Research and Development Tax Credits for Businesses

Researchers working in a lab
••• Paul Bradbury/Getty Images

Recent laws have given inventors and research facilities in business some incentives for doing research and development (R&D) in the form of a tax credit. The PATH Act of 2015 included some increased incentives in the form of a tax credit for businesses, and the 2017 Tax Cuts and Jobs Act (TCJA) included some additional changes to this tax credit.

What is a Tax Credit?

A tax credit is given by the IRS as an incentive for doing something, like research and development in this case. A tax credit is similar to a deduction because it reduces your taxable income, but a tax credit is a better deal because the credit is applied as part of the calculation before the taxable income of the business is set.

Tax credits must be applied for after the fact; you can't apply for a tax credit and then do the research. It's important to talk to a tax professional before you begin your research, to understand the qualifications for this tax credit.

Can My Business Qualify for This Tax Credit?

This tax credit is specifically intended to help small businesses. Any business - corporation, partnership, or sole proprietorship - can be eligible. An LLC is also eligible because LLCs are taxed as either partnerships or sole proprietorships.

What Qualifies as Research and Development?

Many types of businesses do research, and you may not even be aware that the activities of your business may be available as tax credits. Your business may be able to qualify for a tax credit for activities such as: 

  • development of proprietary products, including inventions, 
  • improving product quality, reliability, or functionality
  • work on developing or improving software products
  • research to improve business performance
  • payments to third parties who conduct research for your business
  • payments to employees who work on research projects in your business

The IRS says that research that qualifies for the tax credit must be for "discovering information that is technological in nature." The research must also be about improving "function, performance, reliability, or quality."

What Tax Credits are Available? How Do These Tax Credits Work? 

Usually, a tax credit is taken directly against the income of the business, as shown on the business tax return. In this case, as noted above, the PATH Act has expanded the tax credit for smaller businesses, effective beginning in 2016, and makes the credit permanent. This removes the guess-work of businesses trying to make plans.

More specifically, newer businesses (under 5 years old) and small businesses with under $5 million in gross receipts for the tax year may be able to qualify for a credit of up to $250,000 a year.

Here's how these tax credits work: a business spends money, then makes an application for a tax credit. The credit is applied directly against business income, which is better than taking a deduction for the expense.

There are two types of tax liability against which the tax credit can be taken. Businesses may take the tax credit through the business's federal income tax liability (the amount owed for federal income tax by the business).

OR, if the business meets the IRS criteria for being a "qualified small business," the business may take the tax credit against an amount up to $250,000 of the employer's share of Social Security taxes means you might be able to take the credit even if your business isn't making a profit.

A "qualified small business" for this purpose is a corporation, S corporation or partnership with

  1. Gross receipts of less than $5 million for the tax year, and
  2. No gross receipts for any tax year before the 5-tax-year period ending with the tax year.

These options allow businesses more flexibility in where they apply the tax. Newer small businesses, for example, may not have enough income tax liability against which to apply the tax, so the business can select the other option.

How to Apply for This R&D Tax Credit

You would apply for the credit for a specific tax year in one of two ways, depending on your business type.

Partnerships and S corporations (also LLCs taxed as partnerships or S corporations) must claim this tax credit by filing IRS Form 6765- Credit for Increasing Research Activities. The form offers you two options for taking the credit:

  • Taking the "regular" credit, or
  • Using the alternative simplified credit.

Each option includes a list of included costs (like wages, computer costs, and cost of supplies) and calculations. It's best to read the details in the ​instructions for form 6765 before you begin. The IRS suggests working through both methods to see which results in a greater credit. 

Other business types, including corporations, can claim the tax credit as a General Business Credit, along with other business credits, on Form 3800.

Deducting or Amortizing These R&D Tax Credits

You may also want to look into deducting or amortizing (spreading out) the cost of these research activities. The IRS has guidelines for deducting or amortizing research tax credits. Deductions may be taken in the current tax year while amortizing means spreading the credit over several years (similar to depreciation).

The TCJA allows the business the option to deduct the current year's R&D expenses, but only through December 31, 2021. After that date, businesses must charge these R&D expenses to a capital account and amortize them (like depreciation) over five years.

In Conclusion: Check With Your Tax Professional

As usual with these types of tax benefits, the qualifications, the application, and the process are complicated. The purpose of this article is not to give you tax advice, but to provide you with general information to use in your conversation with your tax professional