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What are R&D Tax Credits and are they worth it?

What are R&D Tax Credits and are they worth it?

Unlock the secrets of R&D tax credits! Learn how they can boost innovation, save thousands, and optimize your business's financial health.

By Austen Legler ・ 6 min read
Tax and Credits

Every business, whether a sprouting start-up or an industry giant, is on the lookout for financial wins. And here’s the kicker: the R&D tax credit could be your golden ticket. 

But what's the catch?

The R&D Tax Credit. It's not just jargon. It's an opportunity, a nod from the government, saying, "Keep innovating, we see you." And the stakes? They're high.

The Joint Committee on Taxation (JCT) recently dropped a bombshell: the federal government dolled out $13.2 billion in R&D tax credits in 2021.

And this number is set to skyrocket to $17.3 billion by 2024.

An image of Federal R&D Tax Credits shows growth from 2021's $13.2 billion to a projected $17.3 billion in 2024.

Why such massive numbers, you ask? Because innovation isn't just about the next big product or tech. It's the backbone of our economy. Understanding and leveraging R&D tax credits? That's not just smart; it's essential. 

Ready to delve deeper? Let's get into the nitty-gritty of R&D tax credits.

What are R&D Tax Credits? 

The R&D Tax Credit is a specific provision in the tax code dedicated to providing businesses with a financial incentive for their research and development activities.

This tax relief allows companies to claim certain R&D expenses, which then leads to a reduced tax liability.

The primary objective? To stimulate innovation, promote economic growth, and maintain a competitive edge in global markets. 

Originating in the early 1980s, this credit was introduced to counterbalance the declining R&D investment in the U.S., offering a financial leg-up to businesses pushing technological boundaries.

Its significance was further cemented with the PATH Act, making the R&D Tax Credit a permanent fixture in the tax landscape.

What is Considered R&D?

Research and Development (R&D) encompasses creative and systematic work undertaken with the intent to broaden the spectrum of knowledge and formulate novel applications of pre-existing knowledge.

Specifically, R&D activities are often centered around:

  • Developing or enhancing the functionality, quality, reliability, or performance of a business component.
  • This component can be a product, process, software, technique, formula, or invention.
  • The endeavor often involves a degree of technical experimentation to ascertain the most effective design or solution.

Companies engaged in such innovative pursuits, aiming to resolve technical uncertainties, potentially qualify for R&D credits.

Did you know? Even if your project fails or gets abandoned, it can still count as R&D!

However, there are myths clouding R&D. Many believe it's exclusive to scientific experiments. In truth, R&D stretches across various sectors, encompassing everything from new software algorithms to new food/beverage formulas to innovative manufacturing processes.

Knowing what genuinely constitutes R&D can unlock significant tax benefits for businesses.

Understanding the basics: What does R&D credit mean?

Okay, so you've figured out your activities align with R&D. But what's this whole "credit" business about?

In the tax world, a credit is essentially a pat on the back from the government – a reward. Instead of a reduction in the income that's taxable (that's a deduction), a tax credit actually reduces your actual tax bill, dollar-for-dollar.

Imagine you owe $15,000 in business taxes. An R&D tax credit of $5,000 would reduce that liability to $10,000. 

Sounds like a win, doesn't it?

Now for the golden questions: What can you claim? 

What expenses are eligible for R&D tax credits?

Salaries of your R&D personnel, the tangible supplies exhausted in experiments, and costs associated with outsourced R&D work are all claimable. Developing a prototype?

Add that to the list. Investing in specific software development? That too. It's essential to remember: the tax credit isn't only about successful outcomes but the endeavor to innovate.

However, there are boundaries. General and administrative costs, for instance, don't make the cut. Even if they supported the R&D activities in some way, they are typically kept out of the eligibility circle.

This holds true for activities that were wholly or partially conducted in support of qualified research.

How do you claim R&D tax credits?

Securing R&D tax credits involves submitting IRS Form 6765, a crucial step for businesses aiming to offset their innovation expenses.

This procedure mandates a careful identification of eligible costs and a thorough compilation of supporting documents, aligning with the criteria of Internal Revenue Code Section 41.

