How the Massachusetts R&D Tax Credit Works

The Massachusetts Research and Development (R&D) Tax Credit encourages businesses to conduct research activities within the state. Its purpose is to foster innovation by allowing companies to lower their corporate excise tax when developing new or improved products and processes. By offsetting a portion of research-related expenditures, the credit helps attract and retain innovative companies. The program is structured to reward specific activities and expenses that align with advancing technology and science.

Eligibility Requirements for the Credit

To qualify for the Massachusetts R&D tax credit, a business must be an entity subject to the corporate excise tax. This includes C-corporations, which apply the credit directly against their tax liability. S-corporations are also eligible to claim the credit against their corporate-level excise tax but cannot pass it through to shareholders. For unincorporated entities like partnerships, the credits are attributed to the owners for use on their own tax returns.

Eligibility hinges on research activities satisfying a four-part test that mirrors federal guidelines under Internal Revenue Code Section 41. The first part is the permitted purpose, which requires the research to be for creating a new or improved function, performance, reliability, or quality in a product, process, or software. This means the work must go beyond simple cosmetic changes and aim for a tangible advancement.

A second requirement is that the research must be technological in nature. This means the process of experimentation must rely on principles of the physical or biological sciences, engineering, or computer science. Activities that depend on social sciences, arts, or humanities do not qualify. For instance, developing a new software algorithm meets this criterion, while creating a new advertising campaign does not.

The third part of the test involves the elimination of uncertainty. At the project’s outset, the taxpayer must face uncertainty concerning the capability or method of developing or improving the product or process. This uncertainty must be technical, not merely financial or market-related. The research is intended to resolve questions about whether a desired outcome is achievable from a scientific or engineering standpoint.

Finally, the activity must involve a process of experimentation. This means the taxpayer must engage in a systematic process designed to evaluate one or more alternatives to eliminate the identified technical uncertainty. This can involve modeling, simulation, or systematic trial and error. The experimentation must be methodical and aimed at resolving specific technical challenges.

Identifying Qualified Research Expenses

Qualified Research Expenses (QREs) form the basis of the credit calculation. The primary category of QREs is in-house research expenses, which includes the taxable wages paid to employees for performing qualified services. This encompasses not only the hands-on work of researchers and engineers but also the salaries of those who directly supervise or support the qualified activities.

In addition to wages, the cost of supplies used or consumed while conducting qualified research is also a QRE. This includes tangible property other than land or depreciable assets, such as raw materials for a prototype. General overhead costs, such as rent, utilities, or administrative salaries for functions like human resources, are not considered direct support and cannot be included.

Another category of QREs is contract research expenses. When a company pays a third party to perform qualified research on its behalf, 65% of the amount paid to the contractor for research conducted in Massachusetts is eligible. The research performed by the contractor must also meet the same four-part test as in-house activities.

Careful documentation is necessary to substantiate all claimed QREs. Companies must maintain records that connect the expenses directly to the qualified research activities. This includes payroll records detailing employee time on R&D projects, invoices for supplies, and contracts with third-party researchers. These records are fundamental for calculating the credit and defending the claim in an audit.

Calculating the Credit Amount

To calculate the credit, Massachusetts provides two methods: the regular credit method and the alternative simplified credit (ASC) method. A company must choose one method per tax year, and the choice often depends on the company’s history of research spending and its gross receipts.

The regular credit calculation is a two-part formula. The main component is 10% of the current year’s QREs that exceed a calculated base amount. The base amount is determined by multiplying the company’s fixed-base percentage by its average annual gross receipts for the four preceding years. The regular credit also includes 15% of basic research payments made to qualified educational institutions and scientific research organizations.

The alternative simplified credit (ASC) method offers a more straightforward calculation. The credit is 10% of the QREs that exceed 50% of the average QREs for the three preceding taxable years. If a company had no qualified research expenses in any of the three preceding years, the credit is 5% of the current year’s QREs. This method is advantageous for companies with increasing research spending or those lacking the historical data for the regular method.

To illustrate, consider a company with $500,000 in QREs this year and an average of $300,000 in QREs over the prior three years. Using the ASC method, the credit is based on the QREs exceeding 50% of the three-year average: $500,000 – (0.50 $300,000) = $350,000. The credit would be 10% of this amount, or $35,000. A business should model both scenarios to determine which method yields a greater benefit.

The R&D credit is subject to certain limitations. The credit cannot reduce a company’s corporate excise tax liability below the minimum tax of $456. Additionally, it is limited to 100% of the first $25,000 of corporate excise tax liability, plus 75% of the liability that exceeds $25,000.

Claiming the Credit and Managing Carryforwards

To claim the credit, a business must complete Massachusetts Schedule RC, Research Credit. This form details the calculation of the credit and must be attached to the appropriate Massachusetts corporate tax return. For C-corporations, this is Form 355, and for S-corporations, it is Form 355S.

When the calculated R&D credit is greater than the company’s tax liability for the year or is limited by the liability caps, the unused portion is not lost. Massachusetts law allows businesses to carry forward any unused credit to future tax years. The standard carryforward period for most unused credits is 15 years.

Any portion of the credit that is disallowed because of the 75% limitation on tax liability over $25,000 can be carried forward indefinitely. This ensures that companies with large credits relative to their tax liability do not permanently lose the value of the incentive. This provision provides long-term value, especially for companies in growth phases with fluctuating profitability.

Certain life sciences companies benefit from more generous provisions. These qualifying companies can carry forward their unused R&D credits for an unlimited period. Eligible life sciences companies may also receive a refund of up to 90% of the remaining balance of unused credits from prior years, providing a direct cash flow benefit.