The Tax Cut and Jobs Act eliminated many business deductions, but it didn’t touch the research and development (R&D) tax credit, which was made permanent with the Protecting Americans from Tax Hikes Act of 2015 (the PATH Act).
Although many businesses meet the qualifying criteria, small and midsize businesses often don’t realize they can take advantage of this potentially lucrative dollar-for-dollar credit. Most businesses that design, develop or improve products, processes, techniques, formulas, inventions or software, however, can claim the credit. With some exceptions, like advertising and quality control expenses, R&D expenses are deductible to qualifying businesses.
Businesses in the following industries, among others, may qualify:
- Apparel and textiles
- Electrical and mechanical contracting
- Life sciences
- Medical device and equipment
- Software (both internal and customer-facing software may qualify)
- Service businesses such as nonprofits, accounting and law generally don’t qualify for the R&D tax credit.
Some businesses wrongly assume they don’t qualify because they don’t believe they “make anything new.” The rules, however, don’t require companies to literally make something new to qualify for the credit. They require only that the credit is being claimed for something that is new to your company. That means finding a new way to produce your product using artificial intelligence or environmentally cleaner components may be enough to qualify.
The requirements can be complicated. Most states also offer an R&D credit.
How to Qualify
To determine whether your company can claim this credit, certain actions need to be taken, including the following:
- Understand which expenditures qualify and which do not (e.g., employee salaries, but only up to the percentage of time spent on R&D activity; supplies that are dedicated to R&D) and be aware of rules that apply to the specific expenditures you are taking
- Assess whether the credit can be used to offset alternative minimum tax liability
- Determine whether your business qualifies as a startup with less than $5 million of gross receipts and little or no income tax liability that can use the R&D credit to offset some payroll tax liabilities
- Calculate the amount of the credit
- Determine whether you can recover any unclaimed credits
- Keep track of any unused credits than can be carried forward as well as any relevant expiration dates
- Complete the necessary tax returns, potentially including filing amended tax returns for the past three to four years of open tax returns for certain new businesses
- Ensure that the requirements under your state’s law are the same as those of federal law
- Collect and maintain the right real-time documentation for all R&D activities, including meetings, successes, and failures
Note that R&D documentation is critical. This is what the IRS and state taxing authorities will want to examine during an audit.
Claiming the R&D tax credit can be advantageous to your business if the necessary steps are taken and documentation is carefully maintained. Contact us today to determine your company’s eligibility.