Quick look: SMBs from dozens of industries may qualify for the R&D tax credit, but eligibility terms and filing processes can be confusing to understand or navigate. Here’s a quick overview of the R&D tax credit, why companies may be leaving money on the table, and how partnering with a PEO can help you get everything you deserve.
No matter the time of year, businesses of all sizes should continually remain aware of potential tax savings to achieve the best possible bottom line. The research and development (R&D) tax credit is an example of an opportunity that can benefit many small- and medium-sized businesses (SMBs) but is often overlooked.
According to the Internal Revenue Code (IRC) Section 41, this general business tax credit is designed to incentivize innovation and is available to organizations that invest in qualified research and development activities. Originally introduced in 1981 and made permanent in 2015, the credit can help eligible SMBs reduce their tax liability.
How does the R&D tax credit work?
The R&D tax credit is a dollar-for-dollar offset of federal income tax liability, and some businesses may apply up to $250,000 of their research credit against their payroll tax liability. Additionally, as of 2016, eligible small businesses with $50 million or less in gross receipts may claim the credit against alternative minimum tax (AMT) liability.
R&D tax credit details vary from state to state, with several states offering R&D tax credits to offset state tax liability. Business leaders should consult their accountant or professional employer organization (PEO) to confirm eligibility.
What qualifies and what doesn’t
Business activities that may qualify for the R&D tax credit include:
- Developing new products, processes, software, techniques, formulas, or inventions
- Improving or redesigning existing products
- Hiring scientists, designers, or engineers engaged in qualified activities
- Dedicating time and resources to new or innovative products
- Developing intellectual property
- Paying for salaries, supplies, contract research, and cloud hosting
Several activities are considered exclusions, including:
- Research conducted after the beginning of commercial production of the business component
- Adaptation of existing business components
- Duplication of existing business components
- Reverse engineering
- Surveys, studies, and activities relating to management function/technique, market research, routine data collection, or routine testing/quality control
- Software developed for internal use except software developed by (or for the benefit of) the taxpayer primarily for the taxpayer’s use in selling, general, and administrative expenses and limited to financial management, human resources (HR) management, and support service functions
- Foreign research conducted outside the United States, the Commonwealth of Puerto Rico, or any possession of the United States
- Research related to social sciences, arts, or humanities
- Research to the extent funded by any grant, contract, or otherwise by another person (or governmental entity)
Further, to be eligible, business activities must pass the IRS’s four-part test:
- Permitted purpose: The activity must be related to developing or improving the functionality, quality, reliability, or performance of a business component (i.e., product, process, software, technique, formula, or invention).
- Technological: The business component’s development must be based on a hard science, such as engineering, physics, and chemistry, or the life, biological, or computer sciences.
- Elimination of uncertainty: From the outset, the organization must have faced technological uncertainty when designing or developing the business component.
- Process of experimentation: The company must have evaluated multiple design alternatives or employed a systematic trial and error approach to overcome the technological uncertainties.
How to claim R&D tax credit
According to the IRS, eligible businesses must provide the following information when filing their claims:
- All business components from that year that relate to the Section 41 research credit claim
- For each component, all research activities performed and the individuals’ names who performed each activity, in addition to the information each individual sought to discover
- Total qualified employee wage expenses, supply expenses, and contract research expenses for the claim year using Form 6765, which includes four main sections:
- Section A: Used to claim the regular credit
- Section B: Applies to the alternative simplified credit (ASC)
- Section C: Identifies additional forms and schedules that warrant reporting based on business structure
- Section D: Required only for qualified small businesses (QSBs) making a payroll tax election
The IRS recommends that organizations calculate their credit using both the regular and simplified credit methods and fill out the corresponding section (A or B) that results in the largest tax benefit. Additionally, businesses can retroactively claim the R&D tax credit by filing amended returns for open tax years, typically within the past three years. However, this timeframe may be longer if the company experienced losses during that period.
A missed opportunity for many
Numerous SMBs may not be fully benefiting from the R&D tax credit despite its ability to put thousands of dollars back into their pockets.
Some businesses may think that their operations don’t qualify for the credit, but various industries are eligible, including manufacturing, engineering, agriculture, film and television production, food and beverage production, shipbuilding, waste management, and more.
Further, even if business leaders are aware their industry may qualify for the R&D tax credit, they may be:
- Confused about required documentation
- Unsure of which activities and expenditures qualify
- Assuming they don’t qualify due to not earning any revenue or not having any employees
- Unaware that they may amend previous tax returns to claim the credit
Don’t leave money on the table
SMBs deserve to reap every cent they’re entitled to. However, determining their R&D tax credit eligibility and navigating the filing process may eat into their limited time that should be devoted to growth.
That’s where a PEO comes in. PEOs specialize in handling other business’s HR functions, including tax administration (and much more). When partnered with a PEO, business leaders can nearly effortlessly confirm their organizations are getting everything they should.
A PEO like ExtensisHR is well-versed in the R&D tax credit. To demonstrate its commitment to SMBs’ long-term success, ExtensisHR partners with Aprio, a premier business advisory and accounting firm. ExtensisHR and Aprio provide clients access to 45 R&D tax specialists, including certified public accountants (CPAs), juris doctors (J.D.s), and technical writers with expertise in accounting, technology, manufacturing, and engineering industries.
A personalized, dedicated team of specialists can help your organization, or your CPAs/accountants capture your tax credits more quickly and easily by:
- Assisting with gathering employee wage data for the tax credit calculation
- Adopting a holistic approach to federal, state, and local credits, and new capitalization requirements under Section 174 so eligible companies take advantage of all available credits
- Assessing credit eligibility, conducting full-service computations, and preparing audit-ready documentation
- Preparing and filing necessary forms
- Reviewing past claims to determine if you received the maximum benefit possible at the most reasonable cost
- Helping you understand new rules regarding Section 174 and how they may impact your bottom line
- Offering complimentary consultations to assess eligibility and estimate potential credit benefits
- Tracking credits/usage quarterly
- Evaluating the best use of your credit and your compliance with new capitalization requirements
Maximizing your credits is a year-round process that extends beyond tax season. Contact ExtensisHR today to confirm you’re receiving every dollar you can—with minimal disruption to your organization’s growth.