Did your client improve upon a product or develop new software this year? If so, they might qualify for the Credit for Increasing Research Activities, commonly known as the Research & Development (R&D) tax credit. Here’s what you should know to help your clients successfully claim the R&D credit.
What is the R&D tax credit?
The R&D tax credit allows businesses to offset their federal tax liability with expenses that were used for the research and development of new or improved “business components.” The IRS defines business components as “any product, process, computer software, technique, formula, or invention, which is to be held for sale, lease, license, or used in a trade or business of the taxpayer.” Qualified Small Businesses may also use these expenses to offset their payroll tax.
While we’re specifically covering the federal R&D credit here, over 30 states have their own R&D tax credits too. Be sure to check if your state, or the state where your client conducted research, is one of them.
Who qualifies for the R&D tax credit?
When we think of “research and development,” most of us likely picture groups of scientists and engineers employed by large corporations. In reality, any business – including small businesses and sole proprietorships – that meet the research requirements can qualify for the R&D tax credit.
However, only qualified small businesses may use the R&D credit to offset payroll taxes (i.e. the employer portion of the Social Security tax). To be a QSB, a business must have
- Gross receipts of less than $5 million for the tax year, and
- No gross receipts for any tax year before the five-year period ending with the tax year.
When the research credit is applied as a payroll tax credit, it cannot exceed $250,000.
How does the IRS define Research & Development?
The IRS has four tests to determine whether activities count as Qualified Research Activities:
The Section 174 Test
This test requires that expenses used to claim the credit “(1) must be incurred in connection with the taxpayer’s trade or business, and (2) represent a research and development cost in the experimental or laboratory sense.” A major requirement for this test is the “elimination of uncertainty.” In other words, without these research activities, the taxpayer would not have had the knowledge or capability necessary to create or improve the business component.
The Discovering Technological Information Test
This test requires that the research performed to eliminate uncertainty. In order to pass this test, the IRS requires research to “fundamentally rely on principles of the physical or biological sciences, engineering, or computer science,” and it must be experimental in nature.
However, the research does not need to expand on the available knowledge in the sciences or be performed by professional scientists. It must simply eliminate uncertainty in the development of the business component.
The Business Component Test
Research activities meet this test if they were carried out in order to create or improve a new business component. This includes “any product, process, computer software, technique, formula, or invention, which is to be held for sale, lease, license, or used in a trade or business of the taxpayer.”
The Process of Experimentation Test
In addition to discovering information that is “technological in nature,” a business must also undertake a process of experimentation that identifies the uncertainty, identify all the “alternatives intended to eliminate that uncertainty,” and carry out “a process of evaluating those alternatives.”
Calculating the R&D Tax Credit
First, you’ll need to identify your client’s qualifying research expenses or QREs. QREs include wages paid to employees for work relating to qualifying research, supplies, and contract expenses.
From there, you have two options for calculating the research credit: the regular credit and the Alternative Simplified Credit. The regular method often results in a larger credit but requires more documentation. This method allows for a deduction of 20% of the current year’s QRE’s over a set base amount. The base amount is found from the average annual gross receipts related to research activities from the prior four years.
The Alternative Simplified Credit (ASC) allows for a deduction of 14% of the current year’s QREs that exceed 50% of the last three years’ QREs.
For example, if a company’s QREs for the previous three years averaged $16,000, and their QREs for this year are $25,000. They will subtract 50% of the three-year average ($8,000) from the current year for a total of $17,000. They can then claim 14% of that $17,000 for a credit of $2,380.
Note: The ASC does not require previous years’ gross receipts.
How to claim the R&D Tax Credit
If you and your client believe they may qualify for the research credit, you’ll start with IRS Form 6765, Credit for Increasing Research Activities. This form allows you to claim the regular research credit or the Alternative Simplified Credit. You can help your client calculate their expected credit with both methods to determine which is more beneficial for them.
Section A applies to the regular credit, while Section B applies to the ASC. If your client is a qualified small business claiming the payroll credit, you will also need to fill out Section D. If they are a qualified small business other than a partnership or S-corp, they must also include Form 3800, General Business Credit.
For more details on calculating and claiming the research credit, refer to Instructions for Form 6765.
Required Information for a Valid Research Credit Claim
In addition to properly calculating QREs and filing all required forms, you’ll also need to provide documentation that the research activities meet the minimum requirements to be considered a Qualified Research Activity. As of 2021, the IRS requires that along with their claim businesses submit the following:
- Identify all the business components to which the Section 41 research credit claim relates for that year.
- For each business component, identify all research activities performed and name the individuals who performed each research activity. As well as the information each individual sought to discover.
- Provide the total qualified employee wage expenses, total qualified supply expenses, and total qualified contract research expenses for the claim year. This may be done using Form 6765, Credit for Increasing Research Activities.
This additional documentation is meant to expedite the process of approving R&D claims or submitting them for further review.
You can find further instructions on filing Form 6765 with your TaxSlayer Pro software here.