When Is the R&D Tax Credit Refundable?
Explore the specific scenarios where the R&D tax credit offers a direct cash benefit instead of only offsetting tax obligations.
The R&D tax credit is a federal incentive to encourage innovation and technological advancement. Businesses often inquire about its refundability, which depends on specific circumstances and tax liability. While generally non-refundable against federal income tax, exceptions exist, particularly for certain small businesses.
The Federal R&D Tax Credit Explained
The federal R&D tax credit stimulates domestic research and development efforts. It provides a credit against a company’s tax liability for qualified research expenses. These expenses include costs for developing new products, processes, software, or significantly improving existing ones.
To qualify, activities must meet a four-part test: they must be technological, address uncertainty, involve experimentation, and aim to develop a new or improved business component. Businesses claim this credit on IRS Form 6765, filed with their annual income tax return.
Non-Refundability for Federal Income Tax
The federal R&D tax credit is generally non-refundable against federal income tax liability. This means the credit can reduce the amount of income tax owed down to zero, but it will not generate a cash refund if the credit amount exceeds the tax liability. For example, if a business owes $100,000 in income tax and has a $150,000 R&D credit, the credit will eliminate the $100,000 tax liability, but the remaining $50,000 credit will not be paid out as a refund.
Businesses are not required to forfeit any unused portion of the R&D tax credit. Instead, any credit amount that cannot be used in the current tax year can be carried forward to offset future income tax liabilities. This carryforward period extends for up to 20 years, providing a long window for businesses to utilize the credit as they become more profitable. In some cases, unused credits may also be carried back to offset tax liabilities from the preceding tax year.
The Payroll Tax Offset Exception
An exception to the general non-refundability rule allows certain qualified small businesses to apply a portion of their R&D tax credit against their payroll tax liability, effectively making it refundable in that context. This provision is particularly beneficial for startups and small businesses that may have little or no income tax liability in their early years but incur substantial R&D expenses. To be considered a “qualified small business” for this purpose, a company must have gross receipts of less than $5 million for the current tax year and must not have had any gross receipts for any tax year in the preceding five-year period.
Eligible businesses can elect to apply up to $250,000 of their R&D credit against their share of Social Security payroll taxes. The Inflation Reduction Act of 2022 further enhanced this benefit, increasing the maximum amount that can be applied against payroll taxes to $500,000 for tax years beginning after December 31, 2022. This additional $250,000 can be used to offset the employer’s share of Medicare taxes. The election to use the R&D credit against payroll taxes is made on IRS Form 6765, and the amount to be applied is then reported on IRS Form 8974, filed with the employer’s quarterly payroll tax return.
State R&D Tax Credit Variations
Beyond the federal R&D tax credit, many states offer their own research and development tax credit programs. These state-level credits are distinct from the federal credit and have their own specific eligibility requirements, definitions of qualified research activities, and claiming procedures. Their refundability often varies.
Some states provide R&D tax credits that are partially or fully refundable, especially for small businesses or those meeting certain criteria. This means that if the state R&D credit exceeds a business’s state tax liability, the state may issue a cash refund for the excess amount. The rules for carryforward periods also vary widely among states, with some mirroring the federal 20-year period, while others have shorter or even indefinite carryforward provisions. Businesses should consult their specific state’s tax regulations to understand the nuances of their R&D credit programs, including any refundability provisions.