How to Implement Research and Development Tax Credits For Your Business

Research and development tax credits are complex. Calculating which expenses qualify is difficult for many middle market companies, and compiling documentation that can withstand Internal Revenue Service or state scrutiny is even more challenging.

Developing a Plan

The R&D tax credit is a valuable incentive that could save a company thousands of dollars annually. Companies must understand their eligibility, document their activities and prepare to claim these dollar-for-dollar tax savings.

The research & development tax credits are available for businesses of all sizes. The tax credit can be claimed for the years in which qualified research expenses are incurred and may also be carried forward to offset future tax liability. R&D tax credits are also refundable, meaning the credit can be claimed even if the taxpayer doesn’t have any tax liability in the current year.

There are several reasons why R&D tax credits are important for companies of all sizes and industries. Some R&D tax credit supporters believe that the credit encourages firms to invest more in R&D, which helps bring R&D spending closer to the socially appropriate level. Others point to the high costs of conducting business in California and believe the R&D tax credit can help mitigate these costs.

The R&D tax credit is one of the most significant federal tax credits. The Protecting Americans from Tax Hikes Act of 2015 made the credit permanent and expanded it to include small businesses and startups. However, many companies still need to claim the credit because they’re unaware of their eligibility or how to implement the credit within their operations.

Identifying Eligible Expenses

The R&D tax credit is a dollar-for-dollar savings that reduces your company’s federal tax liability. However, it requires thorough navigation of the tax code, regulations, and IRS guidance to identify eligible expenses that qualify for this credit. It also requires a high level of understanding to determine if the expenses are likely to be disallowed by the IRS (and this is more common than you may think).

The credit can be claimed by any business, regardless of industry or size, that meets the basic requirements of the IRS tax code. This includes many companies that test products, develop software, engage in data science and analysis, or perform research and development activities requiring substantial risk. This huge incentive is available to most businesses without dedicated R&D departments.

The R&D tax credit can be claimed for the year the expenses are incurred, and any future years you anticipate an offsetting tax liability. Any unused credits can be carried back one year and forward for 20 years, which provides significant flexibility for companies that cannot use the credit immediately.

Creating a Budget

R&D tax credits provide significant dollar-for-dollar deductions on qualifying research expenses. However, many companies fail to take advantage of this valuable incentive because they need to understand how the credit works, misidentify their eligible expenses, and need help with documentation requirements.

R&D work is complex and requires high scientific rigor to prove that a business qualifies for credit. The process involves collecting, processing, and analyzing distinct data sets and creating prototypes and models that can be used to test and refine products. The result is expensive and time-consuming but often worth the effort when the business can successfully demonstrate that its efforts meet or exceed specific criteria.

Supporters of R&D tax credits argue that the work conducted by R&D workers is highly beneficial for the economy and that public funding can encourage the activity to a level closer to what would occur in a free market. They also point to research and development tax credits offered in more than 35 non-U.S. nations as evidence that R&D activity is a global industry.

R&D tax credits are available for large and small businesses, including startups. Corporations and pass-through entities such as partnerships and LLCs can claim the credits. In addition, they can be applied to reduce the alternative minimum tax (AMT).

Implementing the Plan

The research and development tax credit is a major incentive for businesses to invest in innovation. It allows companies to reduce their tax liability or claim payable cash credits as a percentage of their R&D expenses. These expenses are for various activities, such as testing new products or improving existing ones. Companies may perform these experiments in-house or use third-party contractors to do so.

R&D tax incentives can benefit various industries, including agriculture, architecture, engineering, manufacturing, and software development. Unlike some tax incentives, this one has no limitations on the size of the business or industry it applies to. Unused credits may be carried back to the previous tax year or forward for up to 20 years.

While there is broad consensus that some level of government encouragement for research and development is warranted, some critics believe that tax credits are inefficient for achieving this goal. They argue that positive spillover benefits in R&D activity may mean that at least some of the investment prompted by the incentive would have occurred anyway, which dilutes the incentive’s impact.