Your Businesses May Be Missing Out on R&D Tax Credits by Karen A. Lake, CPA
Posted on September 08, 2021
The federal research and development (R&D) tax credit is one of the most valuable tax incentives while also being one of the most misunderstood. Contrary to popular belief, eligibility is not limited to businesses that employ scientists, develop cutting-edge products or make groundbreaking discoveries. Rather, it may apply to businesses, large and small, in a broad range of industries that may include manufacturing, architecture and engineering, agriculture, film and television production, food and beverage production, shipbuilding and waste management.
Here’s what you need to know to qualify for the R&D tax credit, which is scheduled to undergo changes on Jan. 1, 2022.
What is the R&D Tax Credit?
Congress designed the R&D tax credit to incentivize private investment in research that spurs innovation, facilitates change and drives U.S. competitiveness and economic growth. It provides eligible businesses with a dollar-for-dollar reduction of their federal income tax liabilities when they incur certain expenses to develop, design or improve new or existing products, processes, techniques, formulas or software. More specifically, eligible companies may claim a credit for a portion of the qualifying research expenditures (QREs) they incur in a given year, including:
- taxable W-2 wages for employees involved in qualifying research activities.
- supplies used in qualified research activities.
- as much as 65 percent of the costs for contracting with third parties for research activities; and
- up to 75 percent of costs paid to qualified educational institutions or other scientific research organizations. Because it is a tax credit, eligible businesses
The R&D credit reduces federal taxable income, so businesses receive a dollar-for-dollar tax credit and still get to deduct expenses related to research and development.
What Activities and Expenses Qualify for the R&D Tax Credit?
To determine if a business’s activities rise to the level of qualifying research activities or QREs for purposes of claiming the R&D tax credit, they must pass the following four-part test:
- Permitted Purpose – The purpose of the research must be intended to develop or improve the functionality, performance, reliability or quality of a product, process, software, technique, invention or formula the taxpayer holds for sale, lease or license in the normal course of its business.
- Technological in Nature – The business component’s development must be based on hard science, such as engineering, physics and Chemistry, or the life, biological or computer sciences.
- Elimination of Uncertainty – The research must be conducted with the aim of resolving or eliminating technological uncertainty about its ability to develop, improve and design a product, process, software, technique, invention or formula the taxpayer holds for business purposes.
- Process of Experimentation – The research must employ a process of experimentation to evaluate and test alternative designs and methods for eliminating uncertainty and achieving its ultimate goals. This may involve modeling, simulation or systematic trial and error.
At the most basic level, the R&D tax credit is available to businesses that develop or improve products, services or technology. However, businesses should take special care to consider whether each separate activity they engage in meets the research and experimental requirements rather than focusing on the development or improvement of a final product or service. Under the law, they do not need to prove their research was successful or resulted in a new or improved product or service to qualify for the credit’s generous tax savings. In addition, it is important to recognize that the law specifically excludes certain activities from the R&D credit, including research conducted outside the U.S., routine data collection and quality control testing, as well as activities considered to be repairs and maintenance, training or administrative in nature.
What Changes in 2022?
Under current law, eligible businesses may immediately expense (or deduct from their tax liabilities in the current year) qualifying R&D expenses incurred in a particular year. Unused tax credits may be carried back one year and carried forward 20 years. This changes on Jan. 1, 2022, when qualifying businesses will be required to amortize eligible R&D expenses over five tax years rather than deducting from their tax liabilities in the current year. For R&D activities conducted outside the U.S., the amortization period is extended to 15 years.
With these imminent changes in mind, businesses that commonly engage in research and experimental activities should take the time now to meet with their advisors and plan for the impact to their ongoing cash flow and tax liabilities. There are certain strategies businesses may consider to better align their research activities with their unique needs and goals.
About the Author: Karen A. Lake, CPA, is a state and local tax (SALT) specialist and an associate director of Tax Services with Berkowitz Pollack Brant Advisors + CPAs, where she helps individuals and businesses navigate complex federal, state and local tax laws, and credits and incentives. She can be reached at the firm’s Miami office at (305) 379-7000 or firstname.lastname@example.org.