Your business spends money and effort in looking for a new, improved, or technologically advanced product or process. The federal government may reward you through a tax credit. The research and development tax credit, technically called the credit for increasing research activities, serves as a way to recoup some of the cost of this activity and cut your tax bill.
How much is the credit?
The basic credit is 20% of research expenses for the current year over a base amount reflecting such costs in certain prior years. There is an alternative credit of 14%, which is a simplified way to figure the credit.
Research expenses for purposes of the credit include:
- In-house expenses. These include wages to paid to employees for doing research and related supplies.
- Contract expenses. These are limited to 65% of amounts paid to outsiders for research and testing.
Does my business qualify for the Research and Development Tax Credit?
When you think of research, you may envision big drug companies developing new medications or multinational companies creating new supercomputers. Or you may picture Edison toiling away to get patents. But dramatic and commercially important changes are not the criteria for claiming the credit. For example, microbreweries and brewpubs could claim the credit for developing new beers, refining hopping techniques, and creating new packaging processes.
To claim the credit, the research activities must meet a 4-part test:
- Basic research test (the expenditure is incurred in your business and represents R&D in the experimental or laboratory sense).
- Technological information test (discovering information which is technological in nature)
- Business component test (the application is intended to be useful in the development of a new or improved business component of your business)
- Process of experimentation test (there’s testing, surveys, modeling, simulating, etc.)
If you may qualify for the credit, it’s essential to have proper documentation of the activities and related expenses in order to claim the credit. This includes payroll information, proof of expenses and supplies for R&D, contracts with outside companies for their research activities for you, and, of course, your test records, blueprints, designs, and other documentation showing the process and impact expected from your research. No guesswork is allowed.
What special rules apply for small businesses?
There are two special ways in which small businesses can use the research credit:
- Offset alternative minimum tax (AMT)
- Offset a portion of FICA
The definition of “small business” is different for each of these options.
AMT offset. Sole proprietors, partners, and S corporation shareholders can offset their personal AMT by their share of the research credit. This option applies to a business with average annual gross receipts in the 3 prior years not exceeding $50 million. For partners and S corporation shareholders, the test must be met at both the entity and owner levels.
FICA tax offset. At the business’s election, the research credit can be used to offset up to $250,000 of the employer’s share of Social Security taxes (a portion of FICA) paid on wages of employees. A small business for this purpose means receipts under $5 million for the current year and no gross receipts for any year before the most recent 5-tax year period ending with the current year (current year plus 4 prior years).
For example, a partnership has current gross receipts of $4 million, and gross receipts in the 4 prior years of $3 million, $4 million, $7 million, and $1 million, respectively. It didn’t have any gross receipts before that. Because the partnership’s current gross receipts are under $5 million and it didn’t have any gross receipts in the 5th prior year, the partnership qualifies to make this election. The amount of gross receipts in those 4 prior years don’t count. In this example, next year the partnership wouldn’t qualify because of having some gross receipts during that prior 4-year period.
The credit serves as part of the general business credit. As a result, this doesn’t amount to a separate credit but rather a limitation on claiming other credits (such as the research credit) currently. You carry the general business credit in excess of what’s allowed in the current year back one year and forward for up to 20 years. So you don’t lose the credit and save taxes in other years.
If you think you may be eligible for the research credit, be sure to work with a tax professional; this isn’t a do-it-yourself endeavor if you want to nail down your maximum credit amount and avoid IRS challenges.