We all know how crucial technology companies are for the economy. Technological innovation has helped businesses across multiple industries increase productivity, efficiency, and scale.
To help drive continued innovation, the US government created the R&D tax credit program in 1981. This program provides significant tax benefits for businesses that are developing new or improving existing products and technologies.
Many companies do not claim the R&D tax credit because they either do not know about it or they are not sure whether it applies to them.
Thinking whether you are eligible or not? Are you wondering how you can qualify for the R&D tax credit program by the IRS?
Do not worry, we have created this guide to help you understand everything about the R&D tax credit program.
In this guide, you will learn:
- What is the R&D tax credit program?
- How to qualify for the R&D tax credit?
- How can you claim the R&D tax credit?
- What activities are not included in the R&D tax credit program?
- How much money can you get through the R&D tax credit program?
- Tips for getting approved for R&D tax credits.
So, let us dive into how you can get approved for the research and development funding.
1. WHAT IS THE RESEARCH AND DEVELOPMENT TAX CREDIT?
Simply put, the R&D tax credit is an excellent and quick way to get a cash injection into your business by reducing corporate income taxes or employer social security taxes.
Previously, businesses could only use R&D tax credits to offset income taxes, and the R&D tax credit program would periodically expire and get renewed by Congress.
In 2015, Congress passed a resolution that made the R&D tax credit program permanent and introduced new provisions to enable small businesses to take advantage of the program even if they are not profitable. This was designed to encourage small businesses to drive innovation and create more jobs.
Today, a small business with less than $5 million in gross receipts in the tax year and less than 5 years of gross receipts from the tax year, can use the R&D tax credit to offset up to $250,000 per year in employer social security taxes. This typically comes in the form of a refund check from the IRS.
Nonetheless, one of the problems that arise is not knowing which activities qualify for the R&D tax credit. The qualification criteria is complicated, so I recommend seeking professional opinion on your R&D to determine if the work will qualify.
2. HOW YOUR COMPANY CAN QUALIFY FOR R&D TAX CREDIT?
Here is the 4-part that a business must pass in order to qualify for the R&D tax credit.
- Develop new (or improve existing) functionality, performance, reliability, or quality of a product, process, technique, invention, formula, or computer software.
- Eliminate technological uncertainty during your development efforts.
- Undergo a systematic process to evaluate one or more alternatives to eliminate technological uncertainties and achieve the desired end result.
- Rely on principles of the physical or biological sciences, engineering, or computer science.
3. HOW CAN YOU CLAIM R&D TAX CREDIT?
The R&D tax credit is filed with your corporate tax return. You can either use the R&D tax credit to offset income taxes if you are profitable or to offset employer social security taxes.
Here is a list of expenses you can claim:
- Contractor expenses
- Patent expenses
- Hosting expenses
The first thing you must do in order to claim the credit is to document all your qualified expenses for R&D. It is important to keep a track of all your R&D activities. This will also help ensure that you have the evidence required to defend your R&D tax credit claim in the event of an IRS audit.
Here is a list of documents that you might need.
- Lists of R&D projects
- Project notes
- R&D employee time tracking
- Detail of general ledger expenses
- Record of payroll
4. WHAT ACTIVITIES ARE NOT INCLUDED IN THE R&D TAX CREDIT PROGRAM?
Here is a list of the activities that are excluded.
- 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. HOW MUCH MONEY YOU CAN GET THROUGH THE R&D TAX CREDIT PROGRAM?
Companies can use the R&D tax credit to offset:
- Employer portion of social security taxes up to $250,000 for every fiscal year. Small businesses will get the benefit for their research activities irrespective of profitability.
- Income taxes if in a taxable position.
One of the most frequently asked questions is how much R&D cost you can recover. The Federal R&D credit works out to approximately 10% of qualified R&D expenses that can be used to offset income taxes, or to offset social security taxes up to $250,000 per year.
The State R&D tax credit varies, for example, the California credit works out to 7.5% of qualified expenses and can only be used to offset income taxes. Washington state does not have a state R&D tax credit.
6. TIPS FOR R&D TAX CREDIT CLAIMS
PICK OUT THE RIGHT PROJECTS FOR THE R&D TAX CREDIT CLAIM
The most important part of the process is to identify projects, activities and associated expenses that meet the 4-part R&D tax credit test described in section 2. Not all the projects will qualify.
PREPARING THE R&D TECHNICAL NARRATIVE
Most companies have a tough time writing a technical narrative of the qualifying projects. Having a detailed technical narrative outlining how your R&D projects meet the 4-part test is also crucial because it serves as evidence to defend your claim in the event of an R&D tax audit by the IRS. Here are some key steps to remember when preparing a technical narrative:
FOCUS ON TECHNICAL ASPECTS
First, you have to write it from a technical perspective instead of a business viewpoint. A common mistake made by companies during writing is mentioning non-technical challenges like delayed deliveries or dealing with evolving user experience.
You must focus on the challenges and uncertainties you faced during the R&D process. An important thing you need to keep in mind is that the more difficult the technological uncertainty is to solve, the stronger the R&D claim.
You should also be sure to include failed attempts as it will convey the magnitude of difficulty even for experienced professionals.
USE EASY TO UNDERSTAND LANGUAGE
The main purpose of this narrative is to make the authority understand the problem and how you solved it in technical terms. Avoid using unnecessary buzzwords. A pro tip is to let an outsider read the narrative.
KEEP IT SIMPLE
Follow the popular tip, KISS (Keep It Simple Stupid). It is recommended to write short paragraphs addressing the 4-part test for each project. The narrative can cover 2 to 5 sides of A4 paper.
INCLUDE ESSENTIAL DETAILS
This is a great tip for the R&D tax credit claim. You have to make sure that you have included all the details about the project like the length and complexity of the project along with the associated salaries and other expenses such as contractors, hosting, patents, and supplies. You don’t have to fill page after page for the narrative, just ensure all necessary details are included.
COMMON MISTAKES YOU SHOULD AVOID
There are plenty of mistakes that companies make when filing for tax credit claims. You have to make sure that you are working in the financial year of the company. This is because expenditures incurred outside the fiscal year will not be included in the claim. Hence, you must always double-check that you are claiming for the right expenses.
One of the other mistakes is claiming dividends for company directors as qualifying R&D expenses. You can only claim salaries, contractors, hosting, patents, and supplies.
I hope this guide helped you understand the benefits of the R&D tax credit program and how you can get $250,000 from the IRS every year.
The process can be challenging and frustrating, especially when you are focused on running your business. We recommend outsourcing the preparation of your R&D tax credit claims to an expert firm like Boast.AI (Boast Capital).
Boast will make the process hassle-free by managing the entire process including identifying qualifying projects, preparing the technical narrative and financial reports, compiling the R&D tax forms, and defending you in the event of an audit. For more information about the Research and Development tax credit program, kindly get in touch.