RESEARCH AND DEVELOPMENT TAX CREDIT

RESEARCH & DEVELOPMENT TAX CREDIT

  • Only 33% of businesses THAT QUALIFY Actually Claim It!
  • It is Estimated, in 2024, $50 Billion of R&D Tax Credits Went Unclaimed
  • 85% of the R&D Tax Credit Are Utilized By Large Corporation Because Smaller Companies DO NOT KNOW THEY QUALIFY
  • If You Missed the Credit in the Last Three Years, IT IS Not Too Late
  • Businesses MUST amortize R&D Expenditures, By Not Claiming the R&D Tax Credit, Businesses are Increasing Their Tax Liabilities without the Benefit of Significant Tax Credits Savings
  • Even Startups That Have Not Had Profitable Year May Qualify

The Research and Development Must Pass the Four-Part Test

Create or improve an existing product, process, technique, formulas, invention, patent or software, or improve the performance, functionality, quality, reliability or cost of a product or process (develop a new or improve an existing business component test), AND

The research is undertaken to discover information that’s technological in nature. That is, it relies on physics, biology, engineering, mathematics, or computer science. (the technological in nature test), AND

Can demonstrate that you have attempted to eliminate uncertainty about the development or improvement of a product or process (elimination of uncertainty test), AND

Demonstrate that you have evaluated alternatives for achieving the desired result, through modeling, simulation or systematic trial and error or other methods (the process of experimentation test)

R & D Tax Credit Calculator


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Our Steps to R&D Success

Getting Started

Meet with a member of our team to receive an overview of the R&D Tax Credit and review your eligibility. Our team will detail the documentation needed.

Initial Assessment

Our team will use this information & data to estimate what credit you are eligible for and establish an optimal claim timeline. If no credit is identified, there will be no cost for you!

Comprehensive R&D Study

Our technical consultants will determine the list of qualified R&D projects according the 4-part test while our tax consultants will work with you to ensure that the Qualified Research Expenditures (QREs) are accurate.

Report Writing & Finalization

Legacy’s team of Tax and Technical experts will work together to complete the calculations and provide your deliverables, including a detailed technical report and supporting documentation.

Receive your Benefits

After filing the proper documentation with the IRS and State, the R&D Tax Credit will reduce your income tax liability in the current tax year and refund for the previous 3 years. Any remaining credit can be carried forward up to 20 years.

R&D Study Review

Review your R&D Study Report with our Tax and Technical experts for the next year to increase efficiencies for future claims.

What Are the Benefits of R&D Tax Credits?

There are great advantages that R&D Tax Credits can offer a company, including:

Tax savings: The primary benefit of R&D Tax Credits is the tax savings they provide. Companies can use these credits to offset their income tax liability, reducing the amount of taxes they owe.

Cash flow: R&D Tax Credits can also provide a cash flow benefit for companies. If a company has more credits than taxes owed, it can carry the credits forward or back to offset taxes in other years

 Opportunity for innovation: By providing tax incentives for R&D activities, the government encourages companies to invest in new technologies and processes, which can lead to innovation and growth.

Competitive advantage: Companies that invest in R&D activities may gain a competitive advantage by developing new products or services, improving existing ones, or reducing costs through innovation

Job creation: R&D activities often require specialized skills and knowledge, which can lead to the creation of high-paying jobs in fields such as science, engineering, and technology

Are All Industries Eligible for the R&D Tax Credit?

The R&D Tax Credit is not limited to a specific industry. It is an activities-based tax credit. If a company’s employees or contractors are physically working in the U.S. or U.S.-controlled territories and meet the requirements of the four-part test, then you may be eligible, pending other criteria.
Below are industry-specific examples of activities your organization may be doing that could qualify for R&D tax credits:

Technology and Software Development:

⦁ Integration of new and legacy systems
⦁ Design and testing of systems, such as hardware or software
⦁ Modification of existing systems and processes to improve performance, scalability, security, or throughput
⦁ Improvements to off-the-shelf solutions to meet the needs of the taxpayer’s environment

Industrial Manufacturing:

⦁ Design, construction, and testing of prototypes or pilot models
⦁ Development of new construction or processing techniques to improve reliability in the manufacturing process
⦁ Development of new techniques to address health, safety and environmental concerns
⦁ Attempts to minimize product failure in the production process

