Each year the US government provides billions of dollars to innovative businesses for developing new or improving existing technologies, products, materials, and processes, under the Research & Experimentation Tax Credit (R&D Tax Credit) program.
The R&D Tax Credit is a general business tax credit under the Internal Revenue Code section 41 for businesses that incur research and development (R&D) costs in the United States. The US R&D tax credit has been in existence since 1981.
Previously, this program would periodically expire and had to be renewed by Congress. That made it difficult for businesses to include the credit in their long-term planning, since there was no guarantee it would continue.
In 2015, Congress made the R&D tax credit permanent through the Protecting Americans from Tax Hikes (PATH) Act of 2015. They also introduced key changes so that even unprofitable small businesses could benefit.
The R&D tax credit program can be complex and confusing. We’ve gathered answers to the most frequent questions from hundreds of startups to help you navigate the process with confidence.
1. What are the benefits of the R&D tax credit program?
R&D tax credits can be used to offset:
- The employer portion of Social Security taxes, up to $250,000 per fiscal year. This Social Security tax offset allows eligible small businesses to benefit from their R&D activities, even if they aren't profitable.
- Income taxes, if you have taxable income.
- Alternative Minimum Tax (AMT), if your average revenue for the previous three years is less than $50 million and you owe AMT for the current year.
FIND OUT IF YOU QUALIFY FOR R&D TAX CREDITS – FREE ASSESSMENT
2. What is a qualified small business?
A business is a qualified small business if it meets the following three criteria:
- Has gross receipts/revenues of less than $5 million for the current tax year.
- Has gross receipts/revenues for five years or less. The business must not have had gross receipts in any tax year before the five-year period ending with the tax year for which they’re applying. For example, businesses that earned gross receipts before 2016 are not eligible to use 2020 R&D credits to offset Social Security taxes.
- Is not a tax-exempt organization under section 501.
Although the law is designed to help small businesses, larger companies can also benefit from the small business criteria. For example, many life sciences companies have no gross receipts for years until their products receive FDA approval.
3. What activities qualify for the R&D tax credit?
To qualify, your R&D activities must meet all four parts of this test:
- 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.
- 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?
- 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.
- Technological in Nature: The work must be based in the physical or biological sciences, engineering, or computer science.
To see if your activities qualify, consider whether you have:
- Developed a new product, improved an existing one, or added new features?
- Integrated databases or applications that weren’t originally designed to work together?
- Improved your software’s response time?
- Changed a process to reduce costs or improve manufacturing capabilities or timelines?
- Incurred costs for a process, project, or prototype that’s incomplete due to unresolved technical issues?
- Modified your product’s formulation?
- Automated your production process?
- Adapted existing products or machines for new uses?
- Machined or fabricated parts or dies using new materials or to meet tighter tolerances?
If you answered yes to any of these questions, you may be eligible to claim R&D tax credits.
4. What activities are excluded from R&D tax credits?
- Research performed outside the US, Puerto Rico, or any US territory
- Research done after commercial production of the business component has started
- Adapting existing business components
- Duplicating existing business components
- Reverse Engineering
- Surveys, studies, activity relating to management function/technique, market research, routine data collection, or routine testing/quality control
- Software developed for internal use. There are exceptions for this exclusion
- Research related to social sciences, arts, or humanities
- Research funded by any grant, contract, or otherwise by another person (or governmental entity)
5. My product is live and users are paying for it, but I still have ongoing R&D work. Does that mean I cannot claim R&D tax credits?
If you’re still working to resolve technical uncertainties while developing new features or improving existing ones after your product is live, you can still claim R&D tax credits for that work.
6. What expenses can I claim for R&D tax credits?
- Taxable wages for employees who perform, directly supervise, or directly support qualified activities in the US.
- Contract research expenses for qualified activities performed in the US, as long as you retain substantial rights to the results and pay the contractor whether the project succeeds or fails.
- Off-premise computer lease costs used in qualified activities, such as hosting costs related to R&D work.
- Cost of supplies used in qualified activities, including extraordinary utilities, but not capital items or general administrative supplies like travel, shipping, or royalties. For example: prototypes and testing materials.
7. How much of my R&D costs can I recover?
The federal portion is about 10% of eligible expenses, which can be used to offset Social Security taxes (up to $250,000 per year), income taxes, or AMT.
The state portion varies. In California, it’s about 7.5% of eligible expenses, but it can only be applied to income taxes and can be carried forward indefinitely. The New York R&D tax credit is refundable and offers about 50% of the federal R&D credit, up to 6% of R&D expenses in New York State.
For example, a startup with $500,000 in eligible software engineering expenses could receive an R&D credit of $50,000 or more. A qualified small business with over $2.5 million in eligible expenses could receive a $250,000 credit and use the entire amount to offset Social Security taxes for the year.
