Updated: Nov 10, 2021
Tax bill too high? Still needing to pay big taxes for prior glory years with today's economic-reality Dollars? Pandemic got you down? Business hurting? Financial future looking bleak?
Relief may be hidden in the folds of your own business. Did you know you could amend your prior-year returns to take real-dollar advantage now? Have you considered Research & Development (R&D) Tax Credit (Temporary availability before 2015; made permanent (by the PATH Act) since then!)? It is a relief-measure provided by the Federal Government in the form of a nonrefundable tax credit.
First introduced in 1981 as a temporary measure, sometimes becoming available at the "last minute", the R&D Tax Credit became permanent in 2015, thanks to the PATH Act! Now, Startups and small businesses can take advantage of up to $1.25 million of this federal tax Credit - to counteract the Federal Insurance Contributions Act (FICA) part of their payroll taxes each year.
The first steps to make the R&D Credit more universally available - though - were taken in 2003, when the Congress removed the "Discovery Rule" clause from the requirements of the Credit. Therefore, today the R&D functions of business concerns do not have to be "new to the world" to create valid credits - but new to the "Taxpayer"!
To start off, let's not get scared by the tax terminology; a "credit" erodes your tax liability, dollar-by-dollar (as opposed to a "deduction", which eats into your taxable income dollar-by-dollar (resulting in a smaller income-base to be taxed)).
"Non-refundable tax credit" simply means if the credit generated is more than the tax you owe in a given year, you are not entitled to a cash refund for the difference. For example: If you get a $600 credit, but the corresponding tax you owe is only $400, you will not receive a check for the remaining $200. (You would get $200 cash back if the credit was refundable - all else remaining equal.)
Here is the "beauty" of this "non-refundable" credit: even though you don't receive a refund in the current year for the excess amount of the credit over liability, your credit can be "carried-back" for one year, and forward for 20 years!
Moreover, if you believe you had qualifying expenses in any of the past three years, you can still amend those years, and entitle yourself to the rewards of this credit!
Now that we understand the basics: you do not think you qualify for an R&D Credit? Many businesses - and even CPAs still feel they/their clients do not measure up for this golden opportunity - the very mention of the term "Research & Development" conjuring up scary images of advanced laboratories and manufacturing sites. In recent years - however - the applicable rules have been overhauled to now include businesses of all sizes in more than 40 industries!
Note this: the R&D Credit can be as much as 20% of the your qualified R&D expenses over a given base amount in any single tax year. Who would not enjoy such a substantially reduced tax bill?
So, what exactly are the activities that qualify you? The terms cover a broader scope than one might realize, covering "a new or improved function, performance, reliability, or quality”. (One, however, needs to be sensible in defining these, as research in relation to "style, taste, cosmetic, or seasonal design" is not included in the Credit.) Also not allowed is foreign research, surveys, and a few others.
The definition of what is permissible could easily be applied to developing or improving models, prototypes, software, new technologies/enhanced end-products, and production processes. Payrolls, independent contractor payments, and materials may also qualify for R&D Credit.
NOTE the double advantage here: the above expenses are generally deductible from gross revenues to arrive at taxable income AND can be used for R&D Credit purposes!
Additionally, most states (all excluding 13 and DC) offer their own R&D Credits - which at times can be significant!
So why don't more companies claim this Credit?
- SIZE: To qualify, our business needs to be large. That may have been true at one time, but again, the PATH Act shattered that expectation. Now small businesses (i.e. nonpublic companies with less than $50 million in annual revenues for their most recent three years) can forever use R&D Credits generated post 1 January 2016 against both: regular and Alternative Minimum Tax (AMT).
- INDUSTRY: We need to be in manufacturing/specialized industries. Now - under new regulations - more than 40 industries qualify - so that manufacturing is only one in the crowd that is included in the R&D Tax Credit initiative.
- COMPUTATIONS: To figure out the complex calculations requires special expertise. The Congress passed the Alternative Simplified Credit (ASC) method in 2006, which simplified computations. However, a substantial level of expertise is still required to figure the credit, with proper documentation. For this reason, CPAs and others interested typically engage the services of R&D professional firms - thereby reasonably ensuring success in the event of an IRS and/or State probe.
- TOO RISKY: We are raising a "red-flag" to be audited. There is no evidence suggesting a proportionately higher rate of audits of the R&D issue than others, or an increased rate of audits since the Credit became more widely available. That said, when regulatory agencies do decide to probe an R&D Credit claiming entity, they approach the task with a sophisticated team of accountants, engineers, IT experts, and other professionals depending on the nature of the industry. Therefore, although a sensible proposition, firms are not advised to claim this credit unless properly equipped with professionals and experts on their own side to back up their claim. Typically, entities seeking this credit are engineering, manufacturing, architecture, or IT concerns. If you fit within these categories, and if the Credit claim does fit a rational trend from year to year, you would not stand out for claiming R&D.
So, how to tell if your business qualifies? You would be wise to investigate further if at least one of these conditions apply:
- created a software that is "unique" for internal (or external) use;
- had tax liabilities in recent years, and/or expect to have it for the current and future years;
- developed or made enhancements to existing processes, technologies, or products of your firm;
- attained, or applied for a patent;
- plans to develop or test new processes or products - or have hired third-parties (i.e. independent contractors) to do so.
Remember - even if you are a qualifying start-up, you can take advantage of the Credit. True, you may not have income, and therefore taxes to pay yet, but you are still likely to have payroll, and the R&D credit can erode part of your employer payroll taxes!