Research and Development Tax Credits for Businesses
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 subtracted directly from your tax liability. It reduces your taxes dollar for dollar. In other words, for every dollar you receive in a tax credit you save a dollar in taxes.
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, LLC, partnership, or sole proprietorship - can be eligible.
There several parts to this tax credit:
- A tax credit for research and experimentation, and
- A part of the tax credit for small businesses as a payroll tax credit against the employer's portion of social security taxes.
For the payroll tax credit election, a qualified small business is a corporation, S corporation, or partnership with
- Gross receipts of less than $5 million for the tax year, and
- No gross receipts for any tax year before the 5-tax-year period ending with the tax year.
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. The research that qualifies for the tax credit must be for discovering information that is technological in nature and its application must be for use in developing a new or improved component of your business. in addition, all of the activities of the research must be experimentation relating to new or improved function, performance, reliability, or quality.
These activities don't count for this tax credit:
- Research conducted after the product is in production
- Research for a particular customer's need
- Duplication of an existing product or process
- Surveys or studies
- Research conducted outside the US, Peruto Rico, or a US possession
- Research on internal-use computer software
- Research in the social sciences, arts, or humanities,
- Research funded by another person or government entity.
Qualified research activities must also show a proven nexus (connection) between the claimed expenses and qualified research activity.
What Tax Credits are Available? How Do These Tax Credits Work?
The tax credit is up to 20% of qualified expenses above a base amount. In addition, there is a small business payroll tax credit. The payroll tax credit is an annual election of up to $250,000.
Here's how these tax credits work: a business spends money, then makes an application for a tax credit.
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 an 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.
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.
Tax Policy Center. "What are tax credits and how do they differ from tax deductions?" Accessed Jan. 7, 2020.
IRS. "Instructions for Form 6765 Credit for Increasing Research Activities." Accessed Jan. 7, 2020.
IRS. "Instructions for Form 6765 Credit for Increasing Research Activities." Qualified Small Business. Page 2. Accessed Jan. 7, 2020.
IRS. "Instructions for Form 6765 Credit for Increasing Research Activities." Qualified Research. Page 1. Accessed Jan. 7, 2020.
IRS. "Avoid improper claims for business credits; topic makes this year's IRS "Dirty Dozen" list." Accessed Jan. 7, 2020.
IRS. "Instructions for Form 6765 Credit for Increasing Research Activities." Payroll Tax Credit Election. Page 2. Accessed Jan. 7, 2020.
IRS. "Instructions for Form 6765 Credit for Increasing Research Activities." Specific Instructions. Page 3. Accessed Jan. 7, 2020.
IRS. "Form 535 Business Expenses." Research and Experimental Costs. Page 24, Accessed Jan. 7, 2020.