How to Calculate R&D Tax Credit – A Quick Example Guide

Calculating R&D tax credits to unlock their benefits is like going on a treasure hunt. Imagine two paths, the regular research credit (RRC) method and the alternative simplified credit (ASC) method, each holding the promise of financial gains.

For business owners, this journey involves figuring out a complex puzzle—carefully identifying and calculating qualified research expenses to reveal the advantages of the R&D tax credit. 

But here's the catch: this puzzle can be a bit challenging, causing some frustration along the way.

So, let’s make this process of calculating R&D tax credits a bit simpler.

The Two R&D tax credit calculation methods with Examples

As we’ve mentioned above: when it comes to calculating the federal R&D tax credit, businesses like yours can choose between two primary methods: the regular credit method and the alternative simplified credit method.

These methods offer flexibility, allowing you to assess and apply the one that results in a larger credit for a given tax year.

And here's a pro tip: Certain Small businesses (under $5 million gross receipts, and generally less than 5 years old) can get creative.

Instead of income tax, you can claim the R&D credit against payroll taxes. We’ll discuss this provision in more detail towards the end, so keep reading!

What is the regular research credit calculation (RRC) method for the R&D tax credit?

In the traditional or the Regular Research Credit method, the R&D credit amounts to 20% of a company’s current year qualified research expenses over a base amount.

The calculation of this base amount, however, involves a certain level of complexity. So, let’s break it down – 

Follow These Steps for Regular Research Credit Calculation:

1. Total the QREs for the current tax year.
   
2. Calculate the fixed base percentage. Generally, for startups five years old or younger the percentage is 3%. Note: The fixed-base percentage should not exceed 16%.‍
3. Multiply the fixed-base percentage by the average annual gross receipts from the previous four years to calculate the base amount.  Next, subtract this amount from total QREs for the year. Multiply the fixed-base percentage by the average annual gross receipts from the previous four years to calculate the base amount. Note: Multiply total QREs for the year by 50%.‍
4. Finally, take the lesser product of numbers X and Y above (i.e. QRE’s less the base amount vs QRE x 50%).

Result: The R&D tax credit equals 20% of the current year's qualified research expenses over the calculated base amount. 

Let’s break down the above steps with a simple example – 

Example of R&D tax credit calculation using the Traditional Method –

Year 2023

• Qualified Research Expenses (QREs): $10,000
• Gross Receipts: $80,000

Year 2022

• Qualified Research Expenses (QREs): $8,000
• Gross Receipts: $70,000

Year 2021

• Qualified Research Expenses (QREs): $7,000
• Gross Receipts: $60,000

Year 2020

• Qualified Research Expenses (QREs): $5,000
• Gross Receipts: $50,000

Step 1: Calculate Base Amount

Average Annual Gross Receipts for the prior four years: $260,000 / 4 = $65,000

Base Amount = Fixed-Base Percentage (assume 3%) * Average Annual Gross Receipts = 0.115 * $65,000 = $7,475 (Ensure it's at least 50% of the current year’s QREs)

Step 2: Calculate R&D Tax Credit

For the current year (2023):

Current Year QREs = $10,000

Minimum Base Amount = 50% of Current Year QREs = 0.5 * $10,000 = $5,000

R&D Tax Credit = 20% * (Current Year QREs - Minimum Base Amount) = 20% * ($10,000 - $5,000) = $1,000

So, in this example, the R&D tax credit for the year 2023 would be $1,000. It usually is way more.

Now, let’s address a practical scenario:

Older companies that haven’t previously claimed the R&D credit or lack data for historical qualified research expenses may find the second method more accessible. After all, it’s all about finding the approach that fits your business's unique journey.

Alternative simplified credit (ASC) method for R&D Tax Credits – What is it and How do you Calculate it?

The Alternative Simplified Credit (ASC) method provides you with a more streamlined approach to calculate the research credit.

Here's a concise four-step process to calculate R&D credit with ASC method:

1. Calculate Average QREs: Identify and calculate the average Qualified Research Expenses (QREs) for the prior three years.‍
2. Determine 50% of Average: Multiply the average QREs for the three-year period by 50%.‍
3. Calculate Difference from Current Year QREs: Subtract half of the three-year average (Step 2) from the current year's QREs.‍
4. Compute Credit Percentage: Multiply the result of Step 3 by the designated credit percentage (e.g., 14% as of 2009).

This simplified approach streamlines the calculation process, providing businesses with a straightforward method to determine their research credit under the ASC.

Note: Starting from 2009, the ASC is set at 14% of the Qualified Research Expenses (QREs) accumulated in the current tax year, surpassing 50% of the average QREs from the three preceding years.

In cases where the taxpayer had no QREs in any of those three prior years, the credit is determined as 6% of the QREs in the current tax year.

Now, let's dive into the world of numbers once more!

Example Of R&D Tax Credit Calculation Using The ASC Method –

Continuing with our previous example:

Step 1: Calculate Average QREs

• Average QREs (2020-2022) = ($5,000 + $7,000 + $8,000) / 3 = $6,666.67
  

Step 2: Determine 50% of Average Halfway there!

