What is the R&D Tax Credit?

Pin It

If you own your business, you may have expenses that qualify you to take the R & D tax credit. What is this exemption and how can it affect your tax liability? First, it is helpful to look at what constitutes the credit and why it was created.

What Does “R and D” Mean?

The term means Research and Development. This is a general business tax credit under Internal Revenue Code Section 41, for companies that incur research and development costs in the US. It originated in 1981 in the Economic Recovery Act sponsored by representative Jack kemp and Senator William Roth. Congress noted in the example of automobile manufacturers that the costs associated with research and development of new concepts had a negative impact on the US economy. This resulted in the R&D credit, which has expired eight times and been extended fifteen times. Businesses are allowed to deduct a portion of qualified expenses.

The Four-Part Test

What are qualified expenses? According to the government, these are:

  • The research is for a permitted purpose. It must “create new, or improve existing, functionality, performance, reliability or quality of a business component.” That means the research must create or improve a product or a process used directly in the taxpayer’s business.
  • The research must eliminate uncertainty.
  • The research must involve a process of elimination. That is, the taxpayer must use a systematic method to evaluate one or more alternatives to achieve the result in question at the beginning of the research.
  • The research must be technological in nature. It has to rely on scientific, biological or physical science, principles.

There are some exclusions from these qualifications as well. Research that began after the product or service went into commercial production is not eligible. Research that merely adapts existing products or services or duplicates them, is excluded. So is reverse engineering, which is extracting information from something already in production. You cannot deduct expenses for surveys market studies or studies. Research that is paid for by grants or contracts, by other people or by a government agency is excluded, as is any research not done in the United States.

How Much is the Deduction?

According to Bloomberg Magazine, companies that benefit most from this allowance are corporations grossing more than $250 million a year. It is difficult for small businesses to claim the tax credit because the expenses are greatest in the first years when revenues are likely to be small. Startups that claimed the benefit in 2008 averaged about $151,000 a claim. To figure the credit, businesses use cost figures from the prior three years of research and development. They average this amount and then multiply that figure by .50. Businesses can claim fourteen percent of the resulting figure. If you are a new business, and don’t have three years of prior expenses, you can still claim the credit by using six percent of your qualified expenses as your credit.

Who Should Claim the Credit?

Bloomberg says that businesses engaged in technology or software development would benefit from the credit. So would biotechnological corporations or anyone who provides cloud-based services.

Related Resource: Limited Liability Company/Partnership

Small businesses can opt to complete the less-cumbersome ASC, or Alternate Simplified Credit form. Still, large or small, if your business has an on-staff engineer, you probably should look into the R&D Tax Credit.

Pin It