How to Perform R&D Tax Credit Calculations

The Research and Development (R&D) tax credit provides a dollar-for-dollar reduction in tax liability for companies performing qualified research activities in the United States. This incentive encourages investment in innovation by offsetting some of the inherent costs. Claiming the credit involves a detailed calculation process that begins with identifying specific expenditures and applying them to established formulas. This process requires careful record-keeping and a clear understanding of the different calculation methodologies available.

Identifying Qualified Research Expenses

Before any calculation can begin, a company must identify its pool of Qualified Research Expenses (QREs). These are specific costs incurred as part of the research and development process as defined under Section 41 of the Internal Revenue Code. The total of these expenses forms the foundation of the credit calculation. These costs fall into a few distinct categories and are only eligible if the associated activities meet a prescribed set of criteria.

In-House Research Expenses

In-house research expenses include the costs of wages, supplies, and computer rentals for research conducted by the company. Qualified wages are not just for employees directly conducting experiments; they also extend to individuals who directly supervise or provide direct support for research activities. For example, the salary of a lab technician who prepares testing materials or a first-line manager overseeing a team of software developers could be included.

Supplies are tangible property, other than land or depreciable assets, used directly in the research process. This could include materials for building and testing a prototype or chemicals used in a laboratory setting. General office supplies or administrative materials do not qualify. Supplies must be consumed during the course of the experimentation.

Contract Research Expenses

Payments made to third parties to perform research on the taxpayer’s behalf can be included as QREs. For these costs to qualify, the taxpayer must retain substantial rights to the research results, meaning they have ownership and control over the intellectual property. Only 65% of the amounts paid to contractors can be included in the QRE total. The research performed by the contractor must meet the same qualification standards as in-house research. It is important to have clear agreements with contractors that outline the scope of work and ownership to substantiate these claims.

The Four-Part Test

For an expense to be considered a QRE, the underlying activity must satisfy a four-part test. All four of these conditions must be met for the associated costs to qualify.

• Permitted Purpose: The research must be aimed at creating a new or improved product or process in terms of its functionality, performance, reliability, or quality.
• Technological in Nature: The process of experimentation must rely on principles of hard sciences like engineering, computer science, or biology.
• Elimination of Uncertainty: The activity must be intended to discover information that would remove uncertainty concerning the capability, method, or appropriate design of the business component.
• Process of Experimentation: The company must demonstrate it has evaluated one or more alternatives to achieve the desired result, which could involve modeling, simulation, or systematic trial and error.

Understanding Key Calculation Components

The next step involves understanding the historical data points that serve as benchmarks in the calculation. These components are primarily used in the Regular Credit Method and are designed to ensure the credit is awarded for an increase in research activities over time. The two main components are gross receipts and the base amount, both of which require a look back at prior tax years.

Gross Receipts

For the R&D credit calculation, “gross receipts” are defined broadly. The figure includes total sales, net of returns and allowances, and also incorporates income from investments, rents, royalties, and other sources. This comprehensive definition reflects the company’s overall economic activity. When calculating the credit, a business must look at its average annual gross receipts for the four tax years immediately preceding the year for which the credit is being claimed.

Base Amount

The “base amount” is a central element of the Regular Credit Method, representing a historical baseline of research spending. It is calculated by multiplying the company’s “fixed-base percentage” by its average annual gross receipts for the four preceding years. The fixed-base percentage is the ratio of aggregate QREs to aggregate gross receipts from a specific historical period.

For companies that started after 1988, the fixed-base percentage is set at 3% for the first five years in which they have both gross receipts and QREs. The base amount can never be less than 50% of the current year’s QREs, a rule known as the “50% floor.”

Calculation Methods

A company must choose a method to calculate the credit amount. The Internal Revenue Code provides two primary options: the Regular Credit Method (RCM) and the Alternative Simplified Credit (ASC) method. The choice between them depends on factors like the company’s age, the availability of historical records, and which method yields a greater benefit.

Regular Credit Method (RCM)

The Regular Credit Method calculates the credit as 20% of the amount by which the current year’s QREs exceed the base amount. This method is often beneficial for companies with consistent R&D spending over a long period, but it requires significant historical data. For example, if a company has $500,000 in current year QREs and a calculated base amount of $300,000, the excess is $200,000. The credit would be 20% of this excess, resulting in a $40,000 tax credit. The complexity of calculating the fixed-base percentage can make this method challenging for many businesses.

Alternative Simplified Credit (ASC) Method

The Alternative Simplified Credit offers a more straightforward calculation that is less dependent on deep historical data. The ASC is calculated as 14% of the amount by which the current year’s QREs exceed 50% of the average QREs from the three preceding tax years. This method is often preferred by companies that lack the historical data needed for the RCM or find that calculation too burdensome.

To illustrate, assume a company has $500,000 in current year QREs and its average QREs for the prior three years were $250,000. The base for the ASC calculation would be 50% of this average, or $125,000. The credit is then 14% of the excess ($375,000), which equals a $52,500 credit. If a company has no QREs in any of the three preceding years, the credit is 6% of the current year’s QREs.

Completing and Filing Form 6765

After calculating the credit, the final step is to report the figures and formally claim it by filing Form 6765, Credit for Increasing Research Activities. This form is not a standalone return but is an attachment to the company’s primary annual income tax return, such as Form 1120 for corporations or Form 1065 for partnerships.

Navigating the Form

Form 6765 is divided into sections that correspond to the different calculation methods. Section A is used for the Regular Credit Method, where you enter details about your base amount and calculate the 20% credit. If you choose the Alternative Simplified Credit, you will complete Section B instead.

The form requires a breakdown of the total current year QREs into categories like wages, supplies, and contract research. These expenses must be further detailed by the specific business component they relate to, such as the product, process, or software being developed. The totals from this section are then used in either Section A or Section B to perform the final credit calculation.

Making Elections

The form is where a taxpayer makes binding elections. The choice to use the Alternative Simplified Credit is made by completing Section B. Once this election is made on a timely filed return, it must be used in all subsequent years unless the taxpayer receives IRS consent to revoke it. Another election available is the reduced credit under Section 280C, which allows a taxpayer to claim a slightly lower credit amount in exchange for not having to reduce their otherwise deductible research expenses.

Submission Process

The completed Form 6765 is attached to the business’s main federal income tax return and submitted by the return’s due date, including extensions. For partnerships and S corporations, the credit is calculated at the entity level on Form 6765 and then passed through to the individual partners or shareholders on their Schedule K-1. Certain qualified small businesses may also use Form 6765 to make an election to apply the R&D credit against their payroll tax liability.