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Do your startup’s activities qualify for the newly expanded RD tax credit?
Posted by Kanika Sinha
December 7, 2022
The federal research and development tax credit for small- and medium-sized businesses, which represents a dollar-for-dollar reduction in income tax liability, has doubled in value under the Inflation Reduction Act of 2022.
Companies that invest in qualified R&D activities to incentivize innovation and growth may be eligible for this credit. Eligible businesses can take advantage of the enhanced R&D tax credit limit beginning in 2023, but it has to be claimed annually and isn’t automatic.
Common misconceptions about the R&D tax credit
Many businesses owners have mistaken assumptions about the R&D tax credit, like:
The R&D tax credit only applies to big companies.
The R&D tax credit is only available for profitable businesses.
The R&D tax credit is only available for successful projects.
The R&D project needs to create a product or process that never existed previously.
Because of these erroneous assumptions, many businesses don’t take advantage of the credit’s potential benefits. According to data from the National Science Foundation, about $4 billion in R&D tax credits go unclaimed each year.
Starting in 2023, courtesy of the Inflation Reduction Act, eligible businesses can get back up to $500,000 in R&D tax credits every year (up from the previous $250,000 annual limit) for five years for use against payroll taxes.
Further, the credit has been expanded to include the 1.45% Medicare payroll tax in addition to the employer’s 6.2% Social Security tax, for a total of 7.65% in payroll tax liability.
Those receiving the full tax benefit can save up to $2.5 million across a five-year period. Any unused credit, meaning credit that can’t be used immediately or entirely, can be carried back one year or carried forward for up to 20 years.
While the Tax Cuts and Jobs Act of 2017 introduced new changes for businesses — namely, R&D expenditures can no longer be expensed in the first year of service and must instead by capitalized and amortized over five years starting in tax year 2022 – the R&D tax credit still offers a valuable opportunity to lower income tax liability.
Businesses often save hundreds of thousands of dollars through the credit. Legislation to restore the immediate deduction of R&D expenses has bipartisan support, but Congress had not yet acted at the time of publication.
How to tap into the R&D tax credit
To be eligible for the R&D tax credit, businesses must:
Have less than $5 million in gross receipts in the tax year for which the credit is elected.
Have gross receipts of less than $5 million in the taxable credit year and no gross receipts for any of the four preceding taxable years.
Conduct qualified research activities.
What counts as a qualified research activity?
While the first two points above are straightforward, Section 41 (d) of the IRS tax codeposes a four-pronged test for what comprises “qualified research activities” eligible for the R&D tax credit.
To be considered qualified research, businesses must be able to establish that the research activity being performed meets all four tests below:
1. Section 174 test
The business must be able to prove the expenditures were incurred in direct connection with its trade or business and that they represent a research and development cost in the experimental or laboratory sense.
That said, Section 174 treatment is applicable only to the extent that the amount is reasonable under the circumstances. For instance, expenses for the land and depreciable property are not allowed under this test.
However, in certain cases, you may find depreciation to be treated as a section 174 expense. For further explanation on specific expense disallowances, refer to the regulations under section 174 on the IRS website.
2. Technological information test
The business must be able to demonstrate that the research process undertaken fundamentally relies on principles of hard sciences such as physics, biology and chemistry; engineering or computer science.
For example, if you have a food processing startup, adding more salt or spices to your product won’t necessarily make your activities qualify — but efforts to devise a method based on hard sciences to enhance your product’s flavor or maybe to keep food fresher longer would be considered qualified research.
3. Business component test
The business must be able to tie the research it is claiming for the tax credit to the relevant/specific business component. The IRS defines a business component as any product, process, computer software, technique, formula or invention which is to be held for sale, lease, license or further used in trade or business of the company.
4. Experimentation test
The business must demonstrate that it has identified the uncertainty regarding the development or improvement of the specific business component that is the object of the research activities. In addition, the business must be able to show it went through a process of elimination, simulation, systematic trial and error, or other forms of evaluation to arrive at the alternatives, meaning new or improved products or processes.
What counts as a qualified research expense?
The IRS uses three expense buckets to distinguish eligible and ineligible research expenses for R&D tax credits:
Qualified research expenses
Wages paid or incurred to those engaging in, directly supervising or directly supporting the qualified research.
Expenses of research conducted outside the U.S.
Amounts used or incurred for supplies consumed in the conduct of the qualified research.
Duplication or adaptation costs of existing product/process.
Contract research expenses paid to outside vendors brought in to assist in the qualified research.
Surveys, studies, or research expenditures relating to management functions.
Comprehending the new rules
When considering claiming the expanded R&D tax credit, qualified SMBs should pay attention to the Inflation Reduction Act’s new provisions:
$250,000 of R&D credits generated in a tax year can be used to offset the employer portion of FICA payroll tax liability.
$250,000 of R&D credits generated in a tax year can be utilized to offset the employer portion of Medicare payroll tax liability.
R&D credits may offset employer payroll taxes no earlier than the first quarter after the business files its tax return reporting R&D credits
Like anything else on your tax return, you need to maintain records substantiating the R&D expenses you claim. Be sure to document anything related to R&D within your organization, such as test logs, lab results, payroll records, development/engineering notes.
In general, these financial records should show you actually paid the money and that the expense was incurred for a qualified purpose. If an expense was incurred for multiple business purposes, your corresponding records should reflect a breakdown of qualified versus nonqualified activities.
The credit can be clawed back by the IRS if you are unable to produce relevant records upon request in the event of an audit.
The federal R&D tax credit is one of the most beneficial yet underused incentives available to small and mid-sized businesses. A part of the tax code since its introduction as a temporary measure in the Economic Recovery Act of 1981, it was made permanent by the Protecting Americans from Tax Hikes of 2015.
While it has benefited thousands of businesses in diverse sectors, many businesses are not taking advance of its potentially sizable benefits. You can avoid leaving money on the table unnecessarily by engaging Escalon’s experts for a comprehensive R&D study to maximize your credit.
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