Tax credits provide a popular way to pay less tax. A dollar of tax credit, for example, saves a dollar of tax. And one popular tax credit? The research and development credit, or R & D credit, provided by Internal Revenue Code §41, and described as the “Credit for Increasing Research Activities.”
Unfortunately, the R&D credit creates confusion. Both the credit formula and qualification requirements get complicated.
Accordingly, over the next few paragraphs, I describe how the credit works–and when you save taxes by using the credit. But let me start off with the basics…
What is the R&D Credit?
The R&D tax credit is a non-refundable tax credit meant to encourage innovation and keep technology development within the United States. The credit was first introduced in the Economic Recovery Act of 1981. After multiple extensions over the years, the Protecting Americans from Tax Hikes (PATH) Act was passed in 2015 and made the credit permanent. It sounds simple enough, taxpayers receive a credit for qualified research expenses for the taxable year.
What counts as “qualified research?” Qualified research means expenses undertaken for the purpose of discovering information which is:
- technological in nature
- intended to be useful in the development of new or improved business components
- constitute elements of a process of experimentation
Furthermore, the research must be related to:
- a new or improved function
- reliability or quality
Qualified research expenses include any wages paid to an employee for qualified services, and supplies used in the conduct of qualified research.
The 4-Part Test, is my research qualified?
The IRS established a 4 part test to determine qualified research activities, which is outlined in their Audit Technique Guide: Credit for Increasing Research Activities
- The expense must be connected to the taxpayer’s trade or business, and should be experimental in nature.
- The research is performed for the purpose of discovering information that eliminates uncertainty in the development of a business component.
- The information must be used to develop a new or improved business component. A business component can be almost anything which will be held for sale, lease, license, or used in a trade or business.
- The results of the research must be uncertain at the beginning of the research activity.
How the R&D Credit Works
In essence, the R&D credit statue provides a couple of “formulas” taxpayers can use: A standard formula and then an alternative “simplified” formula.
The Standard R&D Credit Formula
The standard R&D credit formula says the amount of the R&D Credit equals to 20% of the lessor of:
- qualified research expenses over the base amount,
- 50% of qualified research expenses
The base amount is the product of the fixed base percentage multiplied by the average gross receipts for the preceding 4 years in which the credit was claimed.
Note: The fixed base percentage is 3% for the first 5 years a company claims the credit. For the 6th year, divide the aggregate qualified expenses from year 4 and 5 by aggregate gross receipts for those years, and divide result by 6.
Lets look at an example. Say your qualified research expenses equal $80,000 in wages plus $20,000 in supplies, or $100,000 in total. Say your average receipts equal $500,000, and this is your third year with qualified research expenses.
The table that follows steps through the math using three inputs: the $100,000 of qualified expenses, the 3% fixed base percentage, and the $500,000 of average gross receipts.
|Total Qualified Expenses (A)||$100,000|
|Fixed Base % (B)||3%|
|Avg Gross Receipts (C)||$500,000|
|Base Amount = B x C||$15,000|
|Subtract (A) from Base amount above = Min Base Amount||$85,000|
|Lesser of 50% of Qualified Expenses or Min Base Amount||$50,000|
|Multiply by 20%||$10,000|
But let’s discuss the individual calculations the formula makes…
Stepping Through Standard R&D Credit Formula Calculations
The first calculation made? The taxpayer calculates the base amount as the fixed based percentage (3% in this example) times the average gross receipts ($500,000 in this example). The formula result, $15,000, sets the threshold that qualified research expenses must exceed.
The second calculation? The taxpayer calculates the qualified research expenses over the base amount. In the example just introduced, $100,000 of qualified research expenses minus the $15,000 base amount results in $85,000 of qualified research expenses over the base amount.
The third calculation? The taxpayer calculates 50% of the qualified research expenses. If the qualified research expenses equal $100,000, as in this example, that 50% share equals $50,000 as the table shows.
Finally, the last step or calculation. The formula calculates 20% of the lesser of the qualified research expenses over the base amount… or 20% of 50% of the qualified research expenses. In the table above, the last row shows this calculation and the actual R&D credit of $10,000.
The Simplified R&D Credit Formula
The statute also provides an “Alternative Simplified Credit” formula taxpayers can elect to use. Here you determine your average prior 3 year qualified research expenses, subtract from current year expenses, and multiply by 14%.
Assume the same facts above and the prior 3 year average qualified expenses equal $100,000, and you calculate the simplified R&D credit shown in the table that follows.
|Total Qualified Expenses (A)||$100,000|
|Avg Qualified Expenses previous 3 years (C)||$100,000|
|Multiply C above by 50% (D)||$50,000|
|Subtract from current qualified expenses (A – D)||$50,000|
|Multiply above by 14%||$7,000|
What Types of Activities Do NOT qualify?
Some bad but maybe predictable news. Some types of research activities do NOT qualify for the credit. (Remember that Congress wants to encourage true innovation that, fingers crossed, dramatically grows the economy.)
Accordingly, under §41(d)(4), a research expenditure does not qualify if it is:
- conducted after the commercial production of a business component
- related to the adaptation of an existing business component
- duplicating an existing business component
- carried out in the form of surveys and studies
- creating certain internal use software (unless related to a qualifying research activity)
- conducted outside of the United States
- related to social sciences, arts, or humanities
- funded by a grant, contract, or other person or entity
I really like the spirit of the R&D credit. It promotes companies to innovate and rewards them with tax savings. And there are probably a lot of companies that possibly qualify and are missing out. If you manufacture products, employ engineers, conduct experiments, own or file for patents, invent processes etc. you may want to consult with your tax accountant and see if you qualify.