Each year the US government provides billions of dollars to innovative businesses for developing new or improving existing technologies, products, materials, and processes, under the Research & Experimentation Tax Credit (R&D Tax Credit) program.
The R&D Tax Credit is a general business tax credit under the Internal Revenue Code section 41 for businesses that incur research and development (R&D) costs in the United States. The US R&D tax credit has been in existence since 1981.
Previously, the program periodically expired and was renewed by Congress. Businesses wishing to include this in their long-term budgeting plans could not rely on the credit being around for certain.
In 2015, Congress made the R&D tax credit permanent as part of the Protecting Americans from Tax Hikes (PATH) Act of 2015, in addition to making key changes so that small businesses that are not profitable could benefit from the credit.
The R&D tax program can be difficult to understand and navigate. We’ve compiled answers to the most common questions we’ve received from hundreds of startups to help you simplify the process.
1. What are the benefits of the R&D tax credit program?
The R&D tax credits can be used to offset:
- The employer portion of Social Security taxes up to $250,000 for each fiscal year. The Social Security tax offset allows qualified small businesses to receive a benefit for their research activities regardless of profitability.
- Income taxes if you are in a taxable position.
- Alternative Minimum Tax (AMT) if you have less than $50 million in average revenue for the 3 preceding years from the tax year, and you owe AMT in the current year.
2. What is a qualified small business?
A business is a qualified small business if it meets the following three criteria:
- Has gross receipts/revenues of less than $5 million for the current tax year.
- Has gross receipts/revenues for five years or less. The business must not have gross receipts for any tax year before the 5-tax-year period ending with the tax year they are applying for. For example, businesses that have generated gross receipts prior to 2016 are not eligible to use the R&D credits from the fiscal year 2020 to offset Social Security taxes.
- Is not a tax-exempt organization under section 501.
Although the law is intended to benefit small businesses, larger businesses can also benefit from the qualified small business criteria. For example, a significant percentage of life science companies have zero gross receipts for long periods of time until their drug receives FDA approval.
3. What activities qualify for the R&D tax credit?
The R&D efforts must pass a 4-part test in order to be eligible:
- Permitted Purpose: the work must be done to develop new (or improve existing) functionality, performance, reliability, or quality of a business component i.e. any product, process, technique, invention, formula, or computer software that the taxpayer intends to hold for sale, lease, license, or actual use in the taxpayer’s trade or business.
- Elimination of Uncertainty: discover information that would eliminate uncertainty concerning the development or improvement of the business component. Uncertainty exists if publicly available information and knowledge cannot be applied to achieve the desired result i.e. capability of development or improvement, method of development or improvement, or the appropriateness of the business component’s design. Some questions to ask yourself are:
– What uncertainties did you attempt to overcome that could not be removed using standard practice?
– What work did you perform in the tax year to overcome the uncertainties described above?
– What advancements did you achieve as a result of the work described?
- Process of Experimentation: the work must be done in a systematic process to evaluate one or more alternatives to achieve the desired result.
- Technological in nature: the work must be within the physical or biological sciences, engineering, or computer science.
When looking at real-world applications to put the R&D tax eligibility criteria into practice, you need to ask yourself if you have:
- Created a new product, made improvements, or added new features to an existing product?
- Integrated various databases or applications that were not designed to communicate?
- Improved response time of your software application?
- Changed a process to reduce costs or to improve manufacturing capabilities/timing?
- Incurred costs related to a process, project, or prototype that is incomplete because of unresolved technical problems?
- Modified your product formulation?
- Automated production?
- Modified existing products or machines to new applications?
- Machined/fabricated parts/dies using new materials or to meet higher tolerances?
If you answered yes to any of the above questions, you have the potential to claim R&D tax credits.
4. What activities are excluded from R&D tax credits?
- Foreign research conducted outside the US, the Commonwealth of Puerto Rico, or any possession of the US
- Research conducted after the beginning of commercial production of the business component
- Adaptation of existing business components
- Duplication of existing business components
- Reverse Engineering
- Surveys, studies, activity relating to management function/technique, market research, routine data collection, or routine testing/quality control
- Software developed for internal use. There are exceptions for this exclusion
- Research related to social sciences, arts, or humanities
- Research funded by any grant, contract, or otherwise by another person (or governmental entity)
5. My product is live and users are paying for it, but I still have ongoing R&D work. Does that mean I cannot claim R&D tax credits?
If you encounter uncertainties while developing new features/ functionality or while making improvements to existing features/ functionality after your product is live, then the work performed to overcome those uncertainties can still be claimed.
6. What expenses can I claim for R&D tax credits?
- Taxable wages for employees who perform or directly supervise or support qualified activities in the US.
- Contract research expenses for qualified activities performed in the US provided the taxpayer retains substantial rights to the activity’s results and must pay the contractor whether it succeeds or fails.
- Off-premise lease costs of computers used in qualified activities. E.g. hosting costs related to the R&D work.
- Cost of supplies used in qualified activities, including extraordinary utilities, excluding capital items or general administrative supplies such as travel, shipping, or royalty expenses. E.g. prototypes and testing materials.
7. How much of my R&D costs can I recover?
The Federal portion is approximately 10% of eligible expenditures that can be used to offset Social Security taxes up to $250,000/ year, income taxes, or AMT.
