Small businesses often face significant financial challenges when it comes to investing in research and development (R&D). The Research and Development Tax Credit is a tax incentive designed to encourage small businesses to invest in innovation and advanced technology, ultimately driving growth and competitiveness in their industries. Despite its potential benefits, many small business owners may be unaware of the tax credit and how to take advantage of it.
This guide is designed to help small business owners understand the research and development tax credit, including eligibility requirements, calculation methods, and the application process. It will also provide best practices for claiming the tax credit, including working with a tax professional and keeping accurate records. By the end of this guide, small business owners will have a comprehensive understanding of the research and development tax credit and the potential benefits it can provide to their businesses.
Eligibility for the Research and Development Tax Credit
To be eligible for the Research and Development Tax Credit, a small business must engage in qualifying research activities, meet certain criteria related to the research activities, and have expenses associated with the activities.
Qualifying Research Activities
Qualifying research activities generally involve activities that seek to create new or improved products, processes, software, or inventions. This can include activities such as developing new technologies, experimenting with new materials, conducting scientific or engineering research, and designing prototypes or models.
Criteria for Eligibility
To be eligible for the tax credit, the research activities must meet four criteria:
- Technological in nature: The research activities must rely on the principles of physical or biological sciences, engineering, or computer science.
- Performed for a qualified purpose: The research activities must be undertaken to create a new or improved product, process, software, or invention that will be used in the taxpayer’s business.
- Elimination of uncertainty: The research activities must involve a level of uncertainty that cannot be resolved through conventional methods.
- Process of experimentation: The research activities must involve a systematic process of experimentation, such as testing hypotheses or developing and evaluating prototypes.
Expenses Associated with Eligible Activities
Eligible expenses include wages paid to employees directly involved in the research activities, supplies used in the activities, and any contract research expenses paid to third-party contractors. The expenses must be incurred within the United States and cannot be reimbursed by another entity.
Recent changes to eligibility requirements include the elimination of the “Discovery Rule,” which required that research activities be “new to the taxpayer” in order to qualify. Additionally, the new law allows certain start-up businesses to use the tax credit to offset payroll taxes.
Small business owners should consult with a tax professional to determine if their research activities meet the eligibility criteria for the Research and Development Tax Credit.
Calculation of the Research and Development Tax Credit
The Research and Development Tax Credit can be calculated using either the Regular Credit Method or the Alternative Simplified Credit Method.
Regular Credit Method
The Regular Credit Method is calculated based on a percentage of the taxpayer’s qualified research expenses (QREs) for the taxable year. The credit rate is generally 20% of the excess of the current year’s QREs over a base amount. The base amount is calculated as a percentage of the taxpayer’s average annual QREs over the previous four years.
Alternative Simplified Credit Method
The Alternative Simplified Credit Method is a simplified method of calculating the credit, which is designed to make it easier for small businesses to claim the credit. This method allows taxpayers to claim a credit of 14% of the excess of their current year’s QREs over 50% of their average annual QREs for the previous three taxable years.
Recent Changes
The Tax Cuts and Jobs Act of 2017 made several changes to the calculation of the Research and Development Tax Credit, including the following:
- The credit can now be carried forward indefinitely (previously, the credit could only be carried forward for 20 years).
- The credit can be used to offset Alternative Minimum Tax liability.
- The credit is now available to offset payroll taxes for certain start-up businesses.
It’s important to note that claiming the Research and Development Tax Credit can be complex, and accurate documentation of QREs is crucial. Small business owners should consult with a qualified tax professional to ensure that they are accurately calculating the credit and submitting all required documentation.
Applying for the Research and Development Tax Credit
To claim the Research and Development Tax Credit, small business owners must complete and file Form 6765 with their tax return.
In addition to the form, small business owners must provide documentation to support their claim for the credit. This can include records of expenses related to the research activities, including employee wages, supplies, and third-party contractor costs. It’s important to keep accurate records of these expenses, including details on how they relate to the qualifying research activities.
Recent Changes
The Protecting Americans from Tax Hikes (PATH) Act of 2015 introduced new provisions to make it easier for small businesses to claim the Research and Development Tax Credit. These provisions include the following:
- The credit can now be claimed on amended tax returns (previously, taxpayers had to file an amended return within 60 days of the due date of the original return).
- The credit can now be applied against the alternative minimum tax (AMT).
- The credit can now be used to offset payroll taxes for certain start-up businesses.
Working with a Tax Professional
The Research and Development Tax Credit can be complex, and small business owners should consider working with a qualified tax professional to ensure that they are accurately claiming the credit and complying with all reporting requirements. A tax professional can also help identify all eligible expenses and activities, as well as assist with recordkeeping to support the credit claim.
Best Practices for Claiming the Research and Development Tax Credit
Small business owners should follow best practices when claiming the Research and Development Tax Credit to ensure that they are accurately calculating the credit and submitting all required documentation. Here are some best practices to consider:
- Identify all eligible expenses and activities: The IRS has strict guidelines on what expenses and activities qualify for the Research and Development Tax Credit. Small business owners should work with a tax professional to identify all eligible expenses and activities and ensure they are properly documented.
- Keep accurate records: It’s important to keep detailed records of all expenses and activities related to the research and development activities. This documentation should include dates, descriptions, and supporting documentation.
- Conduct a contemporaneous review: A contemporaneous review is an ongoing process of reviewing and documenting research activities and expenses as they occur. This can help ensure that all eligible expenses are properly documented and help avoid potential problems during an IRS audit.
- Consult with a tax professional: The Research and Development Tax Credit can be complex, and small business owners should consider working with a qualified tax professional to ensure that they are accurately claiming the credit and complying with all reporting requirements.
- File the correct form: To claim the Research and Development Tax Credit, small business owners must file Form 6765 with their tax return. Ensure that the form is completed accurately and all required documentation is included.
- Consider amended returns: Small business owners can claim the Research and Development Tax Credit on amended returns. If you missed claiming the credit in a previous year, consider filing an amended return to claim it.
By following these best practices, small business owners can maximize their chances of accurately claiming the Research and Development Tax Credit and avoid potential problems during an IRS audit.
Conclusion
In conclusion, the Research and Development Tax Credit is a valuable tool for small business owners to incentivize innovation and growth. However, claiming credit can be complex, and accurate documentation of qualified research expenses is crucial. Small business owners should work with a qualified tax professional to ensure that they are accurately calculating the credit, submitting all required documentation, and complying with all reporting requirements. By following best practices and staying up to date with recent changes to the tax code, small business owners can maximize their chances of successfully claiming the credit and reap the benefits of this valuable incentive.