R&D Tax Credit: More Valuable than Ever in Uncertain Times
By Cole Marr, Research and Development Director and Practice Leader at Sensiba San Filippo
As companies around the country begin to pivot from a sprint to preserve business operations to taking strategic steps to help ensure continued prosperity, several tax planning opportunities should be considered. One option is the Research and Experimentation tax credit (commonly called R&D tax credit). Many wrongly think this credit applies only to companies that employ scientists. However, if your team includes a range of software developers, machinists, or engineers, developing new systems and designs, then you may be entitled to a piece of the tax-credit pie.
The R&D credit is a general business credit that allows any eligible company to offset tax dollar-for-dollar. It helps level the playing field and incentivizes business growth by providing valuable cash savings enabling reinvestment and job retention in the United States.
The federal R&D tax credit provides a credit of up to approximately 10% of project qualifying expenditures. To determine if a research project (or portion of a project) is eligible, the business component (lingo for “project”) and associated activities must satisfy the following four requirements:
It must be undertaken for a Permitted Purpose, which includes a new or improved product or process function, performance, reliability, or quality. Efforts related purely to aesthetics are excluded.
There must be Technological Uncertainty related to capability, methodology, or design of the business component. This requirement is designed to exclude economic or other business uncertainties.
The project or activity must be Technological in Nature, fundamentally relying on a hard science such as engineering, physical/biological sciences, or computer science.
A Process of Experimentation must be used to resolve the uncertainty. The taxpayer must demonstrate how business components progress from initial concept through design, testing, and validation to commercialization, and that technological uncertainty is mitigated throughout this process.
When a project is determined to meet the above four criteria, the associated expenses can be quantified according to three basic expense categories:
Wages include the eligible portion of taxable compensation. A qualified wage is the portion of an employee’s compensation corresponding to the percentage of working time engaged in either direct conduct, supervision, or support of a project.
Supplies are the materials used to evaluate and test designs throughout the development process. Eligible supplies include items used in prototype builds, business component performance evaluations, and engineering software licenses.
Contract Research is outside vendor expenses paid on behalf of the company engaging in qualified research. Any contract research expenses are included at 65% and must take place in the United States.
While the federal R&D credit has existed in one form or another since 1981, recent legislation has bolstered the valuable incentive. On December 18, 2015, President Obama signed the Protecting Americans from Tax Hikes (PATH) Act. This legislation addressed several limitations on applicability and usability many taxpayers struggled with prior. The PATH Act contained several key provisions:
Extension & Permanence: Historically, the R&D credit was extended for a year or two at a time, only to lapse and then be retroactively extended. This limited the ability for businesses to plan R&D expenditures and limited the credit’s impact. The PATH Act extended and made permanent the R&D credit.
Alternative Minimum Tax (AMT): The AMT restriction frustrated many taxpayers who were unable to offset tax with the R&D credits their businesses were generating. The PATH Act allowed eligible small businesses (ESB) to offset tax liability below their AMT amount.
Payroll Tax Offset: One major flaw with incentivizing R&D investment through a tax credit is that a business must have taxable income to offset in order to benefit. This meant that many high-tech startups and young companies were not able to participate. With the PATH Act, Qualified Small Businesses (QSBs) can use the R&D tax credit to offset the FICA portion of the employer payroll tax. This valuable enhancement to the R&D tax credit enables startups to keep up to $1.25 million ($250,000 per year) at work during critical phases in a company’s lifecycle.
The R&D tax credit is a complicated intersection of congressional intent, IRS regulations, and tax court rulings. The process, while complex, can be navigated efficiently and effectively with the right help. The R&D credit experts at SSF are here to provide direction and help you create a plan to use this credit to help build your business. Click here to learn more.
About the Author:
Cole Marr is a Research & Development Director at Sensiba San Filippo. He can be reached at firstname.lastname@example.org or 408-286-7780.