The State portion differs from state to state. California is approximately 7.5% of eligible expenditures, but it can only be applied against income taxes and may be carried forward indefinitely. The New York R&D tax credit is refundable and offers approximately 50% of the Federal R&D credit up to six percent of the R&D expenditures in New York State.
A startup with $500,000 of eligible software engineering expenses, could receive an R&D credit of $50,000 or more, while a qualified small business with over $2.5 million in eligible expenses could receive a credit of $250,000 and use the whole amount to offset Social Security taxes in the fiscal year.
8. What is the deadline to file my R&D tax credit?
To offset income taxes, businesses have the flexibility to amend all open tax years (typically, the last 3 years from the tax year).
To offset Social Security taxes, the R&D tax credits must be specified and elected by a qualified small business with its timely filed (including extensions) income tax return for the taxable year to which the election applies. You can then begin offsetting your Social Security taxes for the calendar quarter that begins after you file your income tax return with the payroll tax credit election.
The deadline for C Corps with a December fiscal year is on or before April 15. The deadline for C Corps with fiscal year ends other than December (except June) is on or before the 15th day of the fourth month following the end of the fiscal year. The deadline for C Corps with fiscal years ending on June 30 is on or before September 15.
The deadline for S Corps with a December fiscal year is on or before March 15. The deadline for S Corps with fiscal year ends other than December is on or before the 15th day of the 3rd month following the end of the tax year.
Six-month extensions are available for both C Corps (7 months for C Corps with a June fiscal year) and S Corps.
If the due date falls on a Saturday, Sunday, or legal holiday, the due date is the next working day.
9. Can a tax return be amended to offset Social Security taxes if the election was not made on an original income tax return as filed?
A qualified small business must elect to utilize R&D credits to offset Social Security taxes on or before the due date of its timely filed income tax return, including extensions.
10. Can the R&D tax credits be used to offset Social Security taxes relating to all employees or only that portion which relates to R&D employees?
It can be used to offset the employer’s portion of Social Security taxes for all employees, not just the R&D employees.
11. How and when do I see the benefits of the Social Security tax offset?
You can start offsetting Social Security taxes for the calendar quarter that begins after you file your income tax return containing the R&D tax credit form with the payroll tax credit election.
Businesses are required to pay 6.2% of each employee’s salary up to $137,700 as Social Security tax. This is reported once a quarter on Form 941 – Q1’s Social Security taxes are reported in April, Q2’s Social Security taxes are reported in July, Q3’s Social Security taxes are reported in October, and Q4’s Social Security taxes are reported in January.
If you file your 2017 R&D tax credit claim along with your federal income tax return by March 30, 2018, you can offset Social Security taxes starting the second quarter of 2018. As a result, the earliest you are likely to see a benefit from 2017’s R&D tax credits is July 2018.
When the credits get applied to Social Security taxes, you receive a refund check from the IRS within 6-8 weeks of the filing of the quarterly Form 941 which includes the Social Security offset.
12. What if I can’t use all my R&D tax credits to offset Social Security taxes this quarter?
If the credit amount exceeds a company’s Social Security tax liability in any given quarter, the excess will be carried forward to the next calendar quarter.
Once you no longer meet the criteria to be classified as a qualified small business, any unused Federal R&D credits that are not elected to offset Social Security taxes may be carried forward for up to 20 years and used to offset income taxes when you become profitable.
13. Am I eligible for the Social Security offset to claim if I’m using a Professional Employer Organization (PEOs)?
Provided the PEO is certified or has authorization from the IRS, you will be eligible for the Social Security offset. Since the PEO is specified as the employer on the W2s of your employees and is responsible for filing the Form 941 to report Social Security taxes on behalf of your company, the PEO needs to handle the Social Security offset and relay the funds to your company once it receives the refund from the IRS.
14. What documentation is needed to support my R&D tax credit?
Your documentation needs to substantiate that the expenditures claimed are eligible for the credit. It needs to be:
- Contemporaneous – documented at the time the R&D was done.
- Dated – prove that the work occurred in the fiscal year you are claiming.
- Highlights technical challenges – it substantiates the R&D that was done.
Documentation can be in the following formats:
- Version control for all technical documents
- Prototypes, including software and physical products
- Test documents
- Developer or Engineering Notebooks
- Meeting minutes
- Whiteboard photos
- Invoices/ receipts
- Contractor agreement outlining the statement of work
Start gathering all of your documentation as it will help defend your claim in the event of an IRS R&D audit.
15. What are the risks of claiming the R&D tax credit?
The IRS may audit your R&D tax claim to determine if the work being done meets the 4-part test and the expenditures claimed can be substantiated.
As a result of the audit, the IRS may allow or deny some or all of the R&D credit. Credits that have been appropriately identified and supported are generally allowed. Credits that aren’t, often get denied.
If the IRS denies your R&D credit, it may assess a penalty if it finds that the credit was either claimed through negligence or the disregard of rules or regulations. Generally, this penalty equals 20 percent of the credit disallowed, i.e., of the tax the IRS believes was underpaid. The IRS may also assess interest due on that 20 percent from the date that the tax should have been paid.
From our experience, R&D tax credits that have backup documentation to substantiate the expenditures claimed do not get denied.
If you’ve never claimed the R&D tax credit before, either because you didn’t think you qualified or you couldn’t use the credits, it’s a great time to reconsider as the R&D credit can provide a meaningful cash injection into your business.