As tax professionals currently find themselves working on 2017 tax returns, now is the time for business owners and managers to be reminded of a very important opportunity—the Research & Development Tax Credit.
What is the Research & Development Tax Credit?
The Internal Revenue Code provides a dollar-for-dollar tax credit for what they have named increasing research activities. This credit is a federal, and in many instances a state, government-sponsored tax benefit that provides economic incentives for companies of all sizes conducting research and development activities in the U.S. The credit is intended to encourage innovation across all industries and to inspire businesses to create new products, services, and opportunities for the country’s future.
What many taxpayers don’t know is that the research and development activities that qualify for the credit don’t necessarily need to be performed by large companies or be related to special scientific laboratory-based projects. In fact, many activities that qualify are often related to a company’s daily activities.
Most businesses hold the beliefs that the credit is not available to businesses that fail in their research and development activities or are recognized as government contractors because their activities are funded by the government. In reality, success is not required to be eligible as long as the proper efforts are present. Additionally, research performed by government contractors may qualify depending on whether they are subject to financial risk under their contracts. For example, any fixed-price contracts would certainly meet the requirements. Any company that has invested capital and resources in an effort to improve its products and processes at its own risk may be eligible to claim research and development credits.
What are the Requirements to Qualify?
Taxpayers must meet all requirements of a four-part test in order to qualify for research and development credits.
- Activities must be in an effort to provide a new or improved function, performance, reliability, or quality.
- Activities must be performed to eliminate technical uncertainty in products, processes or techniques beyond cosmetic changes.
- Activities must include a process of experimentation in order to eliminate the technical uncertainty discussed. This could include using any of a number of methods including the scientific method, hypothesis testing, modeling, and even trial and error.
- Activities must be technological in nature and rely upon principles of the biological or physical sciences, engineering or computer science.
There are, however, a few specific activities that will not qualify for credits. This includes efficiency surveys, management studies, market research, routine data collection, and quality control testing.
Assuming the activities performed to meet the requirements above, eligible qualified research expenditures, including:
- Wages paid to employees engaged in qualified research or in the direct supervision of qualified research.
- Legal fees for patents.
- Contract research expenses.
- Supplies including prototypes, testing materials, tangible property other than land and depreciable property.
What are the Benefits?
The Research & Development Tax Credit is permanent and can provide a benefit of up to around ten percent of annual research and development costs at the federal level and companies that do business in states which also allow the credit (39 states allow the credit at last count) could recognize additional benefits.
As stated above, the Research & Development Tax Credit is a dollar-for-dollar credit (not a deduction) which directly offsets any federal tax liability. Any credit not used currently can be carried forward up to 20 years and offset tax liability in future periods. In addition, credits can be claimed for all open tax years allowing taxpayers up to three years from the date of filing to amend a prior period return and file retroactive claims.
How Do I Determine If I Qualify?
Due to the complexity of the tax rules, the analysis needed and the documentation requirements, a professional consultant should be engaged. Taxpayers should also consider the time needed to complete the determination process and taxpayers and tax practitioners alike will need to plan ahead to make sure complete information is available to determine and apply the proper expenditures and credits. If you have any questions or would like to discuss potential Research & Development Tax Credits, please contact your Aronson tax advisor at 301.231.6200.