate consideration from using these expenses to calculate the R&D credit.

Calculating the Credit Amount

Taxpayers have two methods for calculating the credit: the Regular Credit Method and the Alternative Simplified Credit (ASC) Method. The choice is made annually, and businesses should evaluate which option is more advantageous.

The Regular Credit Method calculates a credit equal to 20% of the current year’s QREs that exceed a “base amount.” This base amount is determined by multiplying a “fixed-base percentage” by the average annual gross receipts from the four preceding tax years. This method can be challenging for companies without extensive historical records.

The Alternative Simplified Credit (ASC) Method is 14% of the amount by which current QREs exceed 50% of the average QREs from the three preceding tax years. For example, if a company has $200,000 in current QREs and an average of $100,000 in prior QREs, the credit is $21,000. If a company has no QREs in the three preceding years, the credit is 6% of the current year’s QREs.

A business can choose the method that results in a larger credit. The ASC method is often better for companies with inconsistent R&D spending or that lack the historical records required for the Regular Credit Method. New companies or those with consistently increasing QREs might find the Regular Credit Method more beneficial.

How to Claim the Credit

The R&D credit is claimed on Form 6765, Credit for Increasing Research Activities. This form must be completed and attached to the company’s annual income tax return, such as Form 1120 for a C corporation or Form 1065 for a partnership.

Form 6765 has sections for both the Regular and ASC methods. The IRS requires businesses to provide extensive information on the form, including a breakdown of expenses by business component and a detailed description of the research activities for each.

The credit is a dollar-for-dollar offset against income tax liability. If the credit is larger than the tax owed, the unused portion can be carried back one year and carried forward 20 years. For C-corporations with a regular tax liability over $25,000, the credit is limited to offsetting 75% of that liability in a given year.

If a business was eligible for the credit in previous years but failed to claim it, it can file an amended tax return for any open tax years, typically the last three. The claim must identify all business components for the year, list the research activities performed, and provide the total qualified expenses.

Certain qualified small businesses can elect to use a portion of the credit to offset their payroll tax liability. This election is for startups with less than $5 million in gross receipts and no more than five years of generating receipts. The election is made on Form 6765, and the offset is claimed using Form 8974 with the quarterly employment tax return.