How to Claim the Research and Development Tax Credit

The Research and Development (R&D) tax credit provides a dollar-for-dollar reduction in a company’s federal tax liability for certain domestic expenses, incentivizing investment in innovation within the United States. Businesses of all sizes in various industries, including manufacturing and software, may qualify. The credit was made permanent by the Protecting Americans from Tax Hikes (PATH) Act of 2015, which also expanded its accessibility for many small and mid-sized businesses.

Determining Eligibility for the R&D Tax Credit

A business may be eligible for the R&D tax credit if it engages in activities to develop or improve products, processes, software, or formulas. To qualify, the research activities must meet a “Four-Part Test” established by the Internal Revenue Service (IRS). The costs for an activity cannot be used to claim the credit if it fails to satisfy any of these four conditions.

• Permitted Purpose: Research must be undertaken to improve the functionality, performance, quality, or reliability of a business component. A business component is a product, process, or software intended for sale, lease, license, or internal use.
• Technological in Nature: The experimentation process must rely on principles of hard sciences like engineering, physics, chemistry, biology, or computer science. For instance, developing new algorithms for a software platform would meet this test.
• Elimination of Uncertainty: At the project’s start, the business must be uncertain about the capability, method, or appropriate design for developing or improving the business component. An example is a manufacturer experimenting with new material formulations.
• Process of Experimentation: The business must evaluate one or more alternatives to resolve the technical uncertainty. This process can include modeling, simulation, or systematic trial and error to test hypotheses.

Identifying Qualified Research Expenses

After confirming activities meet the four-part test, a business must identify its Qualified Research Expenses (QREs). These expenses fall into three distinct categories defined by the tax code. Only costs directly tied to qualified research efforts can be included in the credit calculation.

In-house research expenses include wages paid to employees for performing, directly supervising, or directly supporting qualified research activities. For example, the portion of a developer’s salary for time spent coding a new application is a QRE. Wages for administrative staff who do not directly support the research, such as human resources or sales, are excluded.

The cost of supplies is another in-house research expense. This includes any tangible property, other than land or depreciable assets, that is used and consumed during the R&D process, such as materials for a prototype or cloud computing services for development. General office supplies, meals, and travel costs do not qualify.

Contract research expenses are amounts paid to a third party for conducting qualified research. Only 65% of these payments are eligible as a QRE. To qualify, the business must retain substantial rights to the research results and bear the financial risk, meaning payment cannot be contingent on the research’s success.

The tax treatment for these expenses has changed. Businesses can no longer deduct QREs in the year they are incurred but must instead capitalize and amortize them. Domestic research expenses must be amortized over a five-year period, while research conducted outside the United States has a 15-year amortization period.

Calculating the Credit Amount

After identifying total QREs, a business calculates the credit amount using one of two methods: the Regular Credit (RC) or the Alternative Simplified Credit (ASC). Businesses can select the method that provides the most favorable result for the tax year.

The Regular Credit is 20% of the current year’s QREs that exceed a calculated “base amount.” The base amount is a complex figure derived from the company’s historical financial data, computed by multiplying a “fixed-base percentage” by the average annual gross receipts for the four preceding tax years. This makes the method challenging for businesses without long-standing and detailed records.

For example, if a company has $500,000 in current QREs and a base amount of $300,000, the excess is $200,000. The credit would be 20% of this amount, or $40,000. The complexity of the base amount calculation often leads companies to use the alternative method.

The Alternative Simplified Credit is more straightforward and does not require extensive historical data. The ASC is 14% of the current year’s QREs that exceed 50% of the average QREs from the three preceding tax years. This calculation focuses only on recent research spending.

For instance, assume a company has $500,000 in current QREs and its average QREs for the prior three years were $300,000. The baseline is 50% of that average, or $150,000. The credit is calculated on the excess of $350,000 ($500,000 – $150,000), resulting in a $49,000 credit.

Required Documentation

The IRS requires taxpayers to maintain detailed and contemporaneous documentation to substantiate their claim, as the burden of proof lies with the business. These records should provide a clear link between the expenses claimed and the qualified research activities performed. Having this information compiled and readily available demonstrates a systematic approach to identifying and tracking qualified research. Businesses should keep all supporting documentation for at least three years, the typical period during which the IRS can initiate an audit.

Examples of necessary documentation include:

• Project lists and technical narratives describing each project’s objectives and uncertainties.
• Financial records, such as payroll journals showing employee time on R&D activities.
• Invoices, receipts, and contracts for supplies and contract research.
• Test plans, engineering drawings, prototypes, and records of test results.
• Notes from project meetings that show an ongoing process of experimentation.

How to Submit Your R&D Tax Credit Claim

To claim the R&D tax credit, a business must complete and file IRS Form 6765, Credit for Increasing Research Activities, with its annual federal income tax return. This form is used to report total QREs and calculate the credit using either the RC or ASC method. The form must be attached to the business’s return, such as Form 1120 for a corporation or Form 1065 for a partnership.

Once filed, the R&D credit offsets the business’s income tax liability. Certain qualified small businesses (QSBs) can elect to apply up to $500,000 of the credit against their payroll tax liability. This option is beneficial for startups with significant research expenses but little to no income tax liability. The credit is claimed quarterly against payroll taxes using Form 8974, which is filed with the employer’s quarterly federal tax return.

If the credit amount is greater than the tax liability for the current year, the unused portion is not lost. The credit can be carried back to the previous tax year or carried forward for up to 20 years to offset future tax liabilities.