Business owners who can identify and calculate qualified research expenses resulting from the innovation or improvement of products, services or processes may be eligible for the federal research and development (R&D) tax credit.
Does your business qualify for the R&D tax credit?
Business activities that improve products, processes or services in a way that requires some level of experimentation, research or trial-and-error may qualify for the federal R&D tax credit. No industry or business type is excluded, although some may be more likely to engage in qualified activities just by the nature of their operations.
Activities that generally do not qualify for R&D tax credits include:
- Projects that are:
- Conducted outside of the U.S
- Not based on engineering or the physical, biological or computer sciences
- Rely on aesthetics, arts, social sciences or humanities
- Funded by an unrelated third party
- Administration, non-technical supervision, scheduling or training
- Business requirement definitions, market research or fiscal feasibility studies
- End-user support and/or documentation
- Reverse engineering
- Research after commercial production
- Adaptation or reproduction of an existing business component
- Research related to surveys for efficiency, management of function or technique, marketing, and routine quality control testing
- Sales and marketing
- Repairs and maintenance
- Routine quality control/assurance
Qualified and disqualified expenses
As long as a business's expenses are related to research, development and product/service/process improvements, they may qualify for the federal R&D tax credit. Such expenditures fall into these main categories:
- Contracted services
- Computer rental or lease for certain web-based hosting purposes
Businesses can qualify based on any combination of these expense categories, as applicable.
R&D credit calculation options
Businesses have two ways to calculate the federal R&D tax credit – the regular credit method and the alternative simplified credit method. They usually benefit from using both approaches to see which one yields the larger credit in any given tax year.
In addition, certain small businesses may elect to claim the federal R&D tax credit against payroll taxes instead of income tax. For this purpose, a qualified small business is one with less than $5M in gross receipts for the tax year and no gross receipts for any tax year before the five tax years ending with the current tax year being calculated. The business must claim the payroll tax credit election on an originally filed federal income tax return.
How to calculate the R&D tax credit using the traditional method
R&D tax credit calculation using the traditional method is based on 20% of a company's current year QREs over a base amount. First, however, the fix-based percentage must be obtained by dividing the QREs for tax years during a base period by the gross receipts from the same period. The fixed-base percentage is then multiplied by the business’s average annual gross receipts for the four tax years prior to the year in which the credit is being calculated. The result is the base amount.
Note: When performing these calculations, the fixed base percentage must not exceed 16% and the base amount must not be less than 50% of the current year’s QREs.
Steps to calculate the R&D tax credit via the traditional method2
- Total the QREs for the current tax year
- Determine aggregate QREs over a base period
- Divide the aggregate QREs by the aggregate gross receipts over the same period to determine the fixed-base percentage
- Take the lesser of the fixed-base percentage calculated or 16%
- Multiply the fixed-base percentage by the average annual gross receipts from the previous four years to determine the base amount
- Take the greater of the base amount calculated or 50% of the current year’s QREs
- Subtract the minimum base amount from the current year QREs
- Multiply the result by 20%
How ADP can help your business claim the R&D tax credit
ADP works with clients to calculate R&D tax credits based on their unique business profiles and activities. We maintain relationships with government agencies and notify clients when there's a change in legislation that could affect their tax credit eligibility or their ability to comply with tax credit regulations. What's more, businesses who use ADP for payroll have access to data and reporting capabilities that can help streamline their R&D tax credit calculations.
Frequently asked questions about R&D tax credit calculations
Can R&D credits offset alternative minimum tax (AMT)?
Certain companies, specifically eligible small businesses (ESBs) with average annual gross receipts of less than $50 million over the three years preceding the current tax year can apply their R&D tax credits to offset AMT for years starting in 2016.
Can capitalized assets qualify for the R&D tax credit?
Capitalized assets do not qualify for the R&D tax credit because the supplies expense category only allows non-depreciable, income statement expenditures to be included in the credit calculation.
Does a failed attempt at a new product or process preclude a business from claiming the R&D tax credit?
An attempt at a new or improved product or process does not have to be successful to qualify for the R&D tax credit, as long as the business's expenses meet the statutory requirements. Note that for successful attempts, any expenses incurred after the development phase has ended are not eligible for the credit.
1 Source: IRC Section 41(d)(4), Reg Section 1.41-4(c)(1)
2 Journal of Accountancy
The article contains simplified examples for purposes of demonstrating some of the mathematical computations behind the credit. This does not account for impacts that stem from various company, business and tax factors that interplay with the R&D tax credit. Please consult an experienced tax professional to discuss the application of this information to your particular tax situation or to explore potential exceptions to this discussion that may apply.