Although it may seem like the IRS research and development (R&D) tax credit is only available to researchers and scientists, it actually offers small businesses the opportunity to reduce their tax liability. CO— spoke with Dave Tilstone, executive director of business development at bavius technology and head of business development at iT SpeeX, to learn more about the R&D tax credit and how to apply it to your 2023 tax return .
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What is the Research and Development Tax Credit?
The Research and Development Tax Credit was originally established in 1981 to encourage innovative research and development throughout the United States. The Protecting Americans from Tax Hikes (PATH) Act of 2015 made the research and development tax credit permanent, changed benefits for small businesses, and made the tax credit available to startups. While 'research and development' may bring to mind white coats and breakthrough discoveries, this credit can be applied to a wide range of business activities.
“The truth is, it's not complicated to qualify for credit,” Tilstone said. “Your company simply needs to work on improving its products and processes here in the U.S. There are many Qualified Research Activities (QRAs) that apply to thousands of companies, including small and medium-sized businesses in a myriad of industries.”
Tilstone says that while virtually all large companies apply for the credit, unfortunately fewer than three in 10 apply for the credit. Small businesses often end up leaving a lot of money on the table due to common misconceptions about this particular type of credit.
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It's worth taking the time to determine which parts of your business operations may qualify for this credit. “For every dollar he spends on qualified research, he gets 13 cents back,” says Jim Breese, former CMO of Green Growth CPAs. Each state also offers research and development tax credits at different tax rates. To estimate how much you can claim for this credit, try aliantgroup's R&D tax calculator.
What activities qualify for the research and development tax credit?
Companies can claim two broad categories of activities for R&D tax credits: QRA (also known as qualified research expenses (QRE)) and basic research payments. Most small businesses can claim expenses based on QRE categories.
“For example, architecture firms can qualify for credits by designing master plans and building systems, which are routine practices in this sector,” Tilstone said. “People in the software and technology industry can qualify by designing and implementing cloud-based IT solutions. Manufacturers can qualify for credits when developing second-generation products. The possibilities are endless, which makes credit extremely flexible and valuable.”
Here are some other examples of activities for which you can use this credit:
- developing or designing new products;
- Enhance existing products or processes.
- Developing or improving existing prototypes and software.
- Streamline manufacturing processes and increase automation to reduce costs and waste.
- Improve technologies already in place, such as manufacturing, welding, and drilling.
- Advances in software to bridge and interface between external entities (business-to-business or business-to-consumer) or internal multiple systems.
- This is a service outsourced to an external consultant.
Consult your tax professional to determine whether any aspect of your business operations qualifies for the research and development deduction.
Often, even if a new customer receives a credit, they find that they have undercharged the credit.
Dave Tilstone, Executive Director of Business Development, bavius technology, Head of Business Development, iT SpeeX
How to apply for research and development tax credits
The IRS requires documentation to support your claim for the Research and Development Tax Credit. Experts recommend rigorously documenting the activities you wish to claim for research to establish how much money has been spent on eligible research activities. The burden of proof is on the taxpayer, so it is necessary to keep the following documents:
- Payroll records for employees involved in research and development.
- Expenses, receipts, and accounting for supplies and equipment related to research and development.
- Contracts and invoices paid to third party partners involved in research and development.
- Blueprints, patents, designs, drawings, and prototypes related to research.
- Project and meeting notes related to research.
Tilstone strongly recommends that you work with a CPA or accountant to confirm your eligibility for this credit.
“Even if new customers actually receive credit, we often undercharge them for that credit,” he said. “During these difficult times, we've found that small businesses are able to use the capital they receive from credit as a lifeline to keep their doors open and their employees paid. Perhaps your colleagues have too. You'll be using this tool to get through this difficult time. Credit brings in funds for businesses to hire new employees, invest in new infrastructure, integrate new technology to increase competition, and more. It can be used for any growth efforts.”
Companies seeking to submit eligible research and development expenses must complete Form 6765, which includes the following four sections:
- Section A is for businesses requesting regular credit.
- Section B is for alternative simplified credit.
- Section C allows for additional forms and schedules.
- Section D is intended for eligible small businesses that make payroll tax elections.
The IRS recommends that businesses use the regular simplified method to calculate deductions and select the section that provides the highest tax benefit.
The IRS is considering major changes to the research and development tax credit for the 2024 tax filing season. If adopted, it could impose a significant reporting burden on taxpayers seeking to claim this tax credit. Possible changes include the addition of a new Section E containing various questions about five businesses and a new Section F that requests detailed information related to business components under Section 41 of the Internal Revenue Code.
Procedures for applying for research and development tax credits
Applying for the Research and Development Tax Credit can be done in three easy steps:
- Examine your research and development processes internally to identify activities and associated costs. This requires a thorough review of financial records and business documents.
- Build your case by gathering the necessary documents to support your claim and completing the necessary forms showing your total costs.
- Complete Form 6765 and submit it with your business' federal income tax return to claim the credit.
4-part qualification exam
To determine whether your business qualifies for the federal research and development tax credit and its potential benefits, consider this four-part test under IRS Section 41.
- Section 174 test: Expenditures should be related to your trade or business, reducing uncertainty regarding development and improvement.
- Technical information discovery test: The experimental process must be based on physical science, biological science, engineering, or computer science.
- Business component test: Your business must have the intention of suggesting the discovered information to develop new or improved business components and linking research to relevant aspects of the business.
- Experimental test: If the outcome is initially uncertain, the process should evaluate other methods and designs.
All four of these criteria must be met to qualify.
Research and development tax credits include miscellaneous costs associated with household labor, supplies, contract services, and cloud computing related to product, software, or process development. Eligible labor includes the wages of employees directly involved in the technical design, prototyping, testing, and supervision of products. Certain supplies used in research and development, such as unrecovered raw materials, are also eligible for the research and development tax credit. However, the contract cost must include the economic risk of the work and typically applies to development, engineering, and research contracts.
Type of business covered
Research and development tax credits remain underutilized, primarily because eligible companies do not fully understand their potential. An estimated 14,000 businesses in the U.S. applied for the credit in 2022.
This credit is available to businesses of all sizes. Eligibility for this tax credit depends on whether the company invested in activities recognized as research and development by the IRS within commonly eligible industries such as manufacturing, software, financial services, and agriculture. Regardless of your industry, exploring this tax credit opportunity can optimize your business' financial performance and lead to better resource allocation.
This article was originally written by Emily Heaslip.
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Do I need to file a claim with ERC?
Small businesses considering taking advantage of the Employee Retention Credit (ERC) should carefully evaluate all eligibility requirements and closely follow IRS guidance. It is essential to choose the right advisor who will evaluate your eligibility, understand the eligibility limitations, and educate you on the income tax implications. Trust Experian's tax experts to help your business navigate the complex ERC environment.