Life Sciences and Pharmaceutical:

⦁ Experimentation with new or alternative materials or reagents into existing processes
⦁ Development of new or improved informatics or analytical tools
⦁ Clinical trials
⦁ CRO activities

Financial Services:

⦁ Integration of new platforms with in-house developed software
⦁ Development of new trading platforms
⦁ Integration of new financial products (e.g., crypto) into new or existing applications and systems
⦁ Financial modeling and the development of new algorithms

Food and Beverage:

⦁ Test kitchen activities
⦁ Development of new packaging techniques
⦁ Attempts to improve manufacturing processes

Energy Organizations:

⦁ Design and development of networks and systems to monitor energy capacity transmission
⦁ Development of new and improved batteries
⦁ Development of new biofuel production techniques

Architecture

⦁ Developing innovative design processes to enhance efficiency or sustainability
⦁ Creating software tools to streamline building design and construction workflows
⦁ Implementing advanced modeling techniques for structural analysis or energy performance optimization

Engineering:

⦁ Researching and developing new materials for use in aerospace, automotive, or electronics industries
⦁ Designing and testing prototype systems for improved product performance or safety
⦁ Innovating energy-efficient technologies for renewable energy systems or smart infrastructure

TO GET STARTED, Please fill out this form below.

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ELIGIBILTY FORM

Potential R&D Activities

Please select at least 1 option for each question. Doing so will confirm your full eligibility for an R&D credit.

Company Background

Company Information

R&D Frequently Asked Questions

The Credit for Increasing Research Activities (the “R&D Tax Credit”) is a government-sponsored tax incentive that rewards companies who conduct research and development in the United States and its territories. The R&D Tax Credit is a federal and state (most states) tax credit that can result in dollar-for-dollar reduction of taxes owed at year end. For startups that meet qualifying criteria, the R&D Tax Credit can be used to offset payroll taxes. Originally enacted in 1981 under the Economic Recovery Tax Act, the credit expired eight times and was extended 15 times until it was made permanent in 2015 under the Protecting Americans from Tax Hikes Act (PATH Act). Primarily a labor-based incentive, the R&D Tax Credit aims to promote U.S. innovation by creating positive cash flows and reducing taxes.

Typically, “Research and Development” implies laboratories, test tubes, and white lab coats. However, the IRS’s definition of R&D is rather broad, and can be applied to many industries including manufacturing, engineering, architecture, food & beverage, and software development. Any business of any size can claim the R&D Tax Credit if their R&D activities satisfy the 4-part test and the associated expenditures qualify under IRC Section 41.

A myriad of activities can qualify for the R&D Tax Credit. The intent of the R&D Tax Credit is to incentivize companies with employees or contractors physically in the U.S. to work on something new or improved for the company that is technically challenging and requires an iterative development process to resolve. There are two tests that companies can utilize to determine whether they have qualifying activities: 

Four-Part Test for Qualifying Activities

  • Permitted purpose: The activity performed must relate to a new or improved product, process or design (business component) in terms of: 
    • Function
    • Performance
    • Reliability
    • Quality
  • Technological in nature: The activity must fundamentally rely on principles of: 
    • Physical science
    • Biological science
    • Engineering
    • Computer science
    • Mathematics
  • Elimination of uncertainty: The activity must be intended to discover information to eliminate uncertainty concerning the capability, method, or design for developing or improving a business component.
  • Process of experimentation: The activity must be substantially related to identifying uncertainties in product, process, or design development, evaluating alternatives to eliminate those uncertainties, and testing or modeling to refine or discard those alternatives. These activities must constitute a significant portion of the company’s R&D efforts.

Heightened Three-Part Test: Additional Test for Internal Use Software

  1. Significant economic risk
  2. Innovativeness test
  3. Commercial unavailability

To help better determine eligibility, please be aware that the following activities listed below are non-qualifying activities:

  • Foreign research: Research activities conducted outside of the U.S., Puerto Rico or other U.S. territories.
  • Funded research: Research funded by a government grant or by a customer must be analyzed to determine whether the taxpayer bears significant rights to the research and economic risk associated with the research.
  • Routine testing, quality control, maintenance: Quality control testing or inspection to determine whether particular units of materials or products conform to pre-identified parameters is not qualified. Quality control testing determines if the design of a product or process is appropriate and may be qualified.
  • Adaptations, duplications, reverse engineering: Adaptation of an existing product to a particular customer requirement or needs without any technical uncertainty present.
  • Non-scientific research: Market research, efficiency surveys or advertising studies.
  • Aesthetics: Aesthetic changes to style, taste, cosmetic or seasonal changes.

