Accounting for R&D Tax Credits: Best Practices & Guidelines

Did you know that companies engaged in research activities can obtain a Research and Development (R&D) tax credit? What exactly is this tax credit, and what is the proper accounting treatment to maximize this tax benefit?

In this article, we’ll discuss accounting for R&D tax credits and the importance of proper accounting treatment. We will also provide a comprehensive guide on this topic. You will appreciate how CPAs play a crucial role in helping clients navigate and maximize these benefits.

What is an R&D Tax Credit?

The research and development (R&D) tax credit is a federal tax credit that reduces a business’s federal tax liability for domestic expenses related to research activities dollar for dollar. While this is a federal benefit, some states offer flexibility and incentives to encourage companies to pursue R&D activities.

Historical background and legislative changes

The R&D tax credit was first introduced as the Credit for Increasing Research Activities by Congress in 1981 as part of the Economic Recovery Tax Act of 1981​​.

Before 2003, you could only claim this corporation tax reduction if you discovered a process or product that was new to the world. This rule was amended in 2003, so research conducted to create a new product or process for the taxpayer would count ​​.

With the introduction of the Alternative Simplified Credit (ASC) in 2006, companies were granted more flexibility in calculating credit amounts and could change the baseline calculations​.

When the Protecting Americans from Tax Hikes Act (PATH Act) was passed in 2015, the R&D tax credit became a permanent fixture in the US tax code​​​. In 2018, the R&D tax credit was made even more attractive to businesses by relaxing AMT restrictions for S-corps and C-corps​​.

Qualification criteria

To qualify for this development expenditure tax credit scheme, your company must conduct activities that pass the four-part test: permitted purpose, process of experimentation, elimination of uncertainty, and technological in nature.

GAAP Treatment of R&D Tax Credits

Generally Accepted Accounting Principles (GAAP) methods standardize accounting recording and reporting among companies. GAAP rules indicate that research and development expenses that are incurred must be recorded as costs in the financial period.

According to ASC 740-10-15-3, the guidance to income tax liability applies to domestic national income taxes based on income and an entity’s foreign domestic operations that are consolidated, combined, or accounted for by the equity method .

During the developmental phase, capitalized expenditures are required to meet the following criteria to be qualified research according to GAAP treatment:

• The project is technically feasible and will be used in the future.
• There will be future economic benefits.
• Expenditures can be allocated for the project.
• All the necessary resources for project completion are available.
• The company has the capability and intent to sell the product.

Required Disclosures under GAAP

Companies must disclose information about the nature of the R&D tax credits, the financial statement effects, and the accounting methods used.

This includes detailed descriptions in the notes of financial statements about the credits recognized, amounts capitalized, and the periods in which these amounts will be realized​.

How to Calculate R&D Tax Credits?

There are two ways to calculate RDEC tax credit: the regular research credit method and the alternative simplified credit (ASC) method.

Regular Research Credit Method

According to this method, the R&D tax credit equals 20% of a company’s current-year qualified research expenses over a base amount. These steps gives you a detailed outline of this process:

1. Total the company’s qualifying costs for the year.
2. Calculate the fixed base percentage. This shouldn’t exceed 16%, but for startups five years or younger, this rate is 3%.
3. To determine the base amount, multiply the fixed-base percentage by the average annual gross receipts from the previous four years.
4. Subtract this amount from the total QREs for the year.
5. Take the lesser amount from the computations above.

Alternative Simplified Credit (ASC) Method

The ASC method offers a more streamlined approach to calculating R&D tax credits. Follow these steps to use the ASC method:

1. Calculate the average QREs (Qualified Research Expense) for the past three years.
2. Determine the 50% of the average QREs.
3. Calculate the difference from the current year’s QREs.
4. Multiply the result by the designated credit percentage.

Accounting Methods for R&D Tax Credits

Likewise, there are various accounting methods for R&D tax credits. Your company can choose the option that works best for you.

Flow-Through Method

The flow-through method involves reporting through straight-line depreciation but using accelerated depreciation for tax purposes, and the lower income taxes paid are reflected in financial statements.

Deferral Method

The deferral method involves restricted contributions wherein contributions related to expenses of future periods are deferred and recognized as revenue in the period in which the related costs are incurred.

Journal Entries for R&D Tax Credits

Calculating R&D tax credits depends on your organization’s size and the QREs you’re accounting for. This can be a complicated process, which is why it would be ideal to get the assistance of R&D tax experts to minimize errors.

Initial Recording of Tax Credits

When initially recording R&D tax credits, it is important to capture all expenses related to R&D activities accurately.

Example:

A company incurs $50,000 in qualified research expenses (QREs).

Entry:

• Debit: Research and Development Expense $50,000
• Credit: Accounts Payable or Cash $50,000

Adjusting Entries for Deferred Tax Assets

When recognizing deferred tax assets related to R&D credits, you need to make periodic adjustments to reflect the tax benefit accurately. These adjustments ensure that the tax credits are properly matched with the periods in which the related R&D expenses are incurred.

Example:

Assume the company qualifies for a $10,000 R&D tax credit.

Initial Entry:

• Debit: Deferred Tax Asset $10,000
• Credit: Income Tax Expense $10,000

Periodic Adjustment Entry

• At the end of the year, if the company decides to apply a portion of the R&D tax credit to reduce its income tax payable, the entry might be:
  • Debit: Income Tax Payable $2,500
  • Credit: Deferred Tax Asset $2,500

These entries would continue periodically until the full amount of the deferred tax asset is utilized.

Additional Journal Entries Examples

Example 1:

A company incurs $120,000 in qualified research expenses and determines prior year adjustment that it is eligible for a $24,000 R&D tax credit. The company decides to defer the tax credit.

