One common misconception is that the Research and Development Credit primarily benefits only very large enterprises. However, the R&D Credit can benefit businesses from all along the maturity spectrum from startups through very mature and large companies.
What are Qualifying Activities
It is often believed that qualifying activities only include groundbreaking research which produces results new to industry in general or to a specific industry. Actually, a business’s research and development activities just has to be aimed at producing a technique or product which is new to your company. There is a four-part test:
- Technological in Nature – Activities must rely on principles of science, engineering or computer science;
- Permitted Purpose – Activities must attempt to improve the functionality, performance, reliability or quality of a new or existing business component;
- Eliminate Uncertainty – Activities must be aimed at eliminating uncertainty concerning the development or improvement of a product; and
- Experimentation – All of the activities must include a process of experimentation including testing, modeling, simulating and systematic trial and error.
The research and development must be for a qualified purpose which includes creating or improving new business components. Business components may include software, techniques, processes, products and more.
Special Payroll Relief for Start-up Companies
A special R&D credit provision allows start-up companies to reduce their payroll taxes in lieu of taking an R&D Credit.
Businesses founded in the past five years and with less than $5 million in revenue may be eligible to offset up to $500,000 of their FICA federal payroll liability for up to 5 years using R&D credits.
How Much Can the Credit Reduce My Taxes
Although every situation is different, it has been estimated that a benefit of 12-15 cents of federal and state R&D credits can be obtained for every dollar spent on qualified R&D expenses. Unused federal credits can be carried forward for 20 years.
Documentation to Support the R&D Credit
The IRS requires taxpayers to compile and maintain documentation to support the credit taken on a tax return. For example, documentation for qualified employee wage expenses would include Employee Forms W-2, Payroll registers, timesheets and methods of allocating employees’ time between qualified and nonqualified R&D expenses.
If you believe you may have qualified R&D activities, we and our network may be able to assist you in analyzing the activities.
Written by: Tom Alvarez, CPA; MBT
