Understanding Small Business R&D Tax Credits

• R&D tax credits allow qualified businesses to deduct the cost of qualified research and innovation from their taxable income.
• Small businesses can use the R&D credit to offset the FICA portion of payroll taxes.
• To find out if your business qualifies, you'll need to check Section 41 of the Internal Revenue Code and its related regulations.
• This article is for small business owners who are interested in filing for R&D tax credits.
  

Growing a business eventually requires developing new products, technologies, systems and, sometimes, even industries. This growth is vital to the success of not only your individual company, but also the overall economy, which needs innovation to continue growing.

However, innovation requires expensive research and development (R&D). In many cases, fostering such changes fail, with no return on investment, or require multiple stages of development before becoming profitable. These costs can discourage businesses from investing in R&D. The R&D tax credit was created to provide an incentive for businesses to continue innovation efforts.  

What is the research and development tax credit program?

The Research and Experimentation Tax Credit is also known as the research and development tax credit, or R&D tax credit. As part of the U.S. tax code, the R&D tax credit stimulates economic growth by encouraging companies to invest in research, innovation and new technologies.

It was first introduced in 1981 and regularly renewed in the following decades. In 2015, President Barack Obama signed the PATH Act to permanently extend the R&D tax credit, along with expanding several of its provisions. As of 2016, the R&D tax credit may offset the alternative minimum tax, and startup businesses can utilize the R&D credit against payroll taxes. The Tax Cuts and Jobs Act (TCJA) made further changes to the tax credit that took effect in 2022.

A tax credit allows the taxpayer, which may be a company, to offset the value of that credit against their business's tax liability. According to the IRS, the R&D tax credit is for "expenses paid or incurred for qualified research."

What are the benefits of the R&D tax credit?

Granting businesses tax credits for research and development is generally thought to help the overall economy by increasing innovation. However, some business groups have said these benefits may be lost under the new amortization rules in the TCJA. Starting in 2022, the TCJA will require that businesses amortize their U.S.-based R&D costs over five years, rather than deducting them immediately. Analysis by the Tax Foundation, an independent tax policy research organization, says that canceling the amortization rules will benefit both businesses and workers by increasing economic output and wages, and creating an estimated 19,500 jobs.

Businesses that currently claim the R&D credit, however, benefit from reduced tax liability. This makes it a source of cash for many small and midsize businesses. The R&D credit does the following:

• Reduces your federal and state tax liabilities for the current year as well as future years
• Increases your company's market value and cash flow
• Lowers your business's effective tax rate
• Allows you to keep more of your profits

How do I know if I can claim the R&D tax credit?

In 2004, the IRS changed language used to decide who could claim tax credits for R&D. Now, most companies that test products, employ engineers, engage in data science and data analysis, or outsource product research can claim the credit.

However, your business must show a component of hard science in the research to claim the credit. If you own a restaurant or are an accountant, for example, you cannot claim the credit, even if you do research or test new products. A business in the "humanities" that tries to claim this tax credit may be more likely to be audited by the IRS.

Tip: No matter which type of business you run, if you want to claim a tax credit for R&D, keep proper documentation to prove that your expenses qualify.

Which documents do I need to claim the R&D tax credit?

The IRS does not specify what is "sufficient documentation" to claim a tax credit for R&D. However, the burden of proof is with the taxpayer, which means your business should retain as much documentation relating to your R&D activities as possible in case of an audit. These are some of the documents you should keep on hand:

• Payroll information for employees directly involved in R&D and for employees or managers supervising them
• General ledger reports listing which business expenses and supplies were related to R&D and those that were not
• Copies of contracts and invoices paid to any contractors who do third-party research for you
• Timekeeping records for work plans, payroll, meetings and any other activities to prove they were related to R&D
• Design drawings, test records, blueprints, progress reports, marketing materials and any other documentation that shows the process and impact of your research

Can my small business's research tax credits increase?

Small businesses can use the R&D tax credit in multiple ways. Qualified small businesses can claim tax credits for research expenses that increase over time. To claim this credit, you must show that your expenses have increased from your previous year in business. 

If your qualified small business doesn't have an income tax liability, this credit can be used to offset the FICA portion of payroll taxes up to $250,000. Qualified small businesses are those with annual gross receipts under $5 million and with gross receipts for no more than five years. This allows your small business to claim tax credits for research expenses even if you aren't yet generating revenue.

Do I qualify for the R&D tax credit?

