What Is the Research and Development (R&D) Credit and How Do I Qualify?

We had Jonathan Tucker from KBKG on our Podcast to discuss the Research and Development (R&D) Tax credit. This is just another area that we feel many business owners are unaware of.

What is the Research and Development (R&D) Tax Credit?

The R&D Tax Credit, is a federal benefit that provides companies dollar-for-dollar cash savings for performing activities related to the development, design, or improvement of products, processes, formulas, or software.

This credit provides much needed cash to hire additional employees, increase R&D, expand facilities, and more. The credit was enacted in 1981 to stimulate innovation and encourage investment in development in the US. Since then, many states have also passed the R&D Tax Credit. As such, this benefit is available across a wide variety of industries. 

What are the Potential Benefits of the R&D Tax Credit?

There are several benefits to realizing the R&D tax credit. These benefits can include the following:

• Receive up to 12-16 cents of federal and state R&D tax credits for every qualified dollar
• Create a dollar-for-dollar reduction in your federal and state income tax liability
• Reduce your effective tax rate
• Improve cash flow
• Carry forward the credit up to 20 years
• Perform look back studies to recognize unclaimed credits for open tax years (generally 3 or 4 years)
• Utilize the federal R&D tax credit against payroll tax (applicable to certain startup companies)

R&D Tax Credit - Four-Part Test

Qualified research activities are defined by the four-part test outlined below

1. Technological in Nature
   • Activities must fundamentally rely on the principles of physical or biological science, engineering, or computer science.
2. Permitted Purpose
   • Activities must be performed in an attempt to improve the functionality, performance, reliability, or quality of a new or existing business component.
3. Eliminate Uncertainty
   • Activities intended to discover information that could eliminate technical uncertainty concerning the development or improvement of a product.
4. Experimentation
   • All of the activities must include a process of experimentation including testing, modeling, simulating, systematic trial and error.

R&D Tax Credit - Qualifying Activities

One of the common misconceptions surrounding the R&D tax credit is that participants must wear lab coats and use test tubes in order to qualify for the credit. This could not be further from the truth.

In reality, the definition of R&D for tax credit purposes is fairly broad. Companies are able to qualify activities beginning with the development of concepts and extend to the point where a product, process, formula, or other business component is ready to be commercially released.

If a company is engaged in any of the activities below, looking into a potential R&D credit may be a fruitful exercise. Companies engaged in the following activities should consider looking into the R&D tax credit:

• Developing or engineering a new or improved product, process, formula, or software
• Evaluating the feasibility of a product, process, formula, or software
• Developing engineering architecture
• Developing experimental models & prototypes
• Testing an experimental product, process, formula, or software
• Beta testing
• Improving processes or the manufacturability of a product
• Technical design reviews
• Participating in technical meetings
• Documenting the results of research
• Maintaining research equipmentCompiling research data
• Fabricating experimental models
• Experimenting with new technologies
• Creating more efficient and environmentally friendly designs
• CAD or 3D Modeling
• Supervising technical personnel engaged in R&D

R&D Tax Credit - Qualifying Expenditures

Qualifying expenditures include:

• Wages: For those directly working on, supervising, or supporting the development process
• Supplies: Items used or consumed during the development process
• Contract Research: Outside vendors brought in to assist in the development process