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For most Texas and California businesses, activities like creating a new software system for sale, lease, or license, developing new software systems to support internal business processes, creating new development tools, and improving existing software systems or tools comprise most of their software development activities. Since the focus is usually on completing the project, it is rare when consideration is given to whether the business could claim a tax credit. In many circumstances, these activities would qualify for the Research & Development (R&D) Tax Credit. The credit is available to businesses that develop new or improved products, processes, or software systems. Unfortunately, most software companies do not take advantage of the benefits they are entitled to due to the misconception that the credit is only available to large companies and/or companies performing traditional laboratory research. The truth is that the R&D credit is a commercial credit available to companies of all sizes. In fact, the rules have been updated in recent years to provide small and mid-sized businesses the ability to claim and utilize more credits than ever before. JLK Rosenberger has provided the following R&D tax credit summary to help our clients and prospects determine if they can benefit from the R&D credit.
The R&D tax credit was enacted in 1981. Early on, the regulations required that the company’s activities expand or refine the principles of the industry to qualify for the credit. This requirement restricted the utilization of the credit to large companies with extensive R&D budgets. Over time, access to the credit has expanded so that virtually any type of business could benefit.
In 2015, Protecting Americans from Tax Hikes (PATH) Act made the R&D credit permanent and extended eligibility to startups and small businesses. Eligible companies can take the R&D credit against payroll taxes up to $1.25 million or $250,000 annually over five years. Additionally, private companies can claim the R&D credit against alternative minimum tax (AMT) obligations if the company’s prior three years of gross receipts averages less than $50 million.
Qualified Research Expenses
Given the role that technology plays in every business, there are many potential applications for the R&D credit. Qualified research expenses are divided into two categories: in-house and contract.
- In-house research expenses often include wages and supplies.
- Contract research expenses include any amount paid to a taxpayer other than an employee for research capped at 65 percent of the total amount paid for qualified activities.
Taxpayers should be aware that a project does not have to succeed to claim the R&D credit. As long the activities qualify for the credit, the expenses can be included in the R&D credit calculation.
Calculating the Credit
There are two ways to calculate the credit, including the traditional and alternative simplified methods.
Under the traditional calculation, the R&D credit is equal to 20 percent of the current year’s qualified research expenses over a base amount, which is based on four prior year’s R&D expenses and gross receipts.
The alternative simplified calculation (ASC) is utilized by most small and mid-sized companies. The ASC is a 14 percent credit of the total qualified expenses less 1/6 of the three prior year’s expenses.
First-time R&D filers or companies without historical R&D data may find the second method more suitable, but every situation is unique.
The R&D credit can be carried forward up to 20 years or offset payroll or AMT taxes for some taxpayers. It is available to companies for the current tax year and any other open tax years. This allows companies to claim the credit for three prior years for federal purposes, three prior years for Texas taxpayers, and four prior years for California taxpayers.
If there is more than one research activity, ensure that documentation for each one is tracked and maintained separately. It’s a good idea to keep track of all expenses as they occur and eliminate any non-qualifying ones later, for example, meals and travel expenses. For contract-based R&D expenses, the party that retains the rights is eligible to claim the R&D credit. Review appropriate contracts to discern which entity – the business or the contractor – bears most of the financial risk if the project fails as well as ownership rights. Another tip is to request itemized invoices and separate project billings.
Taxpayers are required to provide financial and technical documentation to substantiate their R&D credits. This documentation often includes:
- W-2s and payroll reports (or 1099s for contractors)
- Time questionnaires or other time tracking data
- General ledger vendor expenses
- Purchase orders or invoices
- Project documentation
- Other documents, as appropriate
Reasonable estimates may be used if precise data is unavailable, especially for wages.
Timing Matters Under Section 174
The Tax Cuts and Jobs Act (TCJA) did not alter the R&D credit, but it did contain a language change. Effective for tax years beginning after December 21, 2021, Section 174’s reference to qualified research expenses will change from ‘research or experimental expenditures’ to ‘specified research or experimental expenditures.’ Although the change may appear inconsequential, it has a significant impact on the value of the credit. As a result, companies should act quickly to take advantage of the credit now.
We’re Here to Help
Businesses in all industries should review expenses at least yearly to determine whether any activities meet the requirements for the R&D credit. Given the complexity of R&D tax credit regulations, it is important to work with a qualified advisor to walk you through the process. If you have questions about the information outlined above or need assistance with claiming the R&D tax credit, 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.