A Short Guide to R&D Tax Credits

If you are the owner of a company then you probably asked yourself the following question at least once – am I eligible to apply for R&D Tax Credits? And you are not the only business owner who has encountered this financial conundrum. However, you needn’t wonder anymore, because we have put together a short but comprehensive guide on R&D tax credits for you and your business.

What Is R&D Tax Credit?

R&D stands for Research and Development, an abbreviation which gives us our first clue in understanding the procedures and process. The best part of businesses starts developing at some point to be able to diversify and survive. Every type of trade out there, from a small, local bakery to a giant electronics corporation needs to add new services and products to their existing line. The only way to come across these new additions is by research and development.

Luckily for all business owners, the government has a policy which allows corporations to ask for a reduction in the taxes they pay for the money they spent on and invested in research and development. This idea is what stands behind the classical R&D tax credits.

In other words, R&D tax credits is a system that allows corporations to apply for a reduction of taxes previously paid for qualified expenditures. The reduction will be ‘dollar for dollar.’ At the present moment, you can ask for three years’ worth of tax credits retroactively. You can also request a postponement or, in other words, a deferment of your tax credits for up to 20 years.

The great thing about R&D tax credits and one worth mentioning here is that not only will you be rewarded for development and research but also for all the changes made along the way. This system means that they don’t take into account only the final product, but all it versions, experiments, and trials that went into making it.

The R&D tax credits law used to have one major flaw. It was introduced back in 1981 as part of the Economic Recovery Tax Act. It expired in 1985 and was renewed eight times since then. This uncertainty of credit that is sometimes active and sometimes not led to a rethinking of most companies’ budgets for research and development. It especially happened because manufacturers were being courted by foreign countries who offered them more generous programs when it came to R&D, as well as permanent ones.

The federal government finally acknowledged this was a problem and decided to make the credit permanent so as to strengthen it and give businesses the certainty it will last for at least one entire project they have on their agenda. The credit became permanent in 2015.

What Type of Research and Development Qualifies for R&D Tax Credits?

Typically speaking, the process that is eligible for tax credits is called qualified research, and it comprises four parts.

#1. The permitted purpose

To be able to qualify, the purpose of your project or activity must be to create or improve an existing component in your business. It can be a product, service, process, functionality, technique, formula, invention or a piece of software. Also, you must intend to sell, license, and lease or use it in your business. If these criteria are not met, you cannot apply.

#2. The elimination of uncertainty

You, as the taxpayer, must strive to discover facts that will, ultimately, eliminate any doubt that might be related to the development or improvement of your business as a whole or parts of it.

#3. The experimentation process

Exactly as the name suggests, you, as a taxpayer and business owner, must create and follow a steady process of experimentation. You must try to evaluate one or several alternatives through which to determine the uncertainty of your products or process. It’s a gray area, though. The Treasury Regulations, for example, pin it down as anything from traditional application of scientific methods to very free trial and error processes.

r&d tax credits research and development concept art

#4. Everything must rely on the technological

This idea means that all the experimentation you do to determine if your idea is viable or not must be conducted via technological, biological, engineering or computer science means. In other words, all your experiments have to be physical. You cannot rely on ideas, philosophies or morals.

R&D tax credits’ qualified research has some ‘exclusions’ as well, of which you should be aware.

  • All the research that you did after you started commercializing the thing you were studying in the first place.
  • Adaptations you performed to existing business parts.
  • Duplications conducted on components of your business.
  • Reverse engineering – this refers to you finding an existing idea about a product or service and deconstructing it so that you can see how it works and later recreate it and sell it as your own.
  • There is an entire series of business-related activities that do not qualify for R&D tax credits and here they are: surveys, studies, management activities, data collection, market research, routine testing and quality control.
  • Developing software for internal use.
  • The analysis that is considered foreign. This means all researching activities performed outside the United States, the Commonwealth, Puerto Rico, and any other lands currently in the possession of the United States.
  • Any research that is related to the social sciences, humanities, and the art department.
  • Any research that has been already sponsored or funded by the authorities, an individual, by contract or via a grant.

What Are the R&D Tax Credits’ Economic Effects in the United States?

There has always been quite the debate regarding what economic effects R&D tax credits actually have. Even so, the best part of all economists tends to believe it is a positive thing in the sense that the credit increases investment in research and development in the United States. However, measuring the actual economic effect this credit has is very challenging. The closest thing we can look at in the sense of numbers are a few studies, such as the one made in 2005 by Ernst & Young.

r&d tax credits concept art with notebook, marker, glasses, and dollar bills

They managed to measure how much money companies got back in the form of R&D tax credits. Here are some details.

  • In 2005, approximately 18 000 companies asked for $6.6 billion in R$D tax credits.
  • There were also some 11 000 C rated corporations and 6 000 S ones that had the same claim for the credit.
  • These companies were divided in size as follows.
    – 29% of them had more or less $1 million in assets.
    – 25% had between $1 and $5 million in assets.
    – 25% had between $5 and $25 million in assets.
    – 21% had over $25 million.
  • Almost 15 000 corporations that had less than $50 million in total assets filed a claim for approximately $891 million in R&D tax credits.
  • A little over 70% of all these companies owned a Standard Industrial Classification in different types of Manufacturing. The remaining 30% were in Information, Services, and Agriculture.

Since Congress transformed R&D tax credits into a permanent thing in February of 2015, the credit has been used to keep the United States up and running in the global race currently going on for R&D investment dollars. Back in 2012, America ranked number 27 out of the 42 countries that were studied, quite an alarming place.

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