Qualified research expenses include:

⦁ Employee wages: Portion of eligible W-2 box 1 wages for employees performing, directly supervising or supporting qualified research

⦁ Supplies:
⦁ Non-depreciable in nature unless related to prototypes
⦁ Extraordinary utilities
⦁ Materials used in testing
⦁ First-run production that is scrapped

⦁ Contract research: 65% of amounts paid to vendors or contractors performing research on behalf of the taxpayer physically within the U.S.

⦁ Research consortia: 75% of U.S.-based eligible work

⦁ Basic research payments: Payments made to a university or other qualified organizations

⦁ Computer lease or rentals: Amounts paid for cloud computing as it relates to development environments

These activities could qualify. There are certain requirements that must be evaluated to determine whether the R&D Tax Credit resides with you or the company that hired you.

R&D Tax Credits can be claimed by businesses in a number of industries, including software development, manufacturing, life sciences, engineering, architecture, food & beverage, aerospace & defense, and agriculture. Any company can claim R&D Tax Credits as long as they are undertaking activities that meet the requirements of the 4-part test:

⦁ Permitted Purpose: In simple terms, the purpose of the activity or project must be to create something new, or improve upon a product, process, software, invention, patent, or formula (referred to as a business component). The permitted purpose falls under a broad umbrella that includes improving functionality, performance, reliability, or quality of the business component. 

⦁ Elimination of Uncertainty: The activities and project in question must attempt to eliminate uncertainty related to the optimal design, development methodology, or component’s capability to achieve the permitted purpose.

⦁ Process of Experimentation: Substantially all of the activities constitute elements of a process of experimentation. The activities must include a systematic evaluation of alternative solutions to eliminate the technical uncertainty through, for example, trial and error or a Product Development Lifecycle (“PDLC”).

⦁ Technological in Nature: The activities and process of experimentation must rely on the fundamental principles of the hard sciences, including biology, computer science, engineering, physics, or chemistry.

Contrary to general belief, businesses do not have to have employees in white coats working in a laboratory to claim R&D Tax Credits. Many activities across a wide range of industries are considered qualified research expenses (QREs). Investments your company makes in developing innovative solutions, creating novel products and formulations, or even making process improvements are claimable expenses as long as the project satisfies the above 4-part test. 

The R&D Tax Credit is a comparative credit, which means that it will depend on the difference between current year qualified research expenses (QREs) and the base amount (calculated using prior year gross receipts and/or expenses). The more research expenses a company incurs year over year, the greater the tax credit will be. Typically, a company can expect a benefit of 7-10% of the federal QREs and another 2-12% in state credits (depending on the state). 

 

To get a better idea of your company’s potential R&D Tax Credit, use our Tax Calculator, or better yet, contact one of our R&D Tax Credit experts.

The R&D Tax Credit is a dollar-for-dollar reduction of federal income or payroll tax liabilities. R&D credits can be claimed on amended tax returns (going back three years), which can generate cash refunds due to overpayments in those years. Additionally, federal R&D Tax Credits roll forward for up to 20 years. 

 

For qualified small businesses (i.e. startups), these credits can be used to offset payroll tax owed to the IRS. Therefore, startups no longer need to be profitable to take advantage of the R&D Tax Credit.

 

In addition, most states also have an R&D Tax Credit available to offset various income, franchise, or sales and use tax liabilities.

Yes, if eligible R&D activities have been conducted in the past and the R&D Tax Credit has not been claimed in those years, taxpayers can still claim them for those open tax years. However, if the tax year has already been closed or the tax return has already been filed, the taxpayer cannot claim R&D Tax Credits for that particular year. This will vary from company to company, but generally, open statutes are in the current year and the prior three years. Depending on facts and circumstances (net operating losses, open audits, etc.), additional years may be open.

There are three main categories of expenses that can be claimed for the R&D Tax Credit:

⦁ Wages – Wages paid to employees who conduct qualified R&D activities, and the wages of the employees who directly supervise and support the research.

