Calculating the Research & Development Tax Credit
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For Los Angeles and Orange County companies engaged in product or process improvement, few other tax benefits reap the substantial tax saving rewards of the Research and Development (R&D) tax credit. Available at the federal level and in most states, including California and Texas, the R&D tax credit helps to spur investments in innovation for startups, small businesses, and corporations alike. Many businesses understand that the credit amount is often significant, creating a compelling reason to examine the opportunity. However, knowing the credit is valuable is not the same as knowing how to calculate the potential savings opportunity.
The IRS offers two methods that can be used to determine credit value, including the Regular Research Credit and Alternative Simplified Credit (ASC). To help clients, prospects, and others, JLK Rosenberger has provided a summary of the key details below.
Regular Research Credit
The traditional method of computing R&D expenses produces a 20 percent credit against current-year qualified research expenses (over a base amount).
The following data is required for the taxable year and the three prior years:
- Annual Box 1 W2 Wages
- Any amounts paid for external consultants
- Cost of supplies used and consumed during the research process
Companies must also establish a historical base amount that must be exceeded to claim any current year credits. To calculate this base amount, the data detailed above is required for the four prior tax years as well as the taxable Gross Receipts for the same years.
If a company did not have gross receipts and QREs in the prior tax years, the same data is needed for each tax year that has occurred since the company performed qualified research.
- Add the total QREs for the current tax year.
- Find the fixed base percentage.
- Add the annual QREs over the previous four years.
- Find the average.
- Multiply the result in step 3 by the fixed base percentage.
- This is the base amount.
- Find the greater of the base amount or 50 percent of current year QREs.
- Subtract the minimum base amount from current year QREs.
- Multiply the result in step 6 by 20 percent.
- This is the amount of the credit.
When using the traditional credit for the regular research credit, the fixed base percentage cannot exceed 16 percent and the base amount cannot be less than 50 percent of current year QREs.
Alternative Simplified Credit Method (ASC)
The Alternative Simplified Credit Method produces a smaller R&D credit percentage but allows more companies to participate by substantially reducing the difficulty of calculating the base period in the Regular Research Credit method.
The following data is required for the current tax year and the three prior tax years:
- Annual Box 1 W2 Wages
- Any amounts paid for external consultants
- Cost of supplies used and consumed during the research process
Calculation:
- Calculate the QREs from the three prior tax years.
- Compute the average QREs from the three prior years.
- Compute one-half of the average QREs to determine the base amount for the current tax year.
- Reduce the current year QREs by the base amount.
- Multiply the remainder by 14 percent to calculate the gross credit amount for the tax year.
- Consider electing the 280C reduced credit if applicable.
What about State Credits?
California
California allows taxpayers to utilize the Regular Credit method with a generous 15% credit rate and a state-specific Alternative ZZZZ method to calculate the R&D tax credit. The Alternative ZZZZ method generates significantly smaller credit amounts, so California taxpayers are encouraged to utilize the Regular Method whenever possible.
Texas
Texas only allows taxpayers to utilize the ASC methodology for calculating credits and has a 5% credit rate.
R&D Credit for Payroll Expenses
For either calculation method, a portion of the R&D credit can be used to offset up to $250,000 in employer social security payroll expenses, but only for certain companies. To qualify, an eligible small business must have no more than five years of gross receipts and less than $5 million in gross receipts for the year the R&D credit is being claimed. In this case, the R&D credit carryforward must be adjusted to account for the amount of payroll tax credit claimed.
What to Know About the R&D Tax Credit?
Deciding which calculation method to use and whether to use a portion of the R&D credit to offset payroll or AMT depends on the circumstances. All else being equal, there are a couple of scenarios where it might make sense to use one method over the other. For example, if QREs decline significantly, the alternative method may be more appropriate. However, if the traditional method is available, it is recommended to figure the calculation both ways to see which produces the most benefit.
We’re Here to Help
Calculating the Research & Development tax credit is a complex process that most often requires the assistance of a specialized tax consultant. The details of each calculation method illustrate just how challenging the process can be. If you have questions about the credit or calculation methods or are interested in finding out if your organization qualifies for these credits, JLK Rosenberger can help. For additional information, call us at 949-860-9902 or click here to contact us. We look forward to speaking with you soon.
