This article was updated June 2019.
While tax reform, often referred to as the Tax Cuts and Jobs Act (TCJA), introduced many new changes for businesses, the R&D tax credit continues to provide reliable opportunities for reducing income tax liabilities—often saving companies hundreds of thousands of dollars.
However, many companies aren’t fully benefiting from the R&D credit because of common misconceptions about its applicability to their operations. Businesses that fail to claim the R&D credit often do so because of confusion around four key topics:
- Which activities qualify as research
- What expenditures qualify for the credit
- What documentation sufficiently supports research
- How businesses use the credit
Gaining clarity around these topics can provide the foundation for identifying and claiming the R&D credit—and lowering a company’s tax burden.
The Protecting Americans from Tax Hikes (PATH) Act of 2015 made the R&D credit permanent and expanded its application to create a potential tax benefit for small businesses and start-up companies. The TCJA retained these provisions.
Because of the permanency of the R&D credit, companies can now rely on and incorporate it into their annual tax-planning strategy.
Why Companies Don’t Think They Qualify
Even with this stability, however, there are common factors that companies assume prevent them from claiming the credit.
Not Paying Federal Income Tax
Start-up companies and small businesses may be eligible to apply up to $1.25 million—or $250,000 each year for up to five years—of the federal R&D credit to offset the Federal Insurance Contributions Act (FICA) portion of their payroll taxes each year.
To be eligible, a company must meet two requirements:
- Have less than $5 million in gross receipts for the credit year
- Have no more than five years of gross receipts
The R&D credit is calculated on the federal income tax return as usual and may be applied against payroll taxes starting the quarter after the credit is claimed. For calendar-year taxpayers, the R&D credit can be applied against payroll taxes as early as July of the following year.
Not Focused on R&D
It’s not only high-tech or life sciences companies with dedicated research departments that qualify for the R&D tax credit. Indeed, most companies don’t have R&D laboratories and instead perform R&D in their test kitchens or fields, wineries or distilleries, or on production floors. Wherever experimentation occurs, R&D may be found.
The Moss Adams R&D Tax Services page contains examples of qualifying activities across industries.
Employees Aren’t Degree-Holding Engineers or Scientists
Companies with large numbers of engineers and scientists stand out as prime candidates for the R&D tax credit because the credit was created to encourage research and experimentation based on the hard sciences.
This holds true regardless of who performs the activities and can include employees with many different job titles and backgrounds. Experimentation performed by both employees and third-party contractors who engage in the improvement of projects and processes may be included.
Not Developing Anything New
The R&D tax credit is for taxpayers that design, develop, or improve products, processes, techniques, formulas, or software. It’s calculated on the basis of increases in research activities and expenditures—and as a result, it’s intended to reward companies that pursue innovation with increasing investment.
R&D doesn't have to be new to the industry. It simply needs to be new to the company, which must have activities that meet the four-part IRS test below.
Subject to Alternative Minimum Tax
Historically, many companies performing R&D haven’t benefited fully from the credit because the company—or its shareholders, in the case of pass-through entities—were subject to the alternative minimum tax (AMT).
For tax years beginning on or after January 1, 2016, individuals or eligible small businesses (ESBs) who are subject to AMT can offset regular taxes and AMT using the R&D tax credit. ESBs are nonpublicly traded companies with average revenue of $50 million or less over the previous three years.
This means R&D credits that may have been previously unusable for ESBs can now be applied to reduce AMT.
Tax Reform Changes
- Increased Usability from Elimination of Corporate AMT. With corporate rates going down to 21%, the AMT rate was eliminated. Nevertheless, there’s still one limitation remaining on R&D credits to prevent taxpayers from using the credit to completely eliminate their tax liability. The rule, effectively known as the 25/25 limitation, restricts taxpayers with over $25,000 in regular tax liability from offsetting more than 75% of their regular tax liability using the credit.
- Retention of Eligible Small Business Credits. Previously, corporations or owners of pass-through companies with less than $50 million in average revenue over the prior three years were allowed to use the R&D credit to offset AMT. Since the corporate AMT was eliminated by the TCJA, this provision will benefit individual taxpayers with R&D credit flowing through from a business that they have an ownership stake in.
- Retention of Qualified Small Business Payroll Credits. Startup companies with less than $5 million in revenue will still be able to make an election that will allow them to offset up to $250,000 in payroll taxes for the first five years they have gross receipts. Starting in 2017, payroll credits must be elected on an original return.
- Increased Usability for Individual Taxpayers. Before tax reform, individual taxpayers were sometimes prevented from using the credit because of AMT at the individual level. Now, the AMT exemptions for individual taxpayers are increasing. As a result, individual taxpayers are likely to use more of the R&D credits passing through to them from their businesses.
Determine R&D Eligibility
Any company that encounters and resolves technological challenges may be eligible for the R&D tax credit. That said, eligibility depends largely on whether the work a company does meets the criteria established by the IRS’s four-part test.
Companies that consider their activities to be business as usual may actually find themselves innovative once they look at the four-part test.
