Understanding the Federal Research and Development Tax Credits

Understanding the Federal Research and Development Tax Credits

Innovation is an integral part of progress and breakthrough developments in many fields. To incentivize companies in the U.S. that engage in research and development (R&D), the federal government offers tax credits specifically designed to support and encourage innovation.

The Protecting Americans from Tax Hikes (PATH) Act of 2015 permanently extended the R&D tax credit and even allowed eligible small businesses to claim the credit against alternative minimum tax (AMT) liability or the employer’s payroll tax liability.

This credit is a dollar-for-dollar reduction in federal income tax obligations determined based on qualified R&D expenses and activities. Expenses such as labor, supplies, contracted research services, and rental or lease costs of computers are considered potential qualified expenses. For an expense to be qualified under the R&D credit, the IRS applies a four-part test whereby the expense should pass all four tests:

1. Technological in Nature – The activity performed must fundamentally rely on principles of physical science, biological science, engineering, or computer science.
2. Permitted Purpose – The activity must improve the company’s function, performance, reliability, or quality.
3. Elimination of Uncertainty – The activity must be intended to discover information to eliminate uncertainty concerning the capability, method, or design for developing or improving a product or process.
4. Process of Experimentation – The company must engage in processes to identify and evaluate more than one alternative to achieve a result, such as trial and error.

Companies that do not have an income tax liability may elect to use their R&D credits up to $250,000 against payroll taxes for five years (or a total of $1,250,000) if they –

• Have gross receipts less than $5 million in the reporting tax year and
• The company has had no gross receipts for the four preceding tax years.

A company can claim unused R&D tax credits for tax returns with an open statute of limitation, generally the prior three years. On the other hand, if the company exceeds the maximum credit of $250,000, the remaining credit can be carried forward for 20 years to offset future tax liability. To claim the R&D credit, the company will have to report the credit on federal Form 6765.

Federal R&D tax credits serve as an important tool in encouraging innovation and growth. By providing these tax incentives companies are encouraged to invest in R&D activities within the U.S., and by understanding the eligibility criteria, companies can take advantage of their benefit.

Please consult your WilkinGuttenplan tax advisor for further information.