Creating an app. Developing software. Improving a process. Launching a new product. Building or testing a prototype. Energy-efficient design. Adapting tools or equipment to streamline construction. Tailoring new materials for use in construction builds. These are all examples of projects that span all sizes of companies, many industries, and different business types. Each of these projects would probably qualify for the Research and Development (R&D) tax credit. The R&D tax credit is a refundable credit that puts money back into the hands of businesses that work to create, experiment, or improve a product or process.
Despite the savings potential, the incentive is still largely misunderstood by most business owners and managers. The most common issue is an erroneous belief that current activities do not qualify. This misconception often prevents Dallas and Los Angeles companies from investigating the tax savings opportunity presented by this credit. A concise understanding of what the R&D credit is and how it can be used can help businesses reclaim eligible research expenses.
On top of the federal benefit, most states have their own R&D credit too, including California and Texas. This could further extend the value for businesses that take the time to verify and document qualified expenses. Since the R&D credit is permanent, businesses do not need to worry about it phasing out. Below are some of the most common myths about the R&D credit – along with insights for proper understanding.
It’s only for large companies.
False: The R&D credit is available and can provide needed cash flow for businesses of all sizes.
When the R&D credit was first introduced, its complex calculations and requirements were mostly targeted and could primarily be used by large companies that owed a lot of tax. Through the years, legislative changes have further expanded the credit benefit to small and mid-sized companies in recent years.
It is only for companies with an official R&D Department.
False: The R&D credit is available to companies across a wide range of industries and does not require a formal R&D function.
All that’s required is meeting the four-part test and correctly and accurately tracking research expenses across departments. Qualified research expenses can also occur outside the organization. Most contract research expenses can be used toward qualified project costs.
The R&D credit is only available for successful business efforts.
False: A qualified research activity does not depend on the outcome of a bid or a project. Instead, eligibility hinges on if the activity meets certain criteria laid out in the tax code. You don’t have to achieve a breakthrough to qualify. It just needs to be an effort towards something new or improved for the business claiming the credit.
The company wasn’t profitable this year, so they don’t qualify.
False: The R&D credit can be carried back one year and carried forward up to 20 years. Additionally, businesses can still claim the R&D credit in years the company claims a loss. And in certain circumstances, the R&D credit can offset payroll taxes.
A qualified small business can apply the R&D credit to either payroll taxes (up to $250,000 annually) if the following conditions are met:
- Must be a qualified small business,
- Have payroll tax liability in the current year; and
- Qualifying research activities and expenditures meet the requirements set forth in IRC §41, including the four-part test.
An eligible qualified small business must have:
- No prior gross receipts (for startups) or no gross receipts for any taxable year preceding the 5-taxable-year period ending with the current taxable year; and
- You have less than $5 million in gross receipts as determined under the rules of § 448(c)(3) in the current taxable year.
This means that you do not have to be a startup company, so companies that have been in existence for many years that meet the requirements above may elect to use R&D credits to offset payroll taxes.
The business isn’t eligible because it’s not performing any new services or activities.
False: The R&D credit isn’t limited to one or a few industries. Any business, if it meets the criteria, can claim the R&D credit. Industries like the ones listed below most often have activities that qualify based on activities already being performed.
- Chemical & Formulations
- Food & Beverage
- Life Science
- Mechanical, Electrical, or Plumbing Contractors
- Tool & Die Casting
- Software/Information Technology
- Systems Integration
Research spending is flat or less than it was last year, so the company is ineligible.
False: The R&D credit does not require a significant increase in R&D investment or spending year-to-year; instead, the R&D tax credit rewards and incentivizes continued R&D efforts, such as incremental changes and improvements for new or existing business processes, and manufacturing processes, and products.
In fact, even if research expenditures are lower in a year, the business may still generate a credit. Expenses are not compared on a year-to-year basis but are compared to a look-back period made up of multiple years.
New R&D Rules for 2022
For taxable years on or after January 1, 2022, pursuant to the 2017 Tax Cut and Jobs Act (TCJA), new requirements kick in that change how the R&D credit can be utilized against taxable income. In essence, the R&D credit and research expenditures under 174, including software development, incurred on or after January 1, 2022, would have to be capitalized. There is pending legislation that would moving the effective date of this change from 12/31/2021 to years beginning after 12/31/2025. The current feel is still overall generally optimistic that the legislation will pass; however, there has not been movement on it since November. The most near-term impact to consider when planning around these changes, would be for quarterly estimates.
As it stands, businesses incurring research and experimental expenses under section 174, including R&D expenditures under section 41, would be required to amortize these expenditures over a 5-year period for domestic research activities and over a 15-year period for foreign research activities, rather than being able to expense them or apply the entirety of the credits against tax owed in the current taxable year.
The R&D tax credit is a powerful federal tax savings tool that often goes unclaimed because of misconceptions about eligibility. Now is the time to evaluate your company’s activities. If you have questions about the information outlined above or need assistance with an R&D credit assessment, JLK Rosenberger can help. For additional information call 972-931-6803 or click here to contact us. We look forward to speaking with you soon.