- Elimination of uncertainty. A company must demonstrate it has attempted to eliminate uncertainty about the development or improvement of a product or process.
- Process of experimentation. A company must demonstrate—through modeling, simulation, systematic trial and error, or other methods—that it has evaluated alternatives for achieving the desired result.
- Technological in nature. The process of experimentation must rely on the hard sciences, such as engineering, physics, chemistry, biology, or computer science.
- Qualified purpose. The purpose of the research must be to create a new or improved product or process, resulting in increased performance, function, reliability, or quality.
As a first step, a company should review its operations for eligible activities. Companies that go on to claim the credit must also be prepared to identify, document, and support their qualifying R&D activities.
Claim the Credit
The amount of R&D tax credit a company can claim will depend on many factors, but the potential tax savings make it worth the time to investigate. For example, R&D tax credits have the potential to offset taxable income, which can reduce a company’s tax burden in the years qualified activities occur.
Companies that haven’t previously taken advantage of the credit also have the option to look back at all open tax years—typically three to four years, depending on when tax returns were filed—to claim the missed opportunity.
If a company doesn’t currently have taxable income or is otherwise limited in how much tax credit it can use, the federal tax credit can be carried forward for 20 years or potentially applied to offset the company’s federal payroll tax under the newly expanded rules. State credits may also be carried forward for a length of time determined by the state.
Tax Reform Changes
Increase in Credit from Decrease in Tax Rates
Prior to tax reform, taxpayers couldn’t take a deduction under IRC Section 174 equal to the amount of the R&D credit. This prevented companies from getting a double tax benefit, and taxpayers were required to reduce their R&D expenses by the amount of the credit. The reduction in expenses created an increase to income and any corresponding taxes.
Taxpayers could avoid the reduction of their research expenses by electing to take a reduced credit in accordance with IRC Section 280C(c)(3), which was retained in the TCJA and calculated using the maximum corporate tax rate. However, because the maximum corporate tax rate was reduced from 35% to 21%, taxpayers will see an increased credit.
Amortization of R&D Expenses Starting in Tax Year 2022
After 2021, companies will no longer be able to immediately expense costs that are treated as specified IRC Section 174 research expenses. Instead, they’ll be required to charge US-based research expenses to a capital account and deduct them over a five-year period. Expenses incurred for research performed outside of the United States will be charged to a capital account and deducted over a 15-year period.
Because R&D tax credits may be claimed for both current and prior tax years, companies can benefit from documenting their R&D activities so they’re well positioned to claim the credit for both situations.
To claim this credit, taxpayers must evaluate and document their research activities contemporaneously to establish the amount of qualified research expenses paid for each qualified research activity. While taxpayers may estimate some research expenses, they must have a factual basis for the assumptions used to create the estimates.
Examples of contemporaneous documentation include these items:
- Payroll records
- General ledger expense detail
- Project lists
- Project notes
- Lab results
- Emails and other documents a company produces throughout the regular course of business
These records combined with credible employee testimony can form the basis of a successful R&D credit claim.
Increased IRS Scrutiny
For taxpayers already claiming the credit and those who may want to determine eligibility, it’s critical to be thorough when calculating and documenting qualified research activities for R&D credit claims. A possible consequence is increased IRS scrutiny and disallowance of credits claimed.
The ruling in Siemer Milling Company (Siemer Milling) v. Commissioner of Internal Revenue is a reminder of those consequences. On April 15, 2019, the United States Tax Court ruled in favor of the commissioner in finding that Siemer Milling lacked sufficient documentation to support the R&D credits claimed.
Importance of Reporting
In the case, the court disallowed over $235,000 dollars in R&D credits claimed by Siemer Milling during tax years 2010 and 2011. This disallowance was due in large part to the taxpayer’s failure to retain and provide supporting documentation demonstrating how the company’s activities met all four tests necessary to constitute qualified research expenses.
Siemer Milling claimed that expenses from activities related to development of new flour products and improvements to its production line qualified for the R&D credit. However, the company offered no documentation to demonstrate how the activities constitute experimentation in the scientific sense.
The court found the taxpayer simply stated that it was involved in new product development involving technical activities, but these conclusory statements were insufficient evidence on their own. Simply reciting the steps undertaken wasn’t enough to conclude the company had undertaken a methodical plan involving a series of trials to test a hypothesis to develop new processes or products.
Notwithstanding, this case did provide a few taxpayer-friendly facts on eligibility for qualified research expenditures:
- Technical uncertainties don’t need to be solved in the credit year but can span more than one year.
- To establish that a company participated in technical activities, it doesn’t necessarily have to employ individuals with specialized degrees.
- The Court discussed what types of documentation or support of estimates would be useful to properly support credits claimed.
We’re Here to Help
For more information about R&D credits or reducing your company’s risk of facing penalties, contact your Moss Adams professional or visit our Credits & Incentives page. For a free estimate of your company’s potential qualified activities, fill out a complimentary credit benefit estimate.