If your company invests time and money into research that improves products, processes, or business components, you might qualify for the Research & Development (R&D) tax credit. The R&D tax credit is an opportunity for businesses who utilize technology or hard sciences to reduce their tax burden by demonstrating that their work improves processes or products in their industry.
By reducing the effective tax rate of a business, the R&D credit can help qualified businesses improve their cash flow – something that has become more important than ever in 2020.
History of the R&D Credit
This credit has been around since 1981, and provides both federal and state tax benefits. Worth as much as .15¢ for each dollar that qualifies, this credit can be carried back 3 years (4 in California) and forward 20 years. Qualified small businesses can use this credit to offset the social security portion of the FICA payroll taxes.
Businesses that frequently qualify for the R&D credit include those in the following industries:
- Architecture
- Engineering
- Biological studies
- Brewing
- Chemical or formula development
- Fabrication
- Food & Beverage
- Mechanical
- Machining
- Manufacturing
- Software development
- Tool & die production
- Wine production
To determine whether or not you may qualify for the R&D, use this 4-part test to help you evaluate your activities. In order to qualify, a business must satisfy all four criteria.
Permitted Purposes
To qualify for the R&D credit, the activity must relate to the company improving or developing new business components. These activities do not necessarily have to be successful. IRS regulations define “business components” as products, processes, techniques, inventions, formulas or software.
Technological in Nature
The business’s activity must be considered “technological in nature”, meaning that it must fundamentally rely on principles of hard sciences such as engineering, computer science, physical sciences, biology, or chemistry.
Elimination of Uncertainty
In order for the business to be considered to perform beneficial research and development, the activity must eliminate uncertainty. This could be in the process of developing or improving a product or process, or by removing uncertainty regarding product design. Examples of uncertainty would be “Can it be done?” or “How can it be done?”
Process of Experimentation
The activity must include the process of experimentation, such as systematic trial and error through simulation, weighing alternatives, forming hypotheses, testing, modeling, and refining hypotheses.
Non Qualifying R&D Activities
There are also activities that specifically do NOT qualify for the R&D credit. These include:
- Research already funded by a grant or similar source;
- Research done outside the US;
- Adaptation of current product to meet customer need;
- Non functional improvements such as style or cosmetic changes;
- Management studies or activities;
- Efficiency studies or consumer surveys; and
- Research after commercial production.
The R&D tax credit was recently made permanent, and more accessible for small and medium-sized businesses. If you think your business might qualify for the R&D tax credit, ask your CPA about it.
