How US R&D Tax Credits Can Boost Your Profits

The US Research & Experimentation Tax Credit, or R&D Tax Credit, is a general business tax credit under Internal Revenue Code section 41 for companies that incur research and development (R&D) expenses in the United States. This tax credit has been available since 1981.
However, it was never permanent—it would expire from time to time and then be renewed by Congress. This made it difficult for companies to rely on the credit for long-term planning. Plus, many businesses couldn’t benefit from the credit if they didn’t owe federal income tax or were subject to the alternative minimum tax (AMT).

In 2015, Congress made the R&D tax credit permanent and introduced key changes so more businesses could benefit. Here’s a summary of those updates:

1. Offset payroll taxes

Starting January 1, 2016, the R&D tax credit can be used to offset the employer’s share of payroll taxes, up to $250,000 per fiscal year. Before this change, R&D tax credits couldn’t be applied to payroll taxes.

2. Offset the AMT

As of January 1, 2016, the R&D tax credit can be used to offset the alternative minimum tax (AMT). This applies to eligible small businesses—those with less than $50 million in average revenue over the previous three years. Before this change, the credit could only be used to offset regular income tax.

What activities qualify for the R&D tax credit?

Qualified research refers to work aimed at achieving innovation in a scientific or technological field. To be eligible, your R&D activities must pass a four-part test:

1. Permitted Purpose: You must be developing new (or improving existing) functionality, performance, reliability, or quality of a business component. This includes any product, process, technique, invention, formula, or software that you intend to sell, lease, license, or use in your business.
2. Elimination of Uncertainty: You must be working to resolve uncertainty about how to develop or improve the business component. Uncertainty exists if you can’t achieve the desired result using publicly available information. This could involve uncertainty about whether you can develop or improve the component, how to do it, or whether your design is appropriate. Ask yourself:

– What technical challenges did you try to solve that couldn’t be addressed with standard methods?

– What work did you do during the tax year to overcome those challenges?

– What breakthroughs or improvements did you achieve as a result?

3. Process of Experimentation: You must use a systematic process to identify the uncertainty and test one or more alternatives to resolve it. This could include modeling, simulation, or structured trial and error.
4. Technological in Nature: The work must be based in the physical or biological sciences, engineering, or computer science.

If you’ve never claimed the US R&D tax credit—either because you thought you didn’t qualify or couldn’t use the credits—now is a great time to reconsider. The recent changes have made the credit accessible to many more small and midsize businesses.

How much of my R&D expenses can I recover?

Let’s use California as an example.

• Federal portion – 6% of eligible expenses, or 14% of half the average R&D expenses over the past three years. This can result in a much higher credit—if your expenses remain steady over three years, you could see a 10% credit.

• State portion – 15% of eligible expenses, calculated as 15% of half the average R&D expenses over the past three years.