What Your Clients Need To Know About Federal R&D Tax Credits

Many small- and medium-size businesses (SMBs) may be missing out on an opportunity to reduce their payroll taxes through research and development (R&D) tax credits. R&D doesn’t apply just to organizations doing hard core science. In fact, any business in any industry that is investing time, effort, and resources to improving products, processes, or solutions is eligible for the federal R&D tax credit and possibly state R&D tax credits. 

What is the Federal R&D Tax Credit?

The R&D tax credit was first established in 1981, in the Economic Recovery Tax Act (ERTA), in an effort to incentivize businesses to devote more resources to research and development that would increase productivity and strengthen the U.S. position in the global marketplace. Congress permanently extended the credits, starting with the 2015 tax year, through the Protecting Americans from Tax Hikes (PATH) Act of 2015. The act also allowed qualified small businesses to apply the research tax credits against any alternative minimum tax they may owe and against the employer share of the Social Security tax owed for each employee, which is significant because not every business pays income taxes. This “cash back” advantage is aimed at helping companies reinvest and continue to grow their business.

How It Works

The federal R&D tax credit is a dollar-for-dollar reduction of a company’s tax bill, based on qualified domestic expenses related to the design, development or improvement of products, processes, techniques, formulas or software. By the time it works its way through the tax compliance process, that net dollar-for-dollar ends up being about 6% to 8% of the total qualified research expenditures.

Activities that may qualify for the R&D tax credit include, but are not limited to the development or improvement of:

• Products (tangible or intangible)
• Processes (manufacturing processes, technical processes, etc.)
• Software (intended for either external or internal use)
• Formulas
• Techniques
• Inventions (patentable activities)

As part of the process, businesses need to identify qualifying expenses and provide adequate documentation that shows how these costs meet the requirements under Internal Revenue Code Section 41. Financial records, business records, oral testimony and technical documents may be used for this purpose.

A taxpayer who has qualified research activities should first perform an R&D study to determine their eligibility for the credit, as well as for satisfying the substantiation and documentation requirements required by the IRS. Once the credit amount is determined, complete Form 6765 and include it with the taxpayer's income tax return.

The R&D credit can be claimed either on an originally filed return or, in the case of credits generated in prior years, on an amended return. A credit that cannot be utilized in the year in which it is generated can be carried back one year, then carried forward up to 20 years, in accordance with general business credit carryover rules. For example, some companies bank the credits because they know there's going to be a future transaction that might generate a lot of taxes and they can use those credits to offset that coming event.

Not Just for the Big Guys

Any business that is innovating to remain competitive and or to grow market share may be performing qualified research and development.  Specifically, if your client is designing new products or processes, modifying their systems or even supporting research in a partner company, they might qualify for the R&D tax credit. 

Preparing for the Future

Companies today are looking at ways to make their business work more efficiently, more streamlined, smarter and with fewer employees. If your clients are engaged in any of these activities, they may be eligible for R&D tax credits.

This article was submitted by Michael Smith, Director of Tax, Strategic Partnerships & Alliances, with ADP.  

Attend the Financial Planning Series Session 

OSCPA's Financial Planning Series: ERC, R&D, Section 174 & Energy Tax Credits: Compliance & Planning Considerations
September 17 | Virtual | Recommended CPE: 2 hours

Learning Objectives:

• Provide an update on recent IRS guidance for ERC
• Review the history of R&D and 174 Amortization Change
• Interpret the draft form 6765 for 2024
• Analyze recent court cases related to R&D and ERC
• Discuss energy credits and the Inflation Reduction Act of 2022
• Develop a plan to monetize and utilize tax credits