• 50% of Average = 0.5 * $6,666.67 = $3,333.33
  

Step 3: Calculate Difference from Current Year QREs Time to subtract and see where we stand in 2023:

• Difference = $10,000 - $3,333.33 = $6,666.67
  

Step 4: Compute Credit Percentage:

• Credit Percentage (as of 2009) = 14%

• Credit = 14% * $6,666.67 = $933.33

Remember: States have their own R&D tax credit programs, each with its own set of rules and limits. To navigate this tax landscape, it's savvy to team up with one of the R&D tax credit companies like TaxTaker. The experts at such firms are the superheroes who can decode the benefits of both federal and state credits for you.

When should a company choose the ASC vs. the RRC R&D calculation method?

The Alternative Simplified Credit (ASC) is a more straightforward option tailored for businesses navigating changes or lacking extensive historical data in the R&D landscape.

Now, how do you navigate this maze? You take a double look at both options—the regular one (RRC) and the simpler one (ASC). Crunch the numbers for each, figure out which path gives the most benefit.

It's like having a GPS for taxes, and having expert tax credit service provider like Taxtaker on board is the secret to ensure the company grabs every bit of R&D tax credit it deserves.

What expenses can be used to calculate the R&D credit?

You'll find these main categories that could qualify your business:

• Labor (payroll): Recognizing and rewarding the individuals who are at the forefront of the development process.
  
  
• Supplies: These encompass the tangible materials that drive your experiments and innovations.
  
  
• Contracted Services (1099s): When you bring in external experts for specialized research tasks.
  
  
• Tech Tools (cloud costs): Costs associated with running your pre production or staging environments for software development.

Here's the exciting part: you get to mix and match these categories based on what fits your business. It's like creating your own recipe for R&D success that suits your unique way of doing things.

Most importantly, your eligibility isn't determined by the success or failure of a project. Even if your venture hits a snag, you still get to claim that credit. It's akin to having a safety net for your creative endeavors.

What are the exclusions for R&D tax credits?

To snag those R&D tax credits, you need to be in the right ballpark. According to the IRS Instructions for Form 6765, certain activities are a no-go. These exclusions include:

• Projects conducted outside of the U.S. won't qualify for R&D tax credits.
• Activities not rooted in engineering, physical, biological, or computer sciences are excluded.
• Anything relying on aesthetics, arts, social sciences, or humanities is not eligible.
• If an unrelated third party funds the project, it's not on the R&D credit menu.
• Roles involving administration, non-technical supervision, scheduling, or training are excluded.
• Crafting business requirement definitions, market research, or fiscal feasibility studies doesn't qualify.
• Activities related to end-user support and documentation are not eligible.
• Reverse engineering, figuring out how things work by taking them apart, is excluded.
• Research conducted after commercial production is not considered for credits.
• Adapting or reproducing an existing business component doesn't make the cut.
• Research related to surveys for efficiency, management, marketing, and routine quality control testing is excluded.
• Activities focused on sales and marketing won't earn R&D credits.
• Repairs and maintenance of existing products or processes are not eligible.
• Routine quality control or assurance activities are not considered for R&D credits.

How to claim R&D tax credits

To claim the R&D tax credit, you need to fill out IRS Form 6765 (Credit for Increasing Research Activities) for qualifying expenses.

Alongside this, ensure that all supporting documentation, such as financial and/or business records, oral testimony and technical documents is maintained.

These documents act as a proof of how your costs meet requirements as listed by Internal Revenue Code Section 41.

The IRS Form 6765 is divided into four sections:

• Section A: Contains eight lines (1, 2, 3, 7, 8, 10, 11, 17) requiring essential information about a company’s qualified research expenses.
• Section B: Applies to the alternative simplified credit (ASC), offering an alternative calculation method.
• Section C: Identifies additional forms and schedules based on a business's structure, ensuring comprehensive reporting.
• Section D: Exclusive to qualified small businesses (QSBs) making a payroll tax election, reflecting specific considerations.

You can choose between claiming the regular credit in Section A or opting for the alternative simplified credit (ASC) in Section B. The IRS recommends businesses to calculate R&D credits using both methods and selecting the one that maximizes their credit gains.

Special Rules For Certain Small Businesses

New or startup businesses can capitalize on the federal R&D tax credit, offering strategic financial advantages. Although the credit isn't refundable, any excess beyond the tax bill can be carried forward for up to 20 years.

Protecting Americans from Tax Hike (PATH) Act of 2015 has given an edge to new and small businesses by allowing them to apply the R&D tax credit against their payroll tax (FICA) for up to five years.

This provides immediate tax relief, irrespective of the profitability of these businesses' research activities.

For eligibility in the payroll tax offset, your business needs to:

• Have no more than five years of gross receipts.
• Gross receipts for the credit year must be less than $5 million.
  

An eligible business can allocate up to $500,000 of its R&D credit to payroll tax liability each year. It's important to note that this option must be elected on an originally-filed tax return.

If a business missed applying the R&D credit to payroll taxes in a prior year, this cannot be rectified through an amended return.

Additionally, the PATH Act extends the benefit, allowing eligible small businesses to use the research tax credit to offset alternative minimum tax (AMT), provided that your company is not being publicly traded and has an average of $50 million or less in gross receipts for the prior three tax years.

Wrapping it Up – 

So, diving into R&D tax credits can be a real boost for your business. It's like finding hidden treasure in your expenses. But guess what? 

There's an even cooler trick— Taxtaker’s R&D tax credit software. Picture it as your friendly helper, making all the complicated stuff simple. It's like having a super-smart friend guide you through, so you get the most out of those credits. Ready to make things easier and supercharge your business? Then reach out to seek Taxtaker’s expert guidance.