Each year, the US government provides billions of dollars to innovative businesses for developing new or improving existing technologies, products, materials, and processes through the R&D Tax Credit program.
Qualified small businesses and startups can use the R&D tax credits to offset up to $250,000 per year in social security taxes, which typically comes as a refund check from the IRS.
Since every business needs capital for innovation and growth, claiming R&D tax credits is one of the cheapest ways to maximize capital and reduce tax liabilities.
What is R&D Tax Credit?
The R&D Tax Credit program is a general business tax credit under Internal Revenue Code section 41 for companies that incur research and development costs in the United States and has been around since 1981. Under the R&D Tax Credit program, the US government provides billions of dollars every year to innovative businesses for developing new or improving existing technologies, products, materials, and processes.
What Can You Recover with R&D Tax Credits?
The R&D tax credits you can recover can be broken down into two parts – federal and state. The Federal portion is approximately 10% of eligible expenditures that can be used to offset Social Security taxes up to $250,000 per year, income taxes, or alternative minimum tax (AMT). However, the State portion differs from state to state.
R&D Tax Credits in Texas
In 2014, the state of Texas put into effect a program for the exemption of sales tax or franchise tax credit for qualified research to foster growth and expansion of research & development in the state. The R&D credit is currently set to expire on December 31, 2026.
As part of the program, anyone that engages in qualified research can claim:
- a sales and use tax exemption on the purchase, lease, rental, storage, or use of depreciable tangible personal property directly used in qualified research, or
- a franchise tax credit based on qualified research expenses.
Note: Both the sales tax exemption and the franchise tax credits cannot be claimed by the same individual for the same period.
In order to claim either tax credit, the R&D work performed must count as qualified research, as defined by the IRS Code of 1986, Section 41(d), and includes research for which expenditures can be treated as expenses under Internal Revenue Code Section 174.
As per the IRS, “the research must be undertaken for discovering information that is technological in nature, and the person undertaking the research must intend to develop a new or improved business component. Substantially all of the research activities must be part of an experimentation process relating to a new or improved function, performance, reliability, or quality”.
How Much Can Businesses Claim in Tax Credits?
Depending on the type of research performed, businesses can claim 5% of the difference between:
- The qualified research expenses incurred during the period on which the report is based, and
- 50% of the average amount of qualified research expenses incurred during the three tax periods immediately preceding the period on which the report is based.
Note: However, if the business has no qualified research expenses in one or more of the three tax periods preceding the period on which the report is based, they can claim 2.5% in tax credits for the expenses incurred during that period.
Businesses that perform the qualified research in contract with one or more public or private institutions of higher education can claim 6.25% of the difference between:
- All qualified research expenses incurred during the period on which the report is based, and
- 50% of the average amount of all qualified research expenses incurred during the three tax periods preceding the period on which the report is based
Note: However, if the business has no qualified research expenses in one or more of the three tax periods preceding the period on which the report is based, they can claim 3.125% in tax credits for the expenses incurred during that period.
What You Need to Claim the Texas State R&D Tax Credits
In order to claim the state tax credits, businesses must register first with the Comptroller’s office either online or by filing Form AP-234, Texas Registration for Qualified Research and Development Sales Tax Exemption.
Once the business is registered successfully, it will be issued a Texas Qualified Research Registration Number, which will be used when completing Form 01-931, Texas Qualified Research Sales and Use Tax Exemption Certificate in order to claim the Sales Tax Exemption credit on eligible expenses used directly in qualified research.
To apply for the Franchise Tax Credit, businesses will need to file a Long Form Franchise Tax Report (05-158-A and 05-158-B) with Credits Summary Schedule (05-160) and Research and Development Activities Credits Schedule (05-178).
Texas R&D Tax Credit Case Study
A software development company based in Austin, Texas began operations in 2006 and has since steadily increased its research expenditures primarily through the addition of both experienced and inexperienced developers.
Based on total Qualified Research Expenditures (QREs), the company qualified for the federal R&D Tax Credit of $230,000 and an additional $77,088 of state R&D Tax Credit in Texas.
Benefits of Claiming R&D Tax Credits
Claiming R&D tax credits has many attractive benefits. Firstly, the R&D tax credits can be used to offset the employer portion of your 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. R&D tax credits can also be used to offset income taxes if you are in a taxable position, which is dependent on your previous tax return statements.
In addition, the R&D tax credits can be used to offset the 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.
Preparing Documentation for R&D Tax Credit
Although the R&D Tax Credit program can potentially help your business recover large amounts of your research and development spend, claiming the tax credits is a complicated process.
There are multiple forms and documentation that you will need. Additionally, documentation also has to adhere to strict criteria, such as:
- It has to be contemporaneous which means it has to be documented at the time the R&D was done. The bigger the claim, the more documentation you would want to have.
- Your documentation must also be dated. You need to prove that the work occurred in the fiscal year you are claiming.
- Your claim needs to highlight technical challenges such that it substantiates the R&D that was done.
Work with Boast.AI for your R&D Tax Credits
Given the complicated process of claiming tax credits, consider working with our Boast.AI team. Boast.AI helps innovative businesses automate the complicated process of claiming R&D incentives. By combining AI-driven software with in-house R&D tax experts, we can help your company get larger returns without the grunt work and audit risk.
With engineers and finance professionals armed with over 20 years of experience in this field, our team has extensive knowledge about the R&D Tax Credit program. We will stay engaged throughout the year to help you identify R&D eligible work on an ongoing basis, enabling us to provide information on other technology grants and financing opportunities.
Moreover, in the event of an R&D review by the IRS, we will defend you in the process and help to ensure that your claim is successful. Get in touch with us now to request a free assessment and get started on your next R&D claim.