Each year the US government provides over $10B of dollars to innovative businesses for developing new or improving existing technologies, products and processes, under the Research & Experimentation Tax Credit (R&D Tax Credit) program.
The R&D Tax Credit is a general business tax credit under Internal Revenue Code section 41 for businesses that incur research and development (R&D) costs in the United States. It has been around since the early 80s and became a permanent fixture as part of the bipartisan PATH Act of 2015. Permanency came with lucrative enhancements that made it easier to benefit from the program.
There has been a lot more buzz around the credit, particularly for startups, but a quick google search can add to the confusion and your understanding of the benefits.
Here are the top 5 questions we get asked everyday to get you straight to the answers!
1. What tax can I offset?
- Startups can offset their employer portion of Social Security taxes up to $250,000 a year, regardless of profitability.
- Federal (and sometimes State) Income taxes if your business is profitable (if you are a pass-through entity, credits will flow through K-1s)
- Alternative Minimum Tax (AMT) if your business has less than $50 million in average revenue for the last 3 years and owe AMT in the current tax year (this was historically a big hindrance to mature businesses prior to the PATH Act)
2. What activities qualify for the credit?
Any activities that the company is performing must pass a four-part test:
- Permitted Purpose: the work must be done to develop new or improved technology, product or process (this happens in dozens of industries!)
- Elimination of Uncertainty: the work must be done in order to resolve technological uncertainty.
- Process of Experimentation: the work must be done in a systematic process to evaluate one or more alternatives to achieve the desired result.
- Technological in nature: the work must be within the physical or biological sciences, engineering or computer science.
3. How does my startup qualify?
A business is considered a qualified small business if it meets this criteria:
- Has gross receipts (revenue) of $5 million or less for the tax year they are applying the credit
- Has as gross receipts (revenue) for five years or less. That means that if a business generated gross receipts prior to 2014, then they cannot use R&D credits to offset Social Security taxes for Tax Year 2018*.
- Is not a ta-exempt organization (non-profit)
*It is important to note that if a company is not eligible for payroll offset, it does not exclude them from claiming R&D credits on their returns. Unused credits are “banked” and carried forward for 20 years to offset any income tax liabilities. It is a highly strategic tax planning tool!
4. Which expenses count towards the credit?
- US -based W-2 (taxable) wages for employees directly involved or supervise/support direct employees- this is the primary driver of the credit!
- US-based outside contractors* that do not retain substantial rights to the work performed for the company that are paid whether its succeeds or fails.
- Supply costs used or consumed in the R&D processes (i.e. prototype costs before product is commercially available).
*It is not enough for the contractor payments to be made in the US, the activity must physically occur on US soil (i.e. paying a US entity for contractor costs oversees will NOT qualify).
5. What type of documentation do I need to gather to prove I am performing R&D activities?
- Documentation is key if your credits are ever reviewed by taxing authorities. Our software guides our clients through the various types of documentation, but it is best to keep consistent data from three areas:
- Dated-any time stamp that proves the work occurred in the tax year you are claiming credits for
- Substantiated-demonstrates a process or shows technical challenges addressed
- Contemporaneous-documented right wan the R&D was done
It can be a big relief when companies learn that they do not need a project management/time tracking system to claim the R&D credit. While extremely helpful and proof of the key pieces of documentation, these systems can be flawed and so the IRS allows for reasonable estimations (percentages) of employees time.
Below are the top pieces of documentation used to defend R&D claims:
- Emails (really!)
- Technical Specifications
- Engineering and Developer Notes (digital)
- Technical meetings (Exec involvement also can qualify)
- Contractor agreements/SOW
- Photos of processes
- Project management summaries