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Research & Development Tax Credit

Updated: Nov 17, 2020

If you are a tech company, software developer, software-as-a-service company, Biotechnology Company, or any company that is providing cloud based technology or services, you are probably sitting on a big tax credit, and you don’t even know it.  The research and development tax credit, has been around since 1981, and was JUST extended last week with the Tax Increase Prevention Act of 2014.  I thought it would be a good time to take a look at this powerful tax credit.

What is the Research & Development Tax Credit?

In an IRS statistic is that 80 percent of the companies that benefit from the R&D Tax Credit are companies that make $250 million or more in gross revenue.  I am here to tell you that the reason for this is that smaller companies don’t know how to capture this credit.   The credit works like this; if you are a start-up company and you don’t have research expenses for the previous three years, you can use 6 percent of your qualified research expenses to offset your income tax liability.

First of all, let’s talk about what a tax credit is, and why it is so valuable.  A tax credit is a dollar for dollar credit against your tax liability.  If you are a C-Corporation this would be your taxable income.  If you are an S-Corporation this would be your personal income.  Everyone is familiar with a tax deduction.  Let’s say that you spent $3,000 on auto expenses in 2014, and you used that $3,000 as a tax deduction.  Let’s further say that you are in the 15 percent tax bracket.  That $3,000 tax deduction means a tax savings of about $450.  Now let’s say you had a $3,000 tax credit.  The credit is a dollar for dollar credit against your liability.  That $3,000 means $3,000 tax savings.

There are two different ways of computing this credit.  One is very long and complicated.  Further, it doesn’t yield the best credit.  The simpler method, Alternative Simple Credit (ASC) involves averaging your last three years of R&D costs, halving it to a base amount, then taking the tax credit on how much more was spent over and above this base amount for the tax year.

Beyond the regulations under IRC § 174, the term “research or experimental expenditures” in that provision has not been the subject of extensive interpretation by the courts and the IRS. This lack of interpretation may be due to the fact that, in the case of an active and ongoing business, expenditures that are not deductible as research expenditures under section 174 may be deductible as ordinary and necessary business expenses under section 162 (but only if not capital expenditures).

The 1986 Tax Reform Act targeted the definition of qualified research with respect to which the credit is allowed. Initially, the term “qualified research” is defined as research with respect to which expenditures may be treated as expenses under section 174. In addition, section 41(d) sets forth three other requirements, some of which have been subject to extensive controversies between the IRS and taxpayers. Specifically, to constitute qualified research:

  1. The research must be undertaken for the purpose of discovering information that is technological in nature;

  2. Substantially all of the research activities must constitute a process of experimentation; and

  3. The experimentation must relate to a permitted purpose.

This definition is relatively broad and encompasses such activities as:

  1. Developing new or improved products, processes or formulas;

  2. Developing prototypes or models;

  3. Developing or applying for patents;

  4. Certification testing;

  5. Developing new technology;

  6. Environmental testing;

  7. Developing or improving software technologies;

  8. Building or improving manufacturing facilities; and

  9. Streamlining internal processes.

Document Your Expenses

Just like anything you do with taxes, you have to substantiate your expenses.  To substantiate its qualified research, a taxpayer must prepare and retain documentation on paper or electronically. Numerous court cases over the years reflect difficulties by the IRS and taxpayers in administering the research tax credit. Some of the most recent court cases, such as U.S. v. McFerrin and Union Carbide Corp. v. Commissioner, have addressed research credit substantiation and credible documentation, a key issue in IRS exams. In these cases, the courts ruled that the taxpayers, in the absence of certain contemporaneous records such as a time tracking or project accounting system, may still estimate research and experimentation expenses by looking to testimony of credible personnel and other available evidence.

So, be careful with this credit and document EVERYTHING.

This is just one little wrinkle that you might not be taking advantage of that can save you a lot of money in taxes.

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