R&D Tax Credit for Small Business

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What is the R&D Tax Credit?

The Research and Development (R&D) Tax Credit is a tax incentive sponsored by the government. It’s offered to companies who develop new or improved business components including products, processes, techniques, formulas, computer software, and inventions that result in new or improved functionality, reliability, performance, and quality. 

More than 30 states offer a credit to offset state tax liability. This tax credit is available at both the federal and state level. 

Regardless of the company size or the industry, many businesses qualify for a dollar-for-dollar tax credit. However, many business owners are unaware of it. There are also a lot of common misconceptions that prevent people from benefiting from this tax credit. 

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How To Know If You Qualify for the R&D Tax Credit?

This credit eligibility has a broad definition. It doesn’t just apply to product development but also activities and operations including software development, quality enhancement, new manufacturing processes, and different innovations. 

Startups are also eligible to apply for the R&D tax credit against their payroll tax for up to five years. 

Let’s see what makes your company eligible for the R&D tax credit: 

  • Have you hired designers, engineers, or scientists?
  • Have you developed processes, patents, prototypes, and software?
  • Has your business improved existing products?
  • Do you devote time and resources to creating new or innovative products?
  • Have you reviewed the potential of different alternatives or methods during the development or improvement process?
  • Is all your R&D being conducted inside the United States?

The R&D tax credit can also be retroactive. You can claim credits for three prior open tax years, depending on when your tax return was filed. 

How Businesses Benefit

R&D tax credits are dollar-for-dollar tax savings that reduce your company’s tax liability. There is essentially no limit to the number of expenses and credits that you can claim each year. 

If the federal R&D credit can’t be used immediately, then it’s carried back one year or carried forward for up to 20 years. There are different rules for each state for carryover. 

You’ll be provided regularly with extra cash. When you factor in state credits, you can get up to 10% of annual R&D costs for federal purposes and many different agendas. 

Misconceptions Regarding R&D Tax Credit Eligibility

  • Your company isn’t paying federal income tax

It’s a common misconception for startups and small businesses to assume that since they’re not paying federal income tax, they’re not eligible for the R&D tax credit. You can apply up to $1.25 million ($250,000 per year) of the federal R&D credit to offset the FICA portion of your payroll taxes each year. 

Your company has to have less than $5 million in gross receipts for the credit year and should have no gross receipts or interest income that dates back more than five years to be eligible for the tax credit. 

  • The company isn’t focused on research and development

R&D is a broad term. It doesn’t necessarily take place in labs and academic settings. If you’re experimenting with a process or a product, technically you’re doing research and development, regardless of whether you’re doing it in a winery, distillery, kitchen, or out there in the field. 

  • Your company doesn’t hire degree-holding scientists or engineers

Of course, the primary candidates for R&D tax credit do seem to be companies that have a lot of scientists and engineers working for them, but you have to understand that it’s not mandatory. 

Any employee who performs experimentation on different processes makes the company eligible for the tax credit. It can be a manager trying to optimize the workflow, an accountant attempting to innovate in bookkeeping, or someone else who improves upon a process. 

  • The company’s not developing new stuff

You might think that since your company’s product or process isn’t new to an industry, you don’t qualify for the tax credit. That’s wrong. You do qualify as long as the research and development are new to your company. 

  • The business is subject to Alternative Minimum Tax

Historically, some companies haven’t fully benefitted from the R&D tax credit because they were subject to the alternative minimum tax. Since 2016, businesses that were subject to AMT can offset regular taxes using the R&D tax credit. 

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The Four-Part Eligibility Test

Any company that resolves technical challenges and overcomes hurdles in a process is eligible for the tax credit. However, there’s a four-part test set in place by the Internal Revenue Code and Treasury Regulations that you should consult.

  • Qualified purpose test

Your business’s research must be done with the intent to create a new or improved business component. This should result in a new or improved function, quality, performance, or reliability. A business component can be a product, software, process, technique, formula, or invention. 

  • Uncertainty test

Your business should demonstrate that it has attempted to eliminate uncertainty about the development or improvement of a business component. Has your business shown that it’s tried to learn something new about the product or process being changed to improve or has it demonstrated that the product can’t be improved without going through this discovery process?

  • Technology test

Can your business demonstrate that its development of a business component relied upon the principles of the hard sciences, engineering, or computer sciences? Companies aren’t required to exceed, expand, or refine existing scientific principles; they just have to utilize them. 

  • Experimentation test

Your business should exhibit that it conducted ample experimentation through more than one method such as the scientific method, iterative trial and error, modeling, and simulation. 

How To Claim the Credit

You should document your R&D activities contemporaneously to establish the amount of qualified research expense paid for each qualified research activity. Some examples of the documentation that you should include are payroll records, lab results, project notes, project lists, a general ledger of expense details, and emails that document a company’s progress throughout the research process. 

These records, combined with a credible testimony from your employees, can form the foundation of a successful R&D tax credit claim. To learn more about the R&D Tax Credit, visit this helpful page.

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