The rules for the R&D tax credit are found in Section 41 of the Internal Revenue Code and its related regulations. This credit can be applied to any taxpayer who incurs qualified R&D expenses on U.S. soil.

To qualify for the credit, you must show that your research and development activities meet the following criteria:

• They are for the purpose of discovering information that is technological in nature.
• They are intended to develop a new or improved business component, such as products, internal-use software, inventions or techniques to be used in your business.
• They rely on hard science, such as computer science, engineering, biological sciences or the physical sciences.
• They involve an attempt to eliminate uncertainty. 
• They use scientific experimentation, including testing and alternatives.

FYI: To qualify as "eliminating uncertainty," this goal must be established in the initial stages of the project.

If R&D is related to internal-use software for your business, it must:

• Be innovative.
• Result in an economically significant reduction in cost or improvement in speed.
• Involve economic risk to develop.
• Not be commercially available.

Which expenses qualify for the R&D tax credit?

These are some expenses related to R&D that qualify for the tax credit:

• Wages that you pay to employees involved in qualified research and development, or employees who supervise or support those involved in R&D
• Supplies used for researching and developing new technologies other than land, property subject to depreciation or improvements to land
• Costs paid to a third-party contractor to perform qualified activities for your business, regardless of the outcome or success of that research
• Research payments to a qualified education institution or scientific research organization for qualified R&D activities
• Costs for developing a patent

Which expenses are excluded from the R&D tax credit?

The R&D tax credit can offset the cost of many areas of research and development. However, some expenses are excluded:

• Research conducted after you have begun commercial production
• Research to adapt an existing product or process to an individual customer
• Duplication of a product or process that already exists
• Surveys or studies you conduct, such as market research
• Research relating to some kinds of software intended for internal use
• Research you conduct outside the United States, Puerto Rico or a U.S. territory
• Research in the humanities, arts or social sciences
• Research funded by another person, government, grant or organization
• The cost of fixed assets necessary to run your business

In some cases, you may also find that expenses that qualify for the R&D tax credit are also eligible for other tax credits, and you will have to choose between them. For example, qualified expenses relating to clinical testing for certain drugs or rare diseases may also qualify for the orphan drug credit. You will need to work with your accountant or a tax preparation expert to decide which credits make the most sense for your business.

The IRS website can provide additional information to help you determine whether your business qualifies for R&D credits and how to claim them.

Is data science research eligible for the R&D tax credit?

In the current economy, businesses that can particularly benefit from the R&D tax credit are those that use data science and big data analysis.

With the growth of online data collection and analysis, many organizations, including small and midsize businesses, have dedicated data analysis and data science departments. Employees involved in these departments use complex algorithms, innovative software and advances in data science to allow them to analyze markets and innovate. The employees responsible for these data science departments are often trained in complex mathematics and computer engineering.

This increases the opportunities for businesses across various industries to claim the R&D tax credit. If your business wants to use data science to understand its market, customers and product innovation, that analysis involves a degree of scientific rigor that almost always qualifies for the R&D tax credit. 

The nature of data analysis also involves a high level of documentation, including the development and testing of distinct data sets, that can help your business prove that it qualifies for the R&D credit.

How is the R&D tax credit calculated?

In 2007, the IRS introduced the alternative simplified credit formula to calculate R&D tax credits. Calculating your tax credit involves five steps:

1. Calculate qualified research expenses for the preceding three years.
2. Average these amounts.
3. Multiply that average by 50%. This number is your credit base.
4. Subtract the amount of your credit base from your total R&D expenses for the year.
5. Multiply by 14% to find your R&D tax credit.

As an example, if your business averaged $100,000 in qualified R&D expenses for the past three years, your credit base would be $50,000 (50% of $100,000). If you spent $120,000 on research and development this year, that is $70,000 more than your base. Multiplied by 14%, that means your tax credit is $9,800. This amount can be claimed all at once or amortized over 60 months. 

If your business doesn't have three years of R&D history to calculate a credit base, then your R&D tax credit can be calculated as a flat 6% of your total R&D expenses for that year. In that case, the credit for $120,000 of qualified expenses would be $7,200.

Though calculating the R&D credit is not complicated, knowing which expenses qualify, and whether you have the correct documentation to back them up, is more difficult for many small businesses. Changes to tax laws, which often go into effect over an extended period of time, can also impact when and how you claim your credits. Before calculating any tax credits, including those for R&D, consult your accountant or a tax preparation specialist. If you prefer to try this on your own, make sure you go with a top accounting software provider to make things as easy as possible. 

Dachondra Cason contributed to the writing and research in this article.