How to Determine if Your Business Qualifies for R&D Tax Credits

As experienced tax professionals who help businesses claim their R&D tax credits, we can confidently say that this incentive is often ignored by small and medium-sized enterprises. This is due to a common misconception that the R&D tax credit is made only for researchers and scientists who work on revolutionary discoveries. However, the truth is that a wide range of business activities can potentially qualify for R&D credit.

The R&D tax credit is a dollar-for-dollar credit against your income tax liability, not just a deduction. This means that if your business qualifies, you can significantly reduce your tax burden while still deducting eligible R&D expenses. Additionally, many states offer their R&D tax credits, further amplifying the potential financial benefits.

Today I’ll walk you through the process of determining if your business activities meet the criteria for the R&D tax credit.

What is the R&D Tax Credit?

The Research and Development (R&D) tax credit is a federal tax incentive made to reward businesses that invest in the development or improvement of products, processes, or software. Contrary to popular belief, this credit isn’t limited to cutting-edge research conducted by scientists in lab coats. It’s available to various businesses, as long as they meet the IRS criteria.

The R&D tax credit allows companies to claim a portion of their qualified research expenses (QREs) as a dollar-for-dollar credit against their income tax liability. This means that if your business qualifies, you can directly reduce the amount of taxes you owe.

In addition to the federal credit, many states offer their R&D tax incentives, further compounding the potential savings. By claiming federal and state credits, businesses can significantly lower their overall tax burden and free up capital for reinvestment in other parts of their company: hiring, infrastructure, strategic initiatives, etc.

Companies across different industries, whether manufacturers or software developers, can benefit from taking advantage of the R&D tax credit. As long as your activities meet the IRS’s four-part test (which we’ll explore in the next section), you could be eligible to claim this tax incentive.

Activities That Qualify for the R&D Tax Credit

To determine if your business can be eligible for claiming R&D tax credits, the IRS uses a four-part test. All four criteria must be met:

• Permitted purpose test: the activity must be intended to develop or improve the functionality, performance, reliability, or quality of a product, process, technique, or software.
• Technical uncertainty test: at the outset, there must be uncertainty about the capability, methodology, or appropriate design for developing or improving the product or process.
• Process of experimentation test: the activities must involve a process of evaluating alternatives through modeling, simulation, systematic trial and error, or other methods.
• Technological in nature test: the process of experimentation must rely on the principles of physical or biological sciences, engineering, or computer science.

As long as your activities meet this four-part test, a wide range of efforts across various industries can potentially qualify. Here are some examples:

Examples of Qualifying Activities

• Developing or designing new products, such as innovative software, machinery, or consumer goods.
• Enhancing existing products or processes to improve performance, efficiency, or durability.
• Iterating and improving prototypes, beta versions of software, or pilot models.
• Streamlining manufacturing processes to increase automation, reduce costs, or minimize waste.
• Refining techniques like welding, machining, casting, or drilling to enhance capabilities.
• Advancing software systems to enable integration, interface with other platforms, or improve cybersecurity.
• Activities outsourced to third-party contractors, consultants, or engineering firms for research and development purposes.

This list is by no means exhaustive, as the R&D tax credit can apply to a broad spectrum of industries, including manufacturing, technology, architecture, engineering, and many more. As long as your efforts involve resolving technical uncertainties through a process of experimentation and technological problem-solving, they could potentially qualify.

Documenting and Claiming the R&D Tax Credit

Thorough documentation is crucial when claiming the R&D tax credit, as the burden of proof lies with the taxpayer. The IRS requires comprehensive records to substantiate your qualified research activities and associated expenses. Failing to maintain proper documentation can result in your claim being denied or challenged during an audit.

Some key documents you should keep include:

• Payroll records for employees directly involved in R&D activities.
• Receipts, invoices, and accounting records for supplies and equipment related to R&D.
• Contracts, agreements, and invoices for any external services or consulting related to R&D.
• Project notes, meeting minutes, design documents, and prototypes relevant to the research process.

To claim the R&D tax credit, you’ll need to complete Form 6765 and submit it with your business’s federal income tax return. This form has several sections:

1. A) For claiming the regular credit
2. B) For the alternative simplified credit
3. C) Additional forms and schedules
4. D) Qualified small businesses making a payroll tax election

The IRS recommends calculating your credit using both methods and choosing the one that provides the highest benefit.

Eligible Expenses

When calculating your qualified research expenses (QREs), you can include:

• Wages for employees directly involved in R&D activities, including supervision and support
• Cost of supplies and raw materials used in the research process or for prototyping
• Payments to third-party contractors, consultants, or other external services directly related to R&D
• Cloud computing costs if used for product, software, or process development

It’s important to note that for the 2024 tax season, the IRS is considering significant changes to the R&D tax credit reporting requirements. This could potentially include additional sections and detailed business component information, imposing a substantial reporting burden on taxpayers.

Why a CPA is a great idea

R&D tax credits if great opportunity for your business and at the same time quite complicated. There are many nuances that you should be aware of if you want to claim them. That’s why partnering with experienced tax professionals is critical when it comes to claiming R&D tax credits. Qualified CPAs and tax experts can:

• Conduct a comprehensive assessment of your business activities to identify all potential areas that may qualify.
• Guide tracking and documenting eligible expenses, including labor, supplies, and contracted services.
• Ensure your claim is calculated accurately and leverages the most advantageous method (regular or simplified).
• Stay up-to-date on the latest changes to reporting requirements, such as the proposed additions for the 2024 tax season.
• Represent your business in the event of an IRS audit, providing the necessary documentation and support.

With them, you’ll have a much higher chance to successfully claim your R&D tax credits.