R&D Tax Credit: Reducing Taxes to Fuel Innovation

Creating new products often requires companies to make substantial investments in research and development. This can be especially challenging for startups and other small and medium-sized businesses. Like many countries, the U.S. as well as many of its states incentivize innovation by providing tax credits to offset these costs. In this article, we’ll explore the research and development (R&D) tax credit, the business activities that qualify for it, and how to claim it.

What expenses qualify for the R&D tax credit?

A percentage of qualifying expenses for the design, development, or improvement of a business component (i.e., a product, process, software, technique, formula, or invention) can be claimed for this dollar-for-dollar tax credit. The federal credit is typically between 6% and 10% of qualified research expenses (QREs), while state credits may range between 1% and 10%. The details of the federal R&D credit are spelled out in Section 41 of the Internal Revenue Code. In general, however, both versions of the credit apply only to investments in hard science that include an experimental component and are intended to eliminate technical uncertainty in the design, development, or improvement process.

There are four main types of expenses can be counted toward the R&D credit:

Wages

This is typically the most significant R&D expense. It includes salaries and bonuses of employees who are directly involved in, supervise, or directly support R&D activities, such as engineers, scientists, software developers, and project managers.

Contract Research

Companies may also claim 65% of amounts paid to contractors for performing qualified R&D research.

Supplies

Businesses may claim materials and supplies that are consumed during the R&D process for the credit. This includes prototyping materials but excludes capital equipment.

Cloud Computing & Hosting

Costs related to cloud computing services that are used for R&D purposes (such as Amazon Web Services, Azure, or Google Cloud) are also includable in the credit calculation.

What expenses are not eligible for the credit?

Section 41 specifically excludes investments in the following:

• • Research that occurs after commercial production of the new or improved component has begun
  • Research involved with adapting and existing component for a particular customer
  • Duplication of an existing business component
  • Routine data collection or quality control testing
  • Market research
  • Research in the social sciences or humanities

This is not a complete list of excluded expenses. If you’re unsure whether a particular R&D investment is eligible for the credit, consult with a tax professional.

How do I claim the R&D credit?

Claiming the R&D credit involves meticulous record keeping and completing additional tax forms.

Keep detailed R&D records.

To claim this tax credit, begin by keeping detailed records of all your R&D activities, including descriptions of the components in development, experiments conducted, testing results, and financial records related to the research such as invoices, receipts, and payroll records. Any records that are relevant to the nature, scope, and cost of your initiatives may be used to support your claim. Make sure all financial records used to calculate your claim can be tied directly to eligible R&D expenses.

File Form 6765 and any additional state tax forms that may be required.

At tax time, you’ll need to file Form 6765, Credit for Increasing Research Activities. This form offers two methods of calculation: the regular credit and the alternative simplified credit. You can perform both calculations and then use the one that provides the larger credit. The regular method requires businesses to average their gross R&D receipts over the previous four tax years, while the simplified calculation is based on QREs over the past three years. In some cases, companies may not qualify for the credit using the regular calculation but still may be eligible under the simplified method. To ensure accuracy and legal compliance, it’s highly recommended to work with a qualified and trusted tax professional when completing these calculations.

Submit the completed Form 6765 with your business tax return. The credit will offset your tax obligation for the year. If the amount of the credit exceeds the current year’s tax obligation, the balance may be carried forward for up to 20 years and/or applied to the previous year’s liability by amending that year’s return. Additionally, be aware of any additional R&D credit that may be available through your state. Most states offer some type of R&D credit, but their rules vary.

Optimize your organization’s tax efficiency to fuel innovation and growth.

Federal and state R&D credits reduce companies’ tax burden to free up resources for investments in innovation. When they take advantage of these credits, businesses can afford to invest more heavily in R&D efforts, hire top talent, and gain a competitive edge by creating cutting-edge products and services.

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