While R&D tax credits continue to provide opportunities for companies to lower income tax liabilities, some organizations don’t get the full benefits.
How do Companies Qualify for R&D Tax Credits?
Some companies fail to claim the R&D credits because they don’t fully know the process. It may sound complex at first. But once you understand it, you will learn how to claim the R&D credit and lower your company’s tax burden.
There are several misconceptions about R&D tax credits and why companies don’t think they are eligible. Let’s find out what those misconceptions are and how you can qualify for a tax credit.
What are the common misconceptions companies have about R&D tax credits?
Below are the common reasons why companies fail to claim the R&D tax credit:
The employees aren’t degree-holders
The goal of the R&D tax credit is to empower companies in doing research and experimentation through hard sciences. Companies with large numbers of scientists and engineers have a higher chance of receiving tax credits.
It may include third-party contractors who helped improve the projects and processes and employees who initiated the experimentation.
The company doesn’t pay federal income taxes
Small businesses can claim up to $1.25 million each year for up to 5 years of the federal research and development tax credit. It will cover the annual Federal Insurance Contributions Act portion of their payroll taxes.
But for them to be eligible, they must meet the following requirements:
- To have gross receipts of less than $5 million for the credit year
- To have no interest income or gross receipt dating back more than five years
The R&D tax credit uses the federal income tax return on its calculation. Companies can apply it against payroll taxes at the beginning of the quarter after electing the credit.
For calendar-year taxpayers, they can use it against payroll taxes in April of the following year.
The company is not making any new development
R&D tax credits are for taxpayers who develop, design, or improve techniques, processes, software, or formulas – to reward them for pursuing innovation.
The calculation of the credits is based on the increase in research expenditures and activities. If there isn’t any new development, then the company isn’t eligible for the credit.
The company is subject to AMT
Some companies don’t qualify for the R&D tax credit because they are subject to alternative tax or AMT.
After January 1st, 2016, small businesses and individuals subject to AMT were able to use the tax credit in offsetting regular taxes and AMT.
How to determine if a company is eligible for R&D tax credits
Companies that encounter technological challenges and resolve them can qualify for R&D tax credits. It means that their eligibility will depend on the type of work they do.
The Internal Revenue Code and Treasury Regulations presented a four-part test to determine a company’s eligibility. Their work must meet the criteria through this four-part test.
What is the four-part test?
The four-part test is one of the highly sought guidelines to consult in determining if a business is eligible for a tax credit. To help clients, here is a summary of the test criteria:
- Qualified purpose. The research must aim to create a new or better business component, which results in a new or improved performance, quality, function, or reliability. It can be a process, product, technique, computer software, or invention.
- Elimination of uncertainty. To pass the test, companies must eliminate technical uncertainty regarding the development or improvement of a business component. There is uncertainty if the information doesn’t establish the method for improving or developing the business component.
- Process of experimentation. Businesses should be able to demonstrate that they followed a method to achieve their desired outcome. Examples of the process include modeling, ongoing testing, systematic trial and error, and simulation.
- Technological in nature. The experimentation process used in discovering the information should rely on hard sciences. It includes physics, engineering, chemistry, computer science, or biology. This part ensures that all newly uncovered information used a scientific process.
Companies must review their operations for eligible activities. If they want to claim the R&D tax credits, they must also be ready to support their qualifying activities.
What are the steps to claim the R&D tax credits?
The first step in claiming the research and development tax credit is ensuring you understand the qualification rules. You can do this by performing a feasibility analysis. The IRS explores and identifies R&D activities, along with the associated research expenses.
They use that information to estimate how much your federal state R&D tax credits are. Knowing how tax credits work helps you identify qualified activities to get a more accurate benefit estimate.
To claim the R&D tax credits, you need to submit the necessary documentation. Because of this, you must rigorously document any activities that you want to claim toward research.
You should be able to establish the amount you spent on qualified research activities.
Below are the types of documentation you may need to submit:
- E-mails
- General ledger expense detail
- Laboratory results
- Payroll records
- Project lists
- Project notes
- Other documentation your company generates through its regular course of business
These documents, along with credible testimony from your employees, can help you with your tax credit claim. You may also need to partner with a CPA or an accountant to make sure you are eligible for the tax credit.
Claiming the R&D tax credit
You can claim the tax credit on a timely filed federal tax return on the same year you incurred the qualified expenses.
You may also claim the credit by amending a return on or before the statute of limitations date, where you can report credits associated with the costs you incurred during that period. The statute of limitations grants three years after the filing date or original deadline to amend the return.
On average, organizations claim 7% to 10% of their qualified expenses as a federal R&D tax credit. For instance, an engineer who receives a W2 amounting to $100,000 annually may generate tax savings amounting to $10,000.
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