R&D Tax Credits: How do They Work?
The R&D tax credit is one of the largest annual tax credits available to U.S. companies, yet many don’t apply out of fear they won’t qualify. Well, that thinking is so yesterday. Over the last four decades, lawmakers and regulators have taken steps to remove qualification barriers, enabling more companies and more industries to benefit from the credit. How does a company qualify? And what goes into claiming the credit? We’ve got it all covered right here.
R&D Tax Credit Criteria: A Four-Part Test
For companies that qualify, the R&D credit is practically a reward for doing business as usual. Qualifying activities can include the development or design of new products, patents, intellectual property or software, with qualifying expenses covering things like employee salaries, supplies, and even contract research.
To be considered for the credit, there are four criteria that your activity must meet:
- Your activity must attempt to develop a new or improved product, process, software, technique, invention, or formula that increases performance, function, reliability, or quality in some way. The best part? Your company doesn’t actually need to achieve improvement or innovation—it just needs to attempt it.
- It must rely on a hard science. This means the research or development process must be technological in nature or based in engineering, physics, chemistry, biology, or computer science.
- There must be an attempt to eliminate uncertainty. Not sure whether that new machinery will actually speed up your production process? Test it during this stage to find out. Of course, the attempted innovation must go beyond aesthetic improvements and pertain to the development of methodology, design, techniques, formulas, or inventions. And remember, the rule is “attempt” to eliminate uncertainty. You don’t have to know whether you can achieve this goal, but you do need to show you at least tried to find out.
- The activity requires experimentation to eliminate or resolve technical uncertainty. This means you must demonstrate that you tried alternative solutions–modeling, simulation, systematic trial and error, or other methods—to create or develop your product or process.
Claiming Your Credit: Documentation is Key
According to the most recent IRS data, in 2014, more than 17,824 companies claimed $12 billion in federal R&D tax credits. But for many companies, the challenge to claiming R&D tax credits isn’t actually qualifying, it’s documenting that they qualify. So, if you’re eligible to claim an R&D tax credit, it’s important to keep track of the details from the get-go.
Try setting up documentation-retention policies and engaging your tax employees. R&D tax credit reports will ask for a project analysis and quantitative information like expenses, gross receipts, and revenue information. You might also need supporting information such as project notes, lists, specifications, requirements—or even prototype drawings. Having these materials on hand when it comes time to submit your claim will help the process run more smoothly.
R&D regulations are changing all the time, especially in a new administration or presidential term. Curious to see what the next four years might mean for the R&D tax credit?
For many companies, the challenge of claiming R&D tax credits isn’t qualifying—it’s documenting that they qualify.