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Activities that your business does every day may be eligible for the Research and Development (R&D) tax credit and yield tax savings.
Under the Internal Revenue Code (I.R.C.) §41, businesses can claim the Research and Development (R&D) tax credit for product design and other similar efforts regardless of how small or large the business may be. Companies also may have the option to take the credit for both current and historical development spend. Any business, regardless of industry, that designs or develops new or improved products, processes, or software can be eligible for this tax credit. To promote competition in the global marketplace, the R&D tax credit incentivizes innovation within the United States and is essentially an activity-based jobs tax credit. Thus, the more employees a company has working on development efforts the more beneficial this incentive can be.
Many companies are unaware that their everyday activities may make them eligible for this tax-savings opportunity. These activities include efforts to improve products or processes by introducing new functionality, higher quality, or better performance. It also includes activities related to developing new products, software, or automating manufacturing lines.
The tax code allows companies to capture costs associated with employee wages, outside contractors, and supplies used during a development process. It also allows for the qualification of cloud hosting costs when developing software.
What are qualified research activities?
Qualified research activities (QRAs) are the efforts performed by employees or third-party contractors related to the development of new or improved products, processes, or software. This tax credit has a broad definition of qualified activities. It is so broad, in fact, that many executives do not realize that many current activities their employees perform would qualify. Typical activities that can qualify for this tax credit include:
- Design, development, and testing of products or processes
- Attempting new concepts
- Customizing equipment or machinery
- Evaluating new or alterative materials
- Building prototypes, pilot models, or custom one-offs
The R&D credit is not industry specific. Businesses across many industries can reap these benefits. Examples of common qualifying industries include, but are not limited to, aerospace, life sciences, manufacturing, food and beverage, software, and technology.
There are certain criteria that must be met for a business to qualify for the R&D tax credit. These qualifications are often referred to as the “Four-Part Test.” To better understand the qualifications, please see the below table for details.
The Four-Part Test
We were trying to…
Efforts to develop a new or improved product, process, or software for use in our business or to be held for sale, lease, or license.
We didn’t know…
We encountered technical challenges concerning our capability, the methodology, or appropriate design of the project.
Technological in Nature
We used the science of…
Our efforts relied on concepts of physical sciences, biological sciences, computer sciences, physics, or an engineering discipline.
Process of Experimentation
We evaluated / tested…
Efforts included testing, evaluating alternatives, conducting a form of systematic trial and error, or using a defined product development process.
Companies that meet the above qualifications can benefit from substantial federal, and potentially state, tax savings.
What are qualified research expenses?
Qualified research expenses (QREs) are the costs directly related to the R&D activities described above. For example, wages paid to employees designing new products, costs for materials used to create a prototype, and expenses for third-party contractors that assist the company in their design efforts, are all QREs. Employee wages include personnel that are directly involved with the development effort and those who are managing and supporting them. The key is to evaluate everyone at the company for their level of involvement.
Other costs include supply or material expenses used during the development effort. Generally, these are material costs related to building and testing pilot models or prototypes. These costs are included even if they are ultimately sold. Keep in mind these costs could include certain tooling, parts, and scrap materials resulting from the development process. Costs for third-party contractors assisting with development and testing can also be included. Third-party contractors could be either outside vendors or 1099 independent contractors. Finally, cloud hosting costs for programming, software development, and testing and validation can also be included.
How can the R&D tax credit benefit taxpayers?
There are several benefits to claiming the R&D tax credit. These benefits can include the following:
- Increase cash flow by reducing income tax liability
- Qualified small businesses (QSBs) can reduce up to $250,000 of the FICA employer portion of payroll tax
- Eligible small business (ESB) owners can offset alternative minimum tax (AMT) liability
- Returns can generally be amended to capture credits not taken in prior years
- Permanent tax savings and reduction of overall effective tax rate
- Many states offer R&D tax credits that can be claimed in addition to the federal R&D tax credit
The R&D tax credit is complex and some companies that are taking the tax credit do not realize that they are incorrectly computing their benefit. CohnReznick has specialists that can review your credits to ensure the company is maximizing the available tax benefit.
Our approach for an R&D tax credit study
CohnReznick’s R&D Credit Service Team can provide businesses with an R&D tax credit estimate at no cost or obligation. This analysis includes a review of eligible costs, discussions with senior management, and an evaluation of available supporting documentation. Based on this information, we estimate the available federal and state R&D tax credits for each year. We then thoroughly explain the results of our analysis and can then create a work plan to finalize the tax credits that best fits the company’s needs and budget.
Don’t miss out and take advantage of the substantial savings the R&D tax credit can offer!
To learn more about the R&D tax credit and how you can benefit from our R&D tax credit services, contact:
Scott Hamilton, CPA, Partner, National Tax – R&D
Jessie Cahill, CPA, Senior Manager, National Tax – R&D
Scott Ibbotson, JD, Manager, National Tax – R&D
Subject matter expertise
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Any advice contained in this communication, including attachments and enclosures, is not intended as a thorough, in-depth analysis of specific issues. Nor is it sufficient to avoid tax-related penalties. This has been prepared for information purposes and general guidance only and does not constitute legal or professional advice. You should not act upon the information contained in this publication without obtaining specific professional advice specific to, among other things, your individual facts, circumstances and jurisdiction. No representation or warranty (express or implied) is made as to the accuracy or completeness of the information contained in this publication, and CohnReznick LLP, its partners, employees and agents accept no liability, and disclaim all responsibility, for the consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it.