FIND OUT IF YOU QUALIFY FOR R&D TAX CREDITS – FREE ASSESSMENT
8. What is the deadline to file my R&D tax credit?
To offset income taxes, you can amend all open tax years (usually the last three years from the tax year).
To offset Social Security taxes, R&D tax credits must be specified and elected by a qualified small business on its timely filed (including extensions) income tax return for the tax year in question. You can then start offsetting Social Security taxes for the calendar quarter after you file your return with the payroll tax credit election.
For C Corps with a December fiscal year, the deadline is April 15. For C Corps with fiscal years ending in months other than December (except June), the deadline is the 15th day of the fourth month after the fiscal year ends. For C Corps with a June 30 year-end, the deadline is September 15.
For S Corps with a December fiscal year, the deadline is March 15. For S Corps with other fiscal year-ends, the deadline is the 15th day of the third month after the tax year ends.
Six-month extensions are available for both C Corps (seven months for C Corps with a June year-end) and S Corps.
If the due date falls on a Saturday, Sunday, or legal holiday, the deadline moves to the next business day.
9. Can a tax return be amended to offset Social Security taxes if the election was not made on an original income tax return as filed?
A qualified small business must elect to use R&D credits to offset Social Security taxes on or before the due date of its timely filed income tax return, including extensions.
10. Can the R&D tax credits be used to offset Social Security taxes relating to all employees or only that portion which relates to R&D employees?
They can be used to offset the employer’s portion of Social Security taxes for all employees, not just those working in R&D.
11. How and when do I see the benefits of the Social Security tax offset?
You can start offsetting Social Security taxes for the calendar quarter after you file your income tax return with the R&D tax credit form and payroll tax credit election.
Employers must pay 6.2% of each employee’s salary (up to $137,700) as Social Security tax. This is reported quarterly on Form 941: Q1 in April, Q2 in July, Q3 in October, and Q4 in January.
If you file your 2017 R&D tax credit claim with your federal income tax return by March 30, 2018, you can start offsetting Social Security taxes in the second quarter of 2018. That means you’ll likely see the benefit from your 2017 R&D tax credits by July 2018.
When credits are applied to Social Security taxes, you’ll receive a refund check from the IRS within 6–8 weeks of filing the quarterly Form 941 that includes the Social Security offset.
12. What if I can’t use all my R&D tax credits to offset Social Security taxes this quarter?
If your credit amount is more than your Social Security tax liability for a given quarter, the extra will be carried forward to the next quarter.
Once you no longer qualify as a small business, any unused federal R&D credits that weren’t elected to offset Social Security taxes can be carried forward for up to 20 years and used to offset income taxes when you become profitable.
13. Am I eligible for the Social Security offset if I use a Professional Employer Organization (PEOs)?
If your PEO is certified or authorized by the IRS, you can benefit from the Social Security offset. Since the PEO appears as the employer on your employees’ W-2s and files Form 941 to report Social Security taxes for your company, the PEO is responsible for handling the offset and passing the refund on to your business once received from the IRS.
14. What documentation do I need to support my R&D tax credit claim?
Your records must clearly show that the expenses you’re claiming are eligible for the credit. Make sure your documentation is:
- Contemporaneous – created at the time the R&D work was performed.
- Dated – to confirm the work took place in the fiscal year you’re claiming.
- Describes technical challenges – to demonstrate the R&D activities carried out.
Acceptable documentation formats include:
- Timesheets
- Version control for all technical documents
- Prototypes, whether software or physical products
- Test documents
- Developer or engineering notebooks
- Meeting minutes
- Photos of whiteboards
- Emails
- Invoices/ receipts
- Contractor agreements detailing the statement of work
Start collecting all your documentation now—it will help you defend your claim if the IRS audits your R&D credit.
15. What are the risks of claiming the R&D tax credit?
The IRS may audit your R&D tax credit claim to verify that your activities meet the four-part test and that your expenses are properly documented.
After an audit, the IRS may approve or deny all or part of your R&D credit. Credits that are well-documented and clearly identified are usually accepted. Those that aren’t often get denied.
If your R&D credit is denied, the IRS may impose a penalty if it finds you claimed the credit through negligence or by ignoring rules or regulations. This penalty is typically 20% of the disallowed credit—that is, 20% of the tax the IRS believes you underpaid. Interest may also be charged on that amount from the date the tax was due.
In our experience, R&D tax credits supported by solid documentation are rarely denied.
If you’ve never claimed the R&D tax credit—whether because you thought you weren’t eligible or couldn’t use the credits—now is a great time to reconsider. The R&D credit can provide a significant cash boost for your business.
