R&D TAX CREDITS

About R&D Tax Credits

The R&D tax credit was first introduced in the Economic Recovery Tax Act of 1981. The aim of the tax incentive was to encourage companies to increase outlay on research, development, and experimentation. Most believe that the tax credit is only available to pharmaceutical or high-tech companies, but certain manufacturers, engineers, architects, and even contractors may qualify for the R&D tax credit.

A word of caution, the IRS looks closely at credits claimed as many companies have inflated the capital expense that is allocated to research and development. The tax credit allows companies to capture credits from not only the current period, but also previous periods.

The requirements of R&D are purposefully broad. Whatever the type and size of the business, a company is said to be carrying out a qualifying activity if it takes risks to resolve ‘technological or scientific uncertainties.’ The activities could include:

  • Creating a new or modifying an existing process, product, service, or formula
  • Testing or evaluating the feasibility of the new process, product, service, or formula
  • Creating engineering architecture
  • Developing prototypes and models
  • Technical design and reviews
  • Carrying out technical meetings
  • Documenting the research findings
  • Compiling data for research
  • Creating more environmentally friendly and efficient design
  • Supervision of personnel engaged in R&D

A firm may qualify for a tax incentive even if it is not certain that the research will actually help in resolving the uncertainty, or result in a scientific breakthrough.

What this means is that the R&D does not even have to be successful. You can qualify for research work undertaken for your own project as well as a client. The IRS looks at different expenditures to approve the tax credit claim. Some of the qualifying expenditure includes:

  • Expense on staff, including pension contributions and
    salaries
  • Expenditure on freelancers and subcontractors
  • Expenditure on an application
  • Expenditure on consumables and materials, including utility used for carrying out the R&D activity

The R&D expenses are known as capital expenses. However, they can also be deducted as current business expenses. Most states provide R&D tax credits. The state tax guidelines follow IRS guidance and federal regulation regarding what constitutes qualified research expenditures.

Remember that the exact types of expenditures that qualify for R&D tax credits differ from state to state. For instance, the threshold that defines expenditure is relatively lower in Connecticut than most states. Section 174 of the state law gives the green light to a greater number of expenditures to qualify for the R&D incentive. On the other hand, California recognizes a limited number of expenditures
that can qualify for the tax credit.

Pennsylvania allows companies holding tax credits related to R&D to apply for selling the credits to a buyer in exchange for a product or service. The state also allows tax credits of up to 10 percent for increase in the R&D expenses as compared to a base period, provided that it does not exceed $15 million.

The IRS allows you to use one of the following accounting methods to account for R&D expenses.

  • Amortizing the expenditure over a period of five years or
    less
  • Deducting the R&D expenses in the tax year in which they
    were paid

The IRS rules mandates that the R&D expenses that are not amortized, deducted, or deferred must be charged to a capital account. The R&D credits can be claimed for expenditures. These credits can be combined to form part of the general business credit.

Rob  O'Neill

FEATURED CASE STUDY

R&D TAX CREDITS


An automation company decided to explore if they qualified for R&D Tax Credits. Almost every process they completed for clients included extensive research in how to improve existing automation and processes. Upon completion of the review it was determined that the company qualified for $143,000 in tax credits over the prior three years and potentially up to $40,000 per year going forward.