Financial and business records, supplemented with oral and technical testimonies, play a pivotal role in substantiating the claim.

Each piece of documentation not only attests to the incurred expenses but also serves as a testament to their compliance with the established tax regulations, ensuring a successful claim process.

How does the R&D Tax Credit Work?

The R&D tax credit operates as an incentive, allowing companies to offset a certain percentage of their qualifying R&D expenditures against federal income tax liabilities.

  1. Rate of Credit: Depending on specific qualifications and the category under which a business falls, approximately 6% to 8% of its annual eligible R&D expenditures can be credited against its federal income tax obligations.
  1. Qualifying Activities: Not all R&D activities qualify for the credit. Recognized activities for the R&D tax credit include:
  • Formulating new processes, patents, innovative formulas, methodologies, techniques, prototypes, or proprietary software.
  • Enhancements, alterations, or redesigns of existing product lines to achieve improved functionality or performance.
  • Onboarding specialized personnel such as scientists, design experts, or engineers, primarily for R&D activities.
  • Allocation of resources to the invention, design, and testing of novel or ground-breaking products.
  • Intellectual property development and patent application processes.
  • Expenditures related to salaries, certain raw materials, third-party research contracts, and specific cloud hosting services that directly contribute to R&D efforts.
  1. Payroll Tax Offset: Companies, especially start-ups and smaller entities, can leverage the R&D tax credit to offset up to $500,000 annually of their payroll tax liabilities. This provision primarily benefits organizations that:
  • Have gross receipts not exceeding $5 million for the tax year in question.
  • Have been operational for no more than five tax years, including the current year.

For such qualifying businesses, there's an opportunity to negate federal payroll taxes for a maximum of five years.

What are the benefits of claiming R&D tax credits?

This credit isn't just about fiscal gains; it fuels innovation. At the federal level, it can yield up to 10% of annual R&D costs, and when considering state credits, the potential benefit expands even further.

This infusion of capital serves as a catalyst for businesses, empowering them to intensify their research pursuits. 

But, and it's a significant "but," meticulous record-keeping and adherence to IRS guidelines are essential for optimizing these credits, underlining the need for specialized expertise like Taxtaker’s in navigating this intricate terrain.

An image titled "Leveraging the R&D Tax Credit for Financial Success" highlights four benefits: substantial savings, tax efficiency, enhanced cash flow, and flexibility.

Are there any restrictions on claiming R&D tax credits?

Notably, there is no fixed limit on annual eligible expenses, allowing businesses to fully harness the credit to offset their research and development expenditures.

Beyond this, any surplus credits can be strategically managed—carried back to previous tax years or carried forward for a substantial 20-year window.

However, it's important to tread carefully as state-specific regulations can introduce nuances and variations.

Is the R&D Credit Worth It? Absolutely!

The R&D tax credit is unequivocally worth pursuing for your business. Here's why:

  1. Substantial Savings: This credit has the potential to save your company hundreds of thousands of dollars annually. It's not just a tax benefit; it's a substantial financial boon.
  1. Tax Efficiency: With a dollar-for-dollar reduction in tax liability, the R&D credit is a powerful tool for optimizing your tax situation. It directly reduces your tax burden, freeing up resources for other critical endeavors.
  1. Enhanced Cash Flow: Claiming this credit can significantly increase your cash flow. The additional capital can be reinvested in your business, driving innovation, expansion, and competitiveness. 
  1. Flexibility at Your Fingertips: The R&D credit is flexible, allowing you to apply it strategically when your company needs it most. It can act as a financial lifeline during challenging times or support your growth ambitions.

In essence, the R&D tax credit is unquestionably "worth it." It's not just a financial incentive; it's a catalyst for innovation and growth. To unlock its full potential and understand how it can specifically benefit your business, explore our tax credit software today.

Register for the webinar here

About the author

Austen Legler
Head of Partnerships

Austen Legler, an experienced marketer and sales professional, has worked with fortune 500 companies, startups, and more. As TaxTaker's Head of Partnerships, he leads the partnership strategy and is focused on building out TaxTaker's partner ecosystem.

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