The Research and Development (R&D) tax credit (also known as the "Increasing Research Activities Credit" and "Research and Experimentation (R&E) Credit") is a federal business tax credit that helps all types of companies that have spent money on research and development recoup some of these costs. This includes expenditures on the development, design or improvement of products, processes, formulas, patents, techniques or software. The credit was introduced in 1981 as a temporary way to boost economic activity but has since become a permanent part of the tax code. Many states offer similar R&D tax credits.
Explore this guide to learn more about the R&D tax credit, whether you’re eligible, and how it can be a powerful financial tool for your business.
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If your business has spent money on research and development in the past year, you likely qualify for the credit. While it’s commonly believed that only large corporations can take the R&D tax credit, it can be claimed by businesses of any size, and across a variety of industries. To qualify, your business simply needs to have engaged in what the Internal Revenue Service (IRS) calls qualified research expenditures, or QREs.
We'll discuss QREs in more depth below, but in general, if your company has attempted to develop new products or processes, or has worked to improve existing products or processes, you'll likely qualify for the R&D tax credit.
If your business qualifies for the R&D tax credit, you'll have some discretion over when and how you apply it. For most businesses currently turning a profit, the credit will be applied against the company's income tax liabilities. For companies like startups that have yet to turn a profit, the credit is usually used to offset the company's payroll tax liabilities.
Below, we've broken down a few common ways you can maximize the R&D tax credit for your business:
If your business meets these requirements, you can use the R&D tax credit to offset the 6.2% employer portion of Social Security payroll tax liability and the 1.45% employer portion of Medicare payroll tax liability, up to $500,000 in payroll taxes. You'll apply the credit to your payroll taxes by selecting this method as an option when filing your income tax return.
If you find out that you've been qualified for the credit multiple years in a row, you can use the surplus value of the credit to help offset some of your income tax liability. You would have to amend prior years’ returns to claim the credits to offset income taxes in other years. The payroll tax credit can only be taken on timely filed returns, not amended returns.
Note: The maximum allowable payroll credit election is $250,000 for tax years December 31, 2015, to December 31, 2022. For tax years beginning after December 31, 2022, the maximum allowable payroll credit election has increased to $500,000.
If you failed to claim the credit in previous years, but still qualified for it, you might still be able to access it. It's possible to go back and amend your income tax return(s) to incorporate the R&D income tax credit, which would allow you to receive a refund for a previous year.
If your business isn’t profitable yet but still incurs research and development expenses, you may feel like you're missing out on the full benefits of the credit — if the R&D tax credit is greater than your actual income tax, it's not refundable. Fortunately, your business can carry forward unused portions of the credit for up to 20 years and carry the credit back one year as well.
In general, expenses used to develop new products, technologies or services, or improve existing products, technologies and services, will qualify for the R&D tax credit. More specifically, the following activities will usually be eligible:
When it comes to the standards set by the IRS, there are four main categories of research and development costs that can be counted as legitimate expenses:
If your company qualifies for the R&D tax credit, there are standard ways to calculate it, both of which we'll discuss below.
Regular method — Under this method, the R&D tax credit will be worth 20% of the company's QREs over a base amount, which will be a product of a fixed-base percentage and the average annual gross receipts from the past four years.
Alternative simplified credit (ASC) method — Under this method, the R&D tax credit is worth 14% of the company's QREs over 50% of its average QREs from the past three years. If there are no QREs from previous years, the credit is worth 6% of the current year's QREs.
How should you choose between the methods? Consulting with tax experts can help you make the best decision. But in general, companies new to claiming the credit will find the ASC method slightly easier.
Figuring out how to claim the R&D tax credit and then how to best apply it to receive the most benefit can be a difficult process. Below, we've broken down how to determine if you qualify, how to claim the credit, how to apply it and which documents you'll need to claim it.
Claiming the R&D tax credit encompasses three major steps:
As mentioned above, studying your research and development processes is a key part of claiming the R&D tax credit. By working with an independent third party to conduct an R&D study, you can make the most of available R&D tax credits and uncover any savings or incentives you might have missed.
What is an R&D study?
An R&D study is a thorough review of your organization’s research and development activities and associated expenses. Its main goal is to pinpoint which activities qualify for state and federal R&D tax credits and incentives.
Who performs R&D studies?
Tax professionals specializing in R&D tax credits typically conduct these studies. They have a deep understanding of R&D credits, related tax laws and how they apply to various industries.
What are the benefits of an R&D study?
Completing an R&D study can deliver financial and regulatory benefits:
Does my business need an R&D study?
If your organization is looking to claim R&D tax credits, you may benefit from an R&D study, regardless of your size or industry. There are no specific thresholds that trigger the need for a study, but it’s especially valuable for organizations with extensive R&D activities or complex projects. An R&D study helps your organization get the most out of R&D credits by identifying all eligible activities and expenses. It backs up your R&D claims and lowers audit risks. You also gain deeper insights into your R&D efforts, so you can make better-informed decisions for future planning and investments.
How long does an R&D study take?
The time varies depending on your business size, project complexity and specific needs. For small to mid-sized projects, it typically takes about six to eight weeks to estimate tax credits and gather necessary information for filing the tax return.
What does the R&D study process look like?
Typically, an R&D study follows these steps:
Here is a simple, four-part test that can help you determine whether your business qualifies for the federal R&D tax credit and the potential benefits it offers. Under IRS Section 41, your company's activities must meet these criteria to be considered qualified research expenditures.
