If your business hasn’t been claiming the research credit (often referred to as the “research and development,” “R&D” or “research and experimentation” credit), now may be a good time to revisit this valuable tax break. Last year’s Protecting Americans from Tax Hikes (PATH) Act made the credit permanent after 34 years of being temporary, including numerous extensions, and expanded the credit’s benefits to certain start-ups and other small businesses that were unable to take advantage of it in past years.
A quick overview
The research credit is complex, but in a nutshell it allows businesses to claim a nonrefundable credit equal to 20% of the amount by which their qualified research expenditures (QREs) exceed a base period amount. You can carry back unused credits one year and forward up to 20 years. Be aware that the research has to be conducted within the United States (including Puerto Rico and U.S. possessions).
To determine the base period amount, calculate your ratio of QREs to gross receipts from 1984 to 1988 and apply it to your average gross receipts for the previous four tax years. (The base period amount cannot be less than 50% of your current-year QREs, however.) There are alternative methods of calculating the credit for companies that didn’t exist from 1984 to 1988, lacked sufficient QREs or gross receipts during that period, or otherwise have trouble qualifying for the traditional research credit. These include an alternative incremental credit (AIC) and a simplified credit. Whichever method you use, the net cash benefit of research credits typically is 6.5% of QREs.
Many companies overlook the research credit because they think it’s limited to companies that conduct laboratory research, such as biotech, pharmaceutical or high-tech firms. But the credit is available to any company that invests in developing new or improved products or processes, including retail and consumer product companies and even service providers. To qualify, research activities must:
- Strive to discover information that’s technological in nature,
- Relate to a new or improved “business component,” such as a product, process, computer software, technique, formula or invention,
- Be designed to eliminate uncertainty concerning the development or improvement of a business component, and
- Be part of a “process of experimentation.”
Generally, QREs include supplies, W-2 wages for employees conducting research, and 65% of consultants’ fees.
New benefits for smaller businesses
Before the PATH Act, it was challenging for smaller companies to take advantage of research credits, even if they conducted a significant amount of qualified research activities. One obstacle, particularly for partnerships and S corporations, was the alternative minimum tax (AMT), which often restricted or even eliminated the owners’ ability to use the research credit. The PATH Act solves this problem by allowing businesses with average gross receipts of $50 million or less during the previous three years to claim the credit against the AMT, beginning this year.
Historically, start-up businesses (companies in operation for less than five years with less than $5 million in gross receipts) haven’t been able to take advantage of research credits because they have little or no tax liability. To allow start-ups to enjoy the benefits of the credit without having to wait until they start generating taxable income, the PATH Act permits them to claim the credit against up to $250,000 in employer-paid FICA taxes.
Get the credit you deserve
R&D benefits many businesses and should benefit the company doing it. If your company commits resources to developing new or improved products or processes, it pays to consult your tax advisor to see if you qualify for research credits.