A Guide to the R&D Tax Credit 

Tax legislation aims to incentivize companies that invest in U.S.-based research and development (R&D). However, as with most tax-related topics, claiming that reward requires complex calculations and analyses.

The credit for increasing research activities, better known as the R&D tax credit, rewards qualified research spending by allowing a credit to offset a business’s tax liability based on qualified research expenses (QREs), such as R&D wages, supplies, and third-party contractors. Unlike a tax deduction, which merely lowers taxable income, tax credits reduce a business’s tax bill dollar for dollar, a significantly better value.

This guide provides an overview of the R&D tax credit, sharing what you need to know about the available tax incentives. Businesses with any level of research activities should work with an experienced R&D tax advisor to ensure compliance and maximize the potential tax benefit.

A Brief History and Overview of the R&D Tax Credit

To promote private-sector innovation in the United States, Congress created the R&D tax credit in 1981 as part of the Economic Recovery Tax Act of 1981. It was a temporary provision that became permanent in 2015 through the Protecting Americans from Tax Hikes Act.

The tax credit has evolved throughout the years, mostly in favor of taxpayers. Today, it’s the most significant federal tax benefit available to companies for investing in R&D. Knowing how valuable the R&D tax credit can be, the IRS has recently stepped up its oversight, underscoring the importance of ensuring compliance by maintaining proper documentation.

The credit amount is a percentage of a business’s qualified research spending that exceeds the business’s baseline or “base period” research expenses. In other words, the credit rewards growth in R&D spend.

Qualifying Activities for the R&D Tax Credit

Any business entity engaged in qualified research activities may be eligible to claim the R&D tax credit. The credit applies only to expenses for “qualified research,” which must satisfy four conditions, backed up by documentation:

1. Permitted Purpose: The primary purpose of the activity must be to create or significantly improve a business component, a term referring to any new or improved product, process, software, technique, or formula. The goal should be to enhance the component’s functionality, performance, reliability, or quality.
   
2. Technological in Nature: The research must fundamentally rely on principles of hard sciences, such as engineering, physics, chemistry, biology, or computer science.
   Note: You do not need to invent groundbreaking technology; applying existing hard sciences to build or improve a product is sufficient.
   
3. Elimination of Uncertainty: At the outset of the project, there must be technical uncertainty regarding the capability to develop the product, the methodology to be used, or the appropriate design. You must face a challenge for which the solution is not readily apparent through standard industry knowledge.
   
4. Process of Experimentation: The company must engage in a systematic process to evaluate alternatives and eliminate the technical uncertainties identified. This can involve modeling, simulation, systematic trial-and-error, or evaluating different design concepts to find the optimal solution.

Examples of Qualifying R&D Activities for the R&D Tax Credit

The IRS allows a vast array of R&D activities to qualify for the R&D tax credit. Here are just a few examples:

• Developing new or improved products, prototypes, or formulations
• Designing and testing new manufacturing processes or techniques
• Creating or improving software, algorithms, or digital platforms
• Experimenting with new materials or components
• Evaluating alternative designs or approaches through modeling or simulation
• Improving existing processes to increase efficiency or reduce waste

Disallowed R&D Activities for the R&D Tax Credit

Several activities are specifically denied an R&D credit:

• Research related to style, taste, cosmetic, or seasonal design factors
• Research after commercial production
• Adaptation of an existing business component (such as retooling to meet a specific customer’s need)
• Duplication of an existing business component
• Surveys and studies
• Certain computer software development
• Foreign research
• Research in the social sciences, arts, or humanities
• Outside-funded research

Qualified research expenditures for the R&D Tax Credit

Statutes and regulations define QREs, which are the expenses that may be counted when calculating the R&D tax credit. QREs fall into four buckets:

• Wages: Amounts paid to an employee to perform qualified services
• Supplies: The cost of supplies used in conducting qualified research
• Rental or lease cost of computers: The cost of leasing or renting computers used in conducting qualified research
• Contract research: 65% of amounts paid to a third party for qualified research

2 Methods for Calculating the R&D Tax Credit

Businesses can choose from two ways to calculate the R&D tax credit amount: the regular method or the alternative simplified method.

R&D Tax Credit: Regular Method

Under the regular method, the credit is 20% of the company’s QREs that exceed a base amount. The base amount’s computation is where things get tricky. Broadly, the base amount is a fixed-base percentage multiplied by the company’s average annual gross receipts over the previous four years. The fixed-base percentage ranges from 3% to 16%, depending on the company’s history of gross receipts and QREs. However, the base amount cannot be less than 50% of the current year’s QREs.

R&D Tax Credit: Alternative Simplified Method

Under the simplified method, the credit is 14% of QREs that exceed 50% of the average QREs over the previous three years. Unlike the regular method, the simplified method doesn’t take a company’s gross receipts into account, making the computation that much easier.

Regular Versus Alternative Method: Which Is Better?

The better method for your business depends in large part on your company’s gross receipts and research spending over the past several years. You can switch R&D tax credit methods every year, so you’re never stuck.

Your R&D tax advisor will run the numbers both ways to determine which provides the greater tax credit.

Interaction Between Federal and State R&D Tax Credits

The federal R&D tax credit is available to businesses that are conducting qualified, U.S.-based research. Most states also offer research tax credits for qualifying activities conducted within their borders.

Often, taxpayers can claim both federal and state R&D tax credits. Many states use the federal R&D tax credit as their baseline for computing their state R&D tax credit, which can make claiming the state tax credit quite simple. There can be complications related to the Section 280C election, which is why it’s always recommended to involve a trusted tax advisor when claiming the R&D tax credit at the federal or state level (or both).

Smith + Howard: R&D Tax Credit Experts

Calculating a business’s R&D credit is complicated for many reasons. For example, the rules for determining what constitutes qualified research are somewhat ambiguous and highly nuanced based on a taxpayer’s facts and circumstances. In addition, taxpayers must also consider the interaction of the R&D tax credit with other areas of tax law. To understand these complexities, businesses are best served by conducting an in-depth review of their research activities to understand which costs are eligible.

Smith + Howard’s Specialty Tax Services team has deep expertise in helping clients across industries claim the R&D credit. Whether conducting an R&D credit study to substantiate an R&D credit claim or evaluating the availability of an R&D tax credit for a planned research project, our advisors dwell in the complexities so that you don’t have to.

To learn more about how the Specialty Tax Services team can serve you, reach out to Jackson Moore.