Research and Development Credit Explained
The federal research and development tax credit represents one of the most powerful ways Congress can encourage innovation. However, it also may represent one of the most underutilized tax breaks, as evidenced by many taxpayers who qualify for its benefits for many years before taking advantage of its savings. This article explains the basics of this credit.
The credit is described in Section 41 of the Internal Revenue Code (“IRC”), and is entitled the “Credit for Increasing Research Activities.”
- Observation: There is no such thing as the federal “Research and Development” credit or “R&D” tax credit. Those are financial statement terms that originate in Financial Accounting Standards Board language describing segregation of accounting expenses. They are GAAP terms, rather than tax terms. But they are commonly used in describing this credit, and roll off the tongue and keyboard better than the clunky-sounding “Credit for Increasing Research Activities.” For that reason, we will unapologetically use the credit’s nickname here too.
All of the expenditures that qualify for use in computing the credit first must qualify as deductible expenses. The R&D credit rules simply allow a portion of those deductions to be converted into credits, which are much more potent. (A deduction lowers income that is subject to tax, while a credit lowers tax itself, often dollar-for-dollar.) Paraphrasing IRC Section 41(d), to qualify for the credit, the expenditures must be undertaken for the purpose of discovering information which is technological in nature, the application of which is intended to be useful in the development of a new or improved business component of the taxpayer, and substantially all of the activities of which constitute elements of a process of experimentation related to a new or improved function, performance, reliability or quality.
Qualifying costs do not include costs incurred after commercial production, including adapting an existing product to a customer’s need. They also exclude market research, quality control testing, funded research, or research conducted outside of the U.S.
In addition to the above criteria, qualifying costs are further limited to wages and supplies, costs for computer use, and 65% of contractor costs (third parties performing research on behalf of a taxpayer – but only if they, too, do so within the U.S.).
It applies to more than you think
R&D often conjures up a vision of scientists in white lab coats working on a prototype of some entirely new thing no one has ever seen (like, for example, a microwave that you can actually leave a spoon in while reheating your soup, thereby avoiding a small fire and hurtful comments from one’s spouse regarding one’s memory). However, a new invention is not required for the credit to apply, and operating in a high-tech field is not necessary either. Any type of business might qualify. Often overlooked is the fact that the credit can apply to improvements in processes. Assuming other criteria are met, this could apply to a redesigned layout of a production line that increases performance. One element that appears with regularity in court cases and rulings in this area is that of experimentation, which in turn means that the potential for failure must be present. Generally the outcome must be unknown for the costs related to an undertaking to qualify. However, the credit may be obtained even if a new invention or a patent is not pursued. You do not need to build a better mousetrap; you can instead find a creative way to build the same mousetrap.
It comes in several variants – all of them complex
The amount of the credit is not determined by simply renaming or treating the qualifying costs (or even a portion of them) as a credit. Instead, the computation of the credit involves multiple steps and some specific terminology.
There are three alternative methods of computing the credit.
- The “regular” credit works like this: Generally 20% of qualifying costs (described above) over a “base period amount” qualify. The base period amount consists of the average of the most recent four years’ revenues multiplied by a “fixed base percentage.” The fixed base percentage is derived from a table, but is based on research expenses divided by revenue for a specified number of years. The fixed base percentage cannot exceed 16%, and the base amount must equal at least 50% of the current year’s qualified expenses.
As noted above, credit-eligible costs are also deductible expenses, and the fact that such costs were used to compute the credit does not change that – with one exception. An amount equal to the credit itself must be removed from research expenses for tax purposes (added back to taxable income). The balance of qualifying costs remains deductible. This addback is not required when using the reduced regular credit described below.
- The “reduced regular credit” is both an alternative to the regular credit and a subset of it. This credit is computed like the regular credit, but then reduced to equal 65% of the regular credit amount. In exchange, the addback described above that applies to the regular credit is not required. A taxpayer may choose between the regular credit and reduced regular credit on an annual basis, but cannot use an amended return to utilize the reduced credit.
- The “alternative simplified credit” is the third and final variant of the credit. Living up to its name, its computation is much simpler than the two regular credits. The credit is equal to 14% of the excess of current year qualified research costs over half of the average costs for the prior 3 years. Taxpayers who do not have qualified costs in one of the prior 3 years receive a credit equal to 6% of current year qualified costs. As is the case with the regular credit (but not the regular reduced credit), the amount of the credit must be added back to current year income. Unlike both of the other methods, once this method is used, it is the only one that can be used for that year and all future years.
- Observation: Each of these formulas tends to reward companies whose research expenditures are growing relative to prior years and relative to their revenue (thus, the name Credit for Increasing Research Activities). A company that maintains a steady level of qualifying research costs can expect to see its credit diminish over the years and potentially disappear.
The R&D credit is one of many that are included in an umbrella of credits known as the General Business Credit. Collectively, the credit is limited to offsetting 25% of a taxpayer’s regular tax liability exceeding $25,000. Portions unusable due to this requirement can be carried forward for as many as 20 years.
A pair of unique features applies only to small or mid-sized taxpayers, beginning with tax years that start on or after January 1, 2016. The first allows the credit to offset not only regular tax, but also Alternative Minimum Tax (AMT). It applies to certain taxpayers who averaged $50 million or less in gross receipts during the 3-year period preceding the credit. The second allows a portion of the credit to offset payroll tax (FICA). That benefit applies to taxpayers with gross receipts of less than $5 million that generated no revenue in years earlier than the 4-year period preceding the year of the credit. In other words, the ability to offset payroll tax is reserved for small start-ups.
Most, but not all, of the states offer some version of the research credit to offset their income taxes. The types of qualifying costs, calculations, and carryforward periods vary widely. Most are based on research performed within the home state.
The credit’s future/conclusion
For decades the R&D credit often expired annually, only to be renewed most years (often retroactively) as part of Congress’ year-end “extenders.” In spite of the fact that it was allowed to expire so many times, this credit has maintained strong support in Congress, and in 2015 the Path Act finally made the credit permanent. Two competing (but somewhat similar) massive tax overhauls proposed by House republicans and President Trump call for most tax credits to disappear, but the R&D credit is listed in both plans as one of the few credits that will survive.
The credit for increasing research activities truly stands apart from other tax breaks in a number of ways. It is in the country’s best interest that we stay on the cutting edge of technological advances and discoveries, and lawmakers have long known that they can influence actions through our pocketbooks. It has broad bipartisan support throughout Washington, and is assured a perpetual life as much as anything in this realm of nonstop tax changes can be. It even enjoys a better than average reputation throughout all but the fringe media. Finally, it benefits a broader range of taxpayers and activities than the casual observer (or even a qualifying, potential participant) might think.
Disclaimer of Liability: This publication is intended to provide general information to our clients and friends. It does not constitute accounting, tax, or legal advice; nor is it intended to convey a thorough treatment of the subject matter.