R&D tax credits encourage research that may not be economically feasible in the short-term but that supports society in the long-term.
Federal research and development tax credits, which were originally established in 1981 as temporary credits, were finally made permanent with the passing of the Protecting Americans From Tax Hikes (PATH) Act in 2015. According to CFO.com, this extended the federal research and development (R&D) tax credit, which had expired on Dec. 31, 2014, retroactively from Jan. 1, 2015. The PATH Act also significantly broadened the number and size of businesses that can take advantage of this investment tool.
According to CFO.com, any business that engages in basic or applied research in the design or development of new processes or products may be eligible for the federal R&D tax credit. This includes traditional R&D industries such as biotech and software. However, many other industries engage in activities that meet the following four criteria:
- Engage in experimental process that is capable of identifying and evaluating one or more alternatives to achieve a result
- Performed to discover information toeliminate technical uncertainty concerning the capability, method or design, which includes simulation modeling, simulation and focused trial and error
- Rely on the sciences, such as physics, biology, engineering or computer science
- Create a new or improved process or product, computer software, technique, formula or invention that achieves enhanced function, reliability, performance or quality
Expenses directly tied to qualified R&D projects, such as supplies used and salaries for research personnel, may be eligible, which includes those personnel who actually conduct research and those who directly manage and support the researchers. Payments for U.S.-based contract research may also be eligible, but is limited to 65 percent of related expenses.
Application of Research and Development Tax Credits
Previously, startups and other small businesses that were not yet profitable couldn't take advantage of the tax credit because they had no taxable income to book the tax credit against. However, with the PATH Act, that's changed. Now, according to the Journal of Accountancy, a qualified small business can use the tax credit against the employer's Social Security portion of its FICA payroll taxes, up to $250,000 per year for a maximum of five years. Here, a qualified small business is defined as those with gross receipts of under $5 million for the current tax year and no gross receipts for any tax year prior to the five tax years ending wit the tax credit year.
Furthermore, eligible small businesses, defined as those privately-held businesses whose average annual three-year gross receipts are under $50 million, can now offset their alternative minimum tax (AMT) payments with R&D tax credits from the 2016 tax year onwards. These privately held businesses, which often operate as S-corporations, partnerships or other pass-through entities, previously could not use the R&D credits because they did not pay income tax at the corporate level.
State-Specific R&D Tax Credits
The vast majority of states also offer R&D tax credits. Notable exceptions are those states that do not have corporate income taxes, namely South Dakota, Wyoming and Nevada. State R&D tax credits are often overlooked, but they can have a large impact on a company's cash flow and operational performance. Many states create competitive R&D program structures to provide these credits to encourage companies to innovate within their state. Some credits are permanent, while others are temporary.
Organizations should look at what's available in their home state and in the states in which they have offices. In addition, if a company that invests heavily in R&D is considering a move, its leaders should compare and contrast the various state offerings as part of their decision-making.
R&D tax credits encourage research that may not be economically feasible in the short-term but that supports society in the long-term. These R&D credits can now be used by more businesses in a broader array of situations. For those interested in using these in their organizations, the links above provide helpful information. Another very useful resource is the IRS Instructions for Form 6765: Credit for Increasing Research Activities.