R&D and the US Research and Development Tax Credit

Posted on
January 17, 2019
in
Small Business
Posted by
Ronald B. Allen

Research and development is the backbone US technical innovation and productivity. In order to support and encourage US-based R&D, the federal government passed a law in 1981 providing income tax credits for R&D. Its real name was the “research and experimentation tax credit” but it is commonly referred to as the R&D or research and development tax credit. Because, after years of renewing the law, Congress has made this tax credit permanent with the PATH Act of 2015. You can help fund your business’s  R&D with the US Research and Development Tax Credit.

The Rationale for the Original R&D Tax Credit

US R&D started falling off in the 1960s and resulted in less technical innovation. This led to less competitive US industries and individual companies. And, the result was a fall in productivity in many industries during the 1970s era of “stagflation.” When a private company makes a discovery via its R&D, that knowledge is eventually used by society as a whole, and business competitors as well. Thus the rationale for the US R&D tax credit was to accelerate R&D in order to increase US technical innovation and competitiveness and to “reimburse” the company that carried out the original R&D for its efforts. This policy has helped feed a stream of technological innovation that has benefitted individual companies, whole business sectors, and society as a whole since its inception in 1981.

The Permanent R&D Tax Credit

When President Obama signed the Protecting Americans from Tax Hikes (PATH) Act in December of 2015, the new legislation not only made the US Research and Development Tax Credit permanent but also cleaned up a substantial number of issues relating to startup companies and small businesses. Accounting firms like Exigo Business Solutions in the Kansas City area have dealt with the old law and now are up to date on the new, and improved, version. If you need to know if this tax credit can apply to you and your business, contact us before doing your taxes for 2018. Some tax provisions that had expired were renewed with the new law and certain credit limitations were dealt with as well. To get the most out of the US R&D tax credit, work with an experienced accounting firm that knows this credit and how to apply it to your taxes.

How the US R&D Tax Credit Works

The details of the R&D tax credit are in the Internal Revenue Code (IRC) section 41 and a number of related regulations. Basically, the credit is applicable to taxpayers who incur expenses on US soil from Qualified Research Activities or QRA.

Here is a breakdown of research activities and expenses that qualify for the R&D tax credit.

Wages

Employee wages to include the amount used as wages for withholding federal taxes are eligible if work is for “qualified” services.

Supplies

These are materials consumed or used expressly during and for the R&D process. (Does not include land and land improvements or property that can be depreciated.)

Contract Research Expenses

These are funds paid to a third party which, in turn, carries out qualified R&D (QRA) but does so expressly on behalf of the person or company paying the taxes. This applies regardless of whether the research was successful or not and provides a tax credit for 65% of cost actually incurred.

Basic Research Payments

These are payments to “qualified” scientific research organizations and educational institutions for doing the research. Tax credits are allowed on 75% of actual incurred costs.

What Qualifies as Research and Development?

So that your company can benefit from the R&D tax credit, you need to know what expenses qualify, how to demonstrate that it’s needed, and what records you need to keep. As we move into this subject it is perhaps becoming clear that having an experienced accountant like Exigo Business Solutions in the Kansas City area on your side will be useful.

Here is an introduction to how various items qualify for tax credits. You will need to show the IRS that the activities or expenses you are claiming for deduction fall into one of these categories.

1. There was technological uncertainty before a project started and the R&D was intended to resolve that technological uncertainty. Or the work was done in order to improve a methodology or design component for the business or a component of that business.

2. The R&D work and expenses claimed must rely on hard science. This can be physical science, biological science, computer science, or engineering.

3. To qualify for tax credits the R&D work must have to do with development of either an improved or new business component. This is defined as improved or new processes, products, techniques, formulas, internal use computer software, or inventions which will be used in the taxpayer’s business or trade or sold by them.

4. The substantial points to demonstrate to the IRS are that all activities involve experimentation by way of the evaluation and testing of various alternatives in order to eliminate preexisting technological uncertainty.

These IRS rules apply to all US R&D. If the R&D has to do with computer software for internal use, three more rules or tests apply.

1. Software that qualifies for the tax credit needs to be innovative, improve speed, or reduce costs in ways that are economically significant and substantial.

2. If the development of the software involves economic risk that is significant, requires commitment of resources that are substantial, and recovery of costs within a reasonable time period is not certain, this R&D work may qualify for the tax credit.

3. The software being developed was not available commercially. And, if the taxpayer is unable to license, buy, or lease similar software without making substantial adjustments, this work may qualify, providing that items one and two are also satisfied.

Activities and Expenses That Do Not Qualify for the US R&D Credit

The IRS is clear about items that will not result in a tax credit if claimed as R&D. Here is a short list.

• Research conducted after the beginning of commercial production or implementation of the business component (with some exceptions)

• Duplicating or adapting components that already exist in a business

• Carrying out studies, surveys and other activities that relate to management techniques or functions

• Doing market testing, research, or development which includes promotions and advertising

• Data collection that is routine

• Ordinary or routine quality control testing and inspections

• Computer software with the exception of development for internal use as described above

• Any and all research which is carried out outside of the USA

• Any social science research

• Research that has already been funded

• Any cost of acquisition of fixed assets for use in the taxpayer’s business or trade

Claiming US Research and Development Credits for Your Business

Your business may or may not have been able to claim tax credits for R&D in the past and that situation may have changed with passage of the Protecting Americans from Tax Hikes (PATH) Act in December of 2015. To find out, contact us at Exigo Business Solutions in the Kansas City area.

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