Business owners who receive a grant to fund research and development might immediately write off their tax credit eligibility, but that could be a mistake. Although the government can limit tax credits for funded research activities, grants and R&D tax credits are not always mutually exclusive. Business owners and CPAs who understand these implications may be able to make the most of tax credit opportunities, while still maintaining compliance.
How to use grants and R&D tax credits
Grants fund research initiatives that have not yet begun, while R&D tax credits cover qualified expenses for research previously conducted. Here’s how they can be used hand-in-hand in some circumstances:
- Apply for a research grant
Business owners have to prove to the government that their work is innovative and will positively impact society. There is a high degree of competition for grants and the application process can be challenging.
- Determine if the funded research tax exclusion applies
Businesses that meet certain financial risk and intellectual property rights criteria for research grants may be eligible for R&D tax credits on activities performed as part of the grant.
- Calculate and file the R&D tax credit
Organizations must show that they engaged in certain activities to develop new or improved products, processes, software, techniques, formulas or inventions. Those who understand what constitutes a qualified research activity and calculate the tax credit correctly generally have a high degree of success.
Examples of how grants and R&D tax credits work
In a typical example, a business just starting research and development can apply for a grant, which will serve as the startup costs for their project. After a year or two, they may apply for the R&D tax credit and use the benefit to fund future research initiatives. This scenario only applies, however, if the R&D passes the funded research tax exclusion.
Can grant recipients qualify for R&D tax credits?
Businesses that receive research grants may qualify for R&D tax credits as long as their activities aren’t considered funded research by the government. Funded research, as outlined under IRS Code Section 41(d)(4)(H), is “any research to the extent funded by a contract, grant, or otherwise by another person (or governmental entity).”
Ineligibility due to funding is determined using a two-part test known as the economic risk and substantial rights tests. First, applicants must show that payment for the R&D was contingent upon its success, and second, that they maintained substantial rights to the results of the research. Copies of contracts and all financial agreements are usually necessary to prove these points.
Research activities that don’t meet the economic risk and substantial rights criteria are generally considered funded and ineligible for the R&D tax credit. It helps to have professional assistance throughout the review process to determine if the legislative and judiciary definitions of the tests are met.
What types of grants can co-exist with the R&D tax credit?
Two grants that in some cases can co-exist with the R&D tax credit are the Small Business Innovation Research (SBIR) and Small Business Technology Transfer (STTR) programs, also known as America’s Seed Fund. Both provide the early stage capital small businesses often need to conduct R&D in ways that may lead to commercial success.
SBIR grants and the research and development tax credit
Small businesses may be able to maximize their investment in research and development by applying for both an SBIR grant and the R&D tax credit, provided they pass the funding exclusion criteria. Achieving this level of financial support isn’t impossible, but it’s also not entirely simple without professional assistance.
Businesses that are eligible for SBIR and meet all proposal requirements are subjected to a rigorous peer review process, which ensures that only the most exemplary scientific projects are awarded grants. Those that later seek the R&D tax credit may be asked to provide adequate documentation showing that their research expenses met IRS qualifications.
Who is eligible for SBIR?
Small businesses eligible for an SBIR grant1 must generally be:
- For-profit organizations located in the United States
- More than 50% owned and controlled by one or more individuals who are citizens or permanent resident aliens of the United States or by another small business that meets this same criteria
- Made up of no more than 500 employees, including affiliates
What are the three phases of SBIR?
Businesses who are awarded SBIR grants typically progress through three phases of R&D:
- Phase I
In this introductory phase, small businesses must demonstrate the technical merit, feasibility and commercial potential of their proposed R&D.
- Phase II
Based on their Phase I performance, participating organizations may receive additional funding to continue their research.
- Phase III
Small businesses begin to commercialize the results of their R&D activities, albeit without direct SBIR funding.
Differences between SBIR and STTR
The STTR program is similar to the SBIR in most regards, except that it requires small businesses to partner with a nonprofit research institution based in the United States. This partnership has three governing guidelines:
- Both parties must have a formal agreement that covers all details related to intellectual property rights, follow-on research and commercialization activities.
- R&D activities must be split so that the small business conducts at least 40% of the research and a single research institution partner performs at least 30%.
- The principal investigator may be primarily employed by the research institution.
Do grants under the Paycheck Protection Program affect R&D tax credits?
Businesses that received a Paycheck Protection Program (PPP) loan under the Coronavirus Aid, Relief, and Economic Security (CARES) Act to cover research-related activities can qualify for the R&D tax credit. However, they may need to reduce their qualified R&D salaries by the amount used in loan forgiveness. When assessing their 2020 expenditures, business owners may want to seek the advice of a reputable consulting firm to make sure they take advantage of any R&D tax credits available to them.
How ADP can help with grants and R&D tax credits
ADP has a diverse team of engineers, scientists, lawyers and CPAs dedicated to helping businesses identify, calculate and document the R&D tax credit. Our clients also rely on us for compliance expertise and can use the robust reporting capabilities that come with our payroll services to have more insightful consultations with their own CPAs. As a result, they may be able to maximize their tax savings and return on investment.
1U.S. Small Business Administration