⦁ Supplies – Supplies and raw materials used or consumed in the R&D process, including prototyping and testing of a new or improved product, process, formulation, or patentable business component. This also includes expenses related to rental of cloud computing assets used in software development.

⦁ Contract Research – Payments made to third-party contractors, 1099 employees, or universities for technical activities conducted on the company’s behalf. These can include technical analysis or testing, design services, and other development activities for a qualified business component.

The more research expenses a company incurs year over year, the greater the tax credit will be. For all research costs in a given year, a company can expect anywhere from 7-10% in federal credits in addition to state credits (percentage varies), where applicable.

YES! a common misconception with research and development (“R&D”) tax credits is that you must be in a profitable tax position to utilize the R&D tax credits. This was the case prior to January 1st, 2016 or before the tax credit was permanently extended as a part of the PATH Act of 2015. However, the IRS provided guidance as part of Notice 2017-23 that describes how qualified small businesses (start-ups) can offset up to $250,000 of the employer portion of payroll tax liability (social security tax) for the eligible tax year. Eligibility – Your business must have less than $5 million in gross receipts in the current tax year and your business must not have gross receipts from more than five years ago. This applies to an “on-time” filing, meaning it’s not an amended return.

 

For Startup Companies: If your business has less than $5 million in annual revenue, and it’s been less than five (5) years since your first gross receipts/sales, you can frequently reduce your Social Security Payroll tax liability under the PATH Act R&D credit. If you do not qualify under the PATH Act R&D Credit, you can take regular R&D Credit against income taxes (rather than against payroll taxes).

The following activities are excluded from R&D Tax Credits:

⦁ Research related to arts, social sciences, or humanities are not considered qualified research activities.

⦁ Research conducted outside the U.S. or its territories is not eligible. 

⦁ Projects solely aimed at adapting or duplicating existing business components and reverse engineering existing products, processes or software.

⦁ Surveys, studies, activity relating to management function/technique, market research, routine data collection, or routine testing/quality control

⦁ Some software developed for internal use, but there are exceptions for this exclusion

⦁ Research funded by any grant, contract, or another person, conglomerate, or government entity

The Tax Cuts and Jobs Act (TCJA), passed in December of 2017, amended Section 174 to require capitalization and amortization of all research and experimental (R&E) costs incurred in the tax years beginning after December 31, 2021 (2022 tax year for calendar filers). Dating back to 1954, taxpayers could deduct their expenses in the same year they were incurred on their tax returns. 

Despite the bipartisan support, and numerous bills and acts introduced to repeal or defer the amortization requirements to provide taxpayer relief in the short term, it is unclear whether a legislative fix will be signed into law anytime soon. The TCJA’s stated purpose was to be an economic incentive to bring jobs back to the U.S. Companies that have never had to separate their section 174 expenses from regular expenses will face a new challenge with the recent change.

Section 174 will affect any industry and company that performs research but the software industry will likely take the biggest hit. The TCJA specifically called out software development expenses incurred in the tax years starting after December 31, 2021, as no longer tax deductible under Rev. Proc. 2000-50. Instead, these costs must be classified as Section 174 expenses and amortized as such. 

Therefore, any software development company that previously deducted its onshore and offshore software development related expenses will now have to capitalize and amortize these costs over five years, for domestic expenses, and fifteen years, for international expenses. Software businesses that retire, dispose, or abandon a software development related project will no longer be able to fully amortize the remaining capitalized costs.

The definition of qualifying research activities in each state is based on the federal tax credit regulations; however, the calculation methodology varies significantly from state to state. For example:

⦁ Some states provide a refund or exchange of unused R&D Tax Credits, so that even if a taxpayer has no tax liability it can still derive a cash benefit.

⦁ The R&D Tax Credits in some states have not been permanently adopted, and may expire in the future.

⦁ Most states require that the research activities must be conducted within their borders to qualify.

⦁ Some states do not offer the alternative simplified credit calculation.

