R&D tax credits offer savings opportunities for many businesses
December 7, 2023
By Jennifer Faust, CPA/PFS
Senior Tax Manager
The Research and Development (R&D) tax credit can help businesses save big at tax time.
Too many business owners don’t claim the R&D tax credit because they are not aware of the credit or think that it doesn’t apply to their business. However, more businesses qualify than you might expect.
What is the research and development tax credit?
The R&D tax credit, established in 1981, is a financial incentive provided by federal and state governments to stimulate investment. This credit is available to companies that allocate funds towards eligible expenses for research and development activities conducted within the U.S.
The tax credit is available to companies developing new or improved business components, including products, processes, computer software, techniques, formulas or inventions, that result in new or improved functionality, performance, reliability or quality.
The credit is available at the federal and state level, with more than 25 states offering a credit to offset federal and state tax liability. Below is information on the federal credit, although many state R&D credits follow the federal guidelines.
Which businesses qualify for the R&D credit?
Far more than you might expect.
The tax credit is not reserved just for researchers, scientists and engineers, nor is it limited to large companies. In fact, many smaller businesses that qualify for the credit might not be aware – and are missing savings opportunities as a result.
The list of possible eligible activities is expansive. It includes businesses that are involved in:
- Manufacturing products
- Developing new products, processes, formulas, software, techniques, etc.
- Improving on existing products, processes, formulas, software, techniques, etc.
- Creating more reliable products, processes, formulas, software techniques, etc.
- Developing prototypes or models, including those generated via computer
- Designing of tolls, jigs, dies or molds
- Applying for patents
- Testing new concepts
- Certifying quality
- Sourcing raw material
- Developing new technologies
- Improving existing or building new facilities
- Attempting the use of new materials, concepts or processes
- Developing custom software for internal uses
- Developing or designing new systems utilizing existing products
- Creating new formulas or products to enter new markets or industries
What expenses qualify for the R&D credit?
Calculating the R&D credit requires documenting your company’s “qualified research expenditures.” For many businesses, the majority of the qualified expenses comes via the wages of the employees involved in research-related activities. That includes wages paid to individuals directly working on, supervising or directly supporting the research and development process.
In addition to wages, supplies used or consumed during the research and development process also can qualify as research expenditures allowable in the credit calculation.
Finally, contract research expenses paid to third parties on behalf of the company also can qualify to be included in the R&D credit calculation, at a reduced rate.
What are the benefits of claiming the R&D tax credit?
The R&D tax credit is just that -- a credit that reduces your federal and potentially your state income tax liability dollar for dollar.
The R&D tax credit is nonrefundable, but any excess credit can be carried forward to future tax years with certain limitations.
In addition, there are special rules allowing certain startup companies that may not have taxable income to utilize the credit to offset payroll taxes instead.
What is the treatment for R&D expenses?
The deductibility of federal R&D tax credits changed last year.
For tax years beginning after Dec. 31, 2021, businesses no longer can immediately deduct their R&D expenses. This includes expenses that are eligible for the R&D credit but also other R&D expenses, such as overhead costs. These expenses must be capitalized and amortized over five years.
The change was approved as part of the Tax Cuts and Jobs Act enacted in 2017, though many hoped that the alteration might be adjusted by Congress prior to it taking effect. The issue continues to be discussed by some federal lawmakers, but it’s unclear if there is enough momentum to adjust the treatment of these tax credits.
How can Honkamp help?
Honkamp can help you figure out if you are missing opportunities to claim R&D tax credits.
Determining which expenses qualify can seem like a daunting task. That is part of the reason why many businesses don’t take advantage of this opportunity. Let our experts help.
Honkamp also can ensure that your business follows the new capitalization rules and can keep you apprised of any future developments on R&D credits.