Research and Development (R&D) credits are a great tax incentive, allowing your company to reduce its federal tax bill, and even save on state taxes. But for some reason, they’re often underutilized by many businesses.
In this blog, we’ll guide you through everything you need to know about these credits, with a focus on R&D calculation methods. That way, you’ll be equipped with the information you need to save on your taxes, and put money back in your pocket.
Understanding R&D Tax Credits
R&D credits are available at the federal and state levels, and both processes work the same way. They’re essentially an incentive for companies to get dollar-for-dollar savings for performing research and development activities.
To be eligible for the credit, your business activities must meet four criteria. These include:
- It must be for development or improvement. Your company’s work must aim to develop or improve a product, process, software, technique, invention, or formula. You don’t need to be successful in this aim; the attempt itself is enough.
- The work must have a technological basis. Your activities must be rooted in science, like technology, engineering, physics, chemistry, biology, or computer science.
- It should eliminate uncertainty. Whatever it is, it needs to eliminate any current uncertainty related to the capability, methodology, or design of the business component.
- You must be engaged in a process of experimentation. You need to prove you’ve experimented with the activity, and tried different solutions.
If your activities are eligible, the credit allows you to get cash back for qualified research expenses. These are defined by the Internal Revenue Code (IRC) Section 41, and fall into four basic categories:
- Wages and salaries paid to employees directly involved in qualified research activities.
- Supplies used directly in the process. This doesn’t include capital equipment or administrative supplies.
- Contract research conducted by US-based third parties.
- Computer costs for renting or leasing computers or cloud-hosting services.
Once you know whether your expenses qualify for the credit, you need to choose between two R&D calculation methods.
The Regular Research Credit Method
This is the older of the two R&D calculation methods. It rewards incremental increases in R&D spending.
The regular research calculation (RRC) method is best suited for larger and more established companies, as it requires comprehensive historical data about your qualified expenses and gross receipts. It amounts to 20% of qualified expenses that exceed a base amount.
So how is this method calculated? Follow the steps below:
- Calculate the fixed-base percentage of your total qualifying expenses for the current tax year. The IRS has instructions for how to do this, but keep in mind that the amount cannot exceed 16%, and it depends on how long your company has existed:
- Startups that are five years old or younger have a 3% base.
- Companies in their sixth year must divide their aggregate expenses for the 4th and 5th tax years by their gross receipts, and divide the resulting amount by 6.
- In year seven, you’ll divide by 3.
- In year eight, you’ll divide by 2.
- In year nine, you’ll divide by 1.5.
- After a decade, you’ll divide by 1.2
- For companies 11 years or older, you just divide the expenses for any 5 of the last ten tax years by gross receipts for those tax years.
- Multiply the fixed-base percentage by your average annual gross receipts from the previous four years to calculate the base amount.
- Next, subtract this from your total qualifying expenses for the year.
- Multiply the fixed-base percentage by the average annual gross receipts from the previous four years to calculate the base amount, to get amount A.
- Multiply your total qualifying expenses for the year by 50%, to get amount B.
- See which base amount (A or B) is lower.
- Your credit is 20% of the lower base amount.
Because this method takes your receipts and expenses from previous tax years into account, it actually rewards you for increasing your research spending over time.
The Alternative Simplified Credit Method
The Alternative Simplified Credit (ASC) Method is the more streamlined of the two R&D calculation methods. It was introduced in 2006, and relies on your qualified expenses for the past three years.
Here’s how the method works:
- Calculate your company’s qualified research expenses for the past three years.
- Calculate the average, by adding the three amounts together and dividing by three.
- Multiply this average by 50% to get the credit base.
- Subtract your credit base from the total amount of your R&D expenses for the current tax year.
- Multiply this number by 14% to calculate your R&D credit.
But what if you’re a newer business and don’t have three years’ worth of records? In that case, you will multiply the current year’s R&D expenses by 6%.
Remember that both methods have specific eligibility requirements, and also limitations.
Eligibility and Limitations
To prove eligibility, you’ll need to retain all records relating to the four requirements listed at the start of this blog. This includes payroll records, expense receipts and invoices, contracts for third-party support, and project notes. The latter includes any documentation of project objectives, like hypotheses, testing results, meeting notes, and progress reports.
Also, remember that there are exclusions to the qualified expense activities. These include:
- Projects conducted outside of the US, even if by a US company.
- Activities funded by unrelated third parties.
- All activities relying on aesthetics, arts, social sciences, or humanities.
- Projects that revolve around data collection, market research, or quality control testing.
- Repairs and maintenance of existing products or processes.
There are also special rules. The Protecting Americans from Tax Hike (PATH) Act of 2015 lets new and small businesses apply an R&D tax credit of up to $500,000 against their payroll tax (FICA) for up to five years. But in order to make use of this, your business must have fewer than five years of gross receipts, of less than $5 million per year.
Advantages and Disadvantages of R&D Calculation Methods
Each of the two R&D calculation methods has advantages and disadvantages, which you need to keep in mind when choosing a method for your calculations.
The regular method
Because it offers a credit rate of 20% on qualified research expenses, this method can provide your business with more substantial savings. It also lets you include a wider range of historical data, which means you might get higher credits if you have significant past R&D expenditures.
On the downside, this is the more complicated of the two R&D calculation methods. And because it relies on detailed supporting documents, your company must ensure that it has clean records. Missing documents can be detrimental to your business’s eligibility.
The simplified method
The most appealing factor of the ASC is that it is the easier of the two R&D calculation methods. That means less stress and pressure when calculating and tracking your credits, and a reduced risk of errors. Because you only need three years’ worth of supporting documentation, the compliance burden is also significantly lighter. That makes it a more accessible option for many businesses, and particularly for startups.
But the simple method isn’t without drawbacks. The main con is that it offers a lower credit rate, capped at 14%. So companies with longer-term or higher historical investments may lose out on potential savings.
Choosing the right method
The pros and cons of the two R&D calculation methods can make it difficult to choose the best option. Generally, the easiest way to decide is to calculate both methods, and see which has the higher return. Then you’ll need to double-check that you have all the necessary historical data for the chosen method.
Another option is to consult a professional.
Tax experts can guide you through the complex process accurately, from calculations to benefits. They can also ensure that either of the R&D calculation methods are considered as part of your company’s overall tax strategy, to decrease your tax liability.
At Fusion CPA, our tax subscription service is designed to help our clients save time and money, and maximize their returns. And that includes making the most of benefits like credits and incentives as part of their tax strategy. For help navigating the intricacies of R&D calculation methods, or other ways of reducing your taxes, schedule a Discovery Call with one of our experts today!
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