⦁ In some states, basic research payments made to universities and certain non-profit organizations can be included in the calculations.
There are 38 states that currently allow taxpayers to claim the R&D Tax Credit. Below is the list of states that DO NOT offer the R&D Tax Credit:

⦁ District of Columbia

⦁ Missouri

⦁ Mississippi

⦁ Montana

⦁ Nevada


⦁ Oklahoma

⦁ Oregon

⦁ South Dakota

⦁ Tennessee

⦁ Washington

⦁ West Virginia

⦁ Wyoming

Previously, CPAs and taxpayers never had to determine whether or not the businesses expenses were Section 162 or Section 174 because all expenses were fully deductible on a tax return. However, many taxpayers businesses do fall under the Section 174 requirements and will need to amortize their research expenses on their tax returns accordingly. 

Taxpayers that have already claimed the R&D tax credit and are electing to forgo the 2022 R&D tax credit to instead fully deduct research expenses as Section 162 expenses (general business expense), should speak to a CPA and closely review your options. We anticipate the IRS will have a way to identify qualified Section 174 industries and taxpayers that are not amortizing their research expenditures. If you have previously claimed the R&D tax credit, suddenly claiming expenses under Section 162 (general business expense) will raise a red flag with the IRS. Research and development companies don’t generally stop doing R&D. R&D expenses should be claimed under Section 174.

This is a common misconception among small and medium businesses. Taking the R&D Tax Credit on a timely-filed return, including extension, does not increase your company’s audit risk. According to the IRS, only 0.9% of corporate tax returns and 0.2% of small businesses (S corps and partnerships) are randomly selected for audit. 

According to IRS guidelines, a return can be selected for audit based on a myriad of reasons. There is no directive that specifically targets companies who claimed R&D Tax Credits.

In addition, prior-year federal R&D Tax Credits can be carried back one year and forward up to 20 years. Once the company reaches profitability, those credits will be available for use. Each state is different when it comes to carryforward and carryback rules, but most follow the general federal guidelines.

To be considered a QSB, a company must meet these requirements:

⦁ Less than $5 million in current-year gross receipts;

⦁ Five or fewer years of gross receipts; and,

⦁ Have qualified research expenses.

Yes, the R&D Tax Credit can be claimed if the federal and state statute of limitations have not lapsed. For the federal credit, an amended return can be filed up to three years from the original filing date. Most states follow the same three-year statute of limitations; however, there could be state-specific regulations for the state in which your business operates. 

In order to understand the impact of this legislation, it’s crucial to understand the relationship between Section 174 Expenses and Section 41 Expenses. Section 174 Expenses are known as Research and Experimentation, or R&E Expenses. The expenses that fall under Sec. 174 can be divided into two categories, based on how essential each is to the activity being performed. Section 174 expenses encompass both direct and indirect research expenses (onshore and offshore) but are not necessarily eligible for the tax credit.  

Section 41 Expenses are known as Research and Development, or R&D Expenses. These are known as “Direct Research Expenses,” and are what usually come to mind when you imagine research and development. 
Section 41 expenses is a subset of Section 174 expenses, focusing only on direct research expenses that qualify for the R&D Tax Credit. 

While the R&D tax credit calculations, including the definition of QREs, are not changing, Section 41 expenses will no longer be deductible on businesses tax returns in the year they are incurred. By default, Section 41 expenses are classified as a Section 174 expense. The new Section 174 rules require companies claiming R&D credits to capitalize and amortize their expenses on their tax return—potentially increasing their tax bill and reducing their anticipated cash flow. As a result, the calculation of Section 41 should be the starting point in determining the potentially qualifying Section 174 expenditures and should be done concurrently.

Companies should work with their CPA to determine what the best estimated quarterly tax payment amount will be. If there’s no urgency to file this spring, a company should consider extending if possible—in the hopes that these changes are repealed in full or part. As CPAs wait for more guidance from the Treasury, taxpayers can still amend their 2020 and 2021 tax returns to generate unclaimed credits and potential cash refunds from prior years. And companies should look to see when they filed their 2019 tax return as the statute to amend and claim prior year refunds is three years from the filing date (2019 tax return filed in 2020). 

The R&D tax credits do expire if they’re unclaimed before statutes expire. It may be beneficial to roll the federal and state credits forward to be used to offset future income tax liabilities that may arise from the changes to Section 174 amortization. 

Yes, we’ll calculate the R&D tax credits and provide the necessary documentation & full instructions for your tax preparer to file. If you use Tax Prep Advocates, we’ll take care of the full process and file the necessary tax paperwork on your behalf as well.