As with any credit, proper documentation is essential for successfully receiving the benefits of the R&D credit and lowering audit risks. When claiming the R&D tax credit, you should prepare the following documentation and records:
The primary purpose of the R&D tax credit is to boost economic activity by encouraging companies to innovate and invest in new technologies, products and services. If you claim the credit for your business, the potential benefits include:
Many companies that qualify for the R&D tax credit don’t claim it simply because they don’t understand it. For example, according to the National Science Foundation, in 2010 almost $9 billion in R&D tax credits were claimed — while an additional $4 billion in eligible credits went unclaimed.
Contrary to what many people think, the R&D tax credit is open to companies of all sizes. In fact, roughly half of all companies that claim the credit are classifiable as small or middle-sized businesses. Qualifying for the credit depends only on whether or not your company spent money on qualified activities that the IRS recognizes as research and development.
While this isn't an exhaustive list, here are some of the industries that often qualify for the R&D tax credit:
Regardless of your industry, it’s a good idea to investigate potential tax credits that could improve your financial performance. Doing so ensures that you’re taking advantage of all possible credits and can also provide insights into ways you might reallocate funds or spending to maximize your tax benefits.
The R&D tax credit can offer many important benefits — including cost savings and the ability to fuel growth — to a number of industries. As we've seen, misunderstandings about what might qualify a business for the R&D tax credit can prevent companies from taking advantage of this valuable asset. Below, we've broken down some common industries that can benefit from the R&D tax credit.
Unsurprisingly, tech companies — think companies involved in software or app development, electronics or even telecommunications — have a lot to gain from the R&D tax credit. As the pace of technological innovation continues to grow, most tech companies will invest in data analysis, product design and development, and testing as a matter of course. Even if these processes are aimed at optimizing current technologies rather than developing new ones, they can still qualify for the R&D tax credit.
If your business model incorporates some aspect of the engineering process, you likely qualify for the R&D tax credit. Developing new designs or creating new products typically requires extensive research and testing, which means these activities usually meet the R&D tax credit requirements.
Manufacturing is probably the widest umbrella in terms of industries that qualify for the R&D tax credit. If your company engages in common internal processes, from customer analysis to part or product design or even establishing your production line, you probably meet the R&D tax credit requirements.
Pharmaceutical and biotechnology companies, manufacturers of medical devices and even agricultural companies all typically qualify for the R&D tax credit. Since many of these businesses rely heavily on high-quality research processes, they'll easily meet the requirements. But there are other ways to qualify, including product testing, lab maintenance and any attempts to improve an existing product.
Many businesses that easily meet the requirements for the R&D tax credit don't take advantage of it, simply because they aren't aware they qualify. We've broken down some of the most common myths and misconceptions surrounding the R&D tax credit below.
Most companies are convinced that if they don't have a team of PhDs constantly conducting cutting-edge studies, they aren't really doing research. But that's simply not true. The IRS definition is broad enough that a wide variety of activities can qualify a company for the R&D tax credit, from researching customer behavior to improving a pharmaceutical formula and even designing a building.
Because the R&D tax credit initially began as a temporary incentive, a rumor persists that claiming the credit might increase your company's chance of being audited. Again, this simply isn't true. As a permanent incentive, the R&D tax credit is designed to encourage companies to develop new or improved innovations.
Of course, it's still possible you might experience an audit, which is why it's important to make sure you've filed properly and have the right documentation prepared. Working with an experienced tax preparation expert can help you make sure you're ready to answer any questions the IRS might ask — as well as making sure you safely get the most out of the R&D tax credit.
A common misconception is that only profitable companies can claim the R&D tax credit. In fact, the PATH Act of 2015 introduced new changes to the R&D credit, one of the most important of which makes it easy for startups and other companies that haven't yet turned a profit to access the credit. The change allows businesses to reclaim part of their R&D investment by reducing their payroll tax liability.
The federal R&D tax credit doesn’t have a cap or maximum amount. It is typically worth up to 15% of qualified research expenditures. But whatever you generate, you can offset up to $500,000 of payroll costs each year on a timely return. This means successfully applying for the credit could potentially save your company millions of dollars over several years.
In addition, most states in the U.S. offer their own version of the R&D credit, which can further increase the value of this deduction for companies that qualify.
Many smaller or younger startups are not impacted by Section 174 (pre-revenue) and can claim against payroll to save cash. The amount of this credit was doubled for 2023 as part of the Inflation Reduction Act, so it is more important than ever to understand your opportunity for savings. Applying the credit to your company's payroll taxes needs to be done on an income tax form filed in a timely fashion and will cover up to $250,000 of the employer's portion of Social Security payroll taxes and up to $250,000 of the employer’s portion of Medicare payroll taxes.
The first step in understanding the credit is verifying that you qualify. The following five-question test will help you better understand if these credits are available to your business.
To qualify, you need to answer "yes" to the above questions. If you believe you qualify, you can calculate an estimated amount for the credit, to give you a better idea of what you can expect on return.
For more information about the R&D tax credit and whether you qualify, take a look at the resources below:
Although it can yield significant benefits, the R&D tax credit commonly goes unclaimed because of misinformation and lack of knowledge. But that doesn't mean claiming it is necessarily an easy process.
The R&D tax credit is a complex credit based on projects, meaning that your research needs to qualify for the credit. From there, it needs to be properly and accurately documented. Bringing in an experienced tax expert can ensure you're claiming as large a credit as possible, and that you'll be doing it successfully.
Don’t let the complexity of the R&D tax credit keep you from taking advantage of it. Our tax specialists can cut through the confusion and guide you every step of the way, including determining whether an R&D study would make sense for you. Learn more about how our tax credit experts can help you uncover missed opportunities, identify potential savings and ensure a successful claim process.
Armanino has the industry expertise, tax credit experience and track record of customer satisfaction to best advise your tax credit incentive strategy and compliance needs.
Contact us today for a free assessment.