Initial Entry:

• Debit: Research and Development Expense $120,000
• Credit: Accounts Payable or Cash $120,000

Recognizing the Tax Credit:

• Debit: Deferred Tax Asset $24,000
• Credit: Income Tax Expense $24,000

Periodic Adjustment (Quarterly):

• Debit: Income Tax Payable $6,000
• Credit: Deferred Tax Asset $6,000

Example 2:

A startup incurs $80,000 in qualified research expenses and qualifies for a $16,000 R&D tax credit, which it uses to offset payroll taxes.

Initial Entry:

• Debit: Research and Development Expense $80,000
• Credit: Accounts Payable or Cash $80,000

Recognizing the Payroll Tax Offset:

• Debit: Payroll Tax Expense $16,000
• Credit: Deferred Tax Asset $16,000

Using the Tax Credit (Monthly):

• Debit: Payroll Tax Payable $4,000
• Credit: Deferred Tax Asset $4,000

These examples illustrate the importance of accurately recording R&D expenses and the related tax credits to ensure compliance and maximize financial benefits. Proper documentation and periodic adjustments are key to effectively managing R&D tax credits.

In general, you should keep records of all expenses incurred for R&D efforts, including the wages of the people involved in developing the process or product, the facilities used, and other third-party costs. All these factors can lower your company’s taxable income, enabling you to allocate more money for research.

Impact of R&D Tax Credits on Financial Statements

R&D tax credits can impact your financial statements in various ways, so you must ensure that the credit you’re claiming is correct and well documented.

Income Statement Effects

R&D tax credit claims can lower a company’s income tax liability. The lower taxable income you’ll have to pay, the more funds you can allot to future R&D activities.

Balance Sheet Implications

Because the R&D tax credit considers your previous research-related expenses, it might affect your future balance sheets. Ultimately, if your activities qualify, you’d be given more incentive.

Cash Flow Statement Considerations

The tax credit will give you more cash flow, which you can use for future R&D expenses. If you increase your R&D expenses, you might be able to increase the credit you’re entitled to for long-term investments.

Timing of R&D Tax Credits Recognition

Recognizing R&D tax credits involves several considerations to ensure compliance with accounting standards and to maximize the benefits. The timing of recognition is critical and depends on the company’s financial situation and the nature of its R&D activities.

Recognizing R&D Tax Credits

In most cases, calculating R&D tax credits requires examining the R&D expenses for the past three years.

Companies need to identify and document all qualifying research expenses (QREs) over this period. This documentation is crucial for both calculating the credit and for any potential audits by tax authorities.

Recognition Period

• R&D tax credits should be recognized in the financial period in which the related R&D expenses are incurred. This approach aligns the tax benefit with the period of the expense, ensuring accurate financial reporting.

Example:

• If a company incurs $200,000 in qualifying research expenses in 2023 and determines that it qualifies for a $40,000 R&D tax credit, the company should recognize this credit in its 2023 financial statements.

Entry

• Debit: Deferred Tax Asset $40,000
• Credit: Income Tax Expense $40,000

Special Considerations for Timing

Losses Due to Research Activities:

• If a company incurs losses due to significant R&D activities, the recognition of R&D tax credits may extend beyond the current financial period. In such cases, the credits may be carried forward to offset future taxable income.

Example:

• A startup incurs $300,000 in R&D expenses in 2023 but has no taxable income. The resulting $60,000 R&D tax credit can be carried forward to offset future taxable income once the company becomes profitable.

Entry:

• Debit: Deferred Tax Asset $60,000
• Credit: Income Tax Expense $60,000

Considerations for Different Business Types

The impact and utilization of R&D tax credits can vary significantly between startups and established companies. Understanding these differences is crucial for effective tax planning and financial management.

Startups

For startups, R&D tax credits can provide a vital cash flow benefit, especially when the company is not yet profitable. The credits can be used to offset payroll taxes, providing immediate financial relief.

Payroll Tax Offset:

• Startups can elect to use R&D tax credits to offset up to $250,000 of payroll taxes annually. This option is particularly beneficial for pre-revenue companies that do not have sufficient income tax liability to use the credit.

Example:

• A startup with $150,000 in qualifying R&D expenses in 2023 qualifies for a $30,000 R&D tax credit. The company opts to use this credit to offset payroll taxes.

Entry:

• Debit: Payroll Tax Expense $30,000
• Credit: Deferred Tax Asset $30,000

Established Companies

Established companies, which typically have consistent taxable income, may focus more on using R&D tax credits to reduce their income tax liabilities. This approach helps lower the overall corporation tax burden and frees up resources for further investment in R&D.

Income Tax Offset:

• Established companies apply the R&D tax credit against their income tax liability, reducing the amount of taxes owed.

Example:

• An established company with $500,000 in qualifying R&D expenses in 2023 qualifies for a $100,000 R&D tax credit. The company uses this credit to reduce its income tax payable.

Entry:

• Debit: Income Tax Expense $100,000
• Credit: Deferred Tax Asset $100,000

Note on Timing

• Established companies need to ensure that the recognition of R&D tax credits is aligned with the financial period in which the expenses are incurred, adhering to GAAP requirements.

Special Considerations of R&D Tax Credits for Startups

R&D tax credits can offset the tax you’ll have to pay for personnel involved in R&D activities.

This incentive gives your company more means to dedicate to R&D efforts. However, R&D tax credit claims can lead to scrutiny from the IRS, which is why you should ensure you have proper documentation to support your claim.

Changes in Estimates and Accounting Policies

Estimates might change due to asset value appreciation or other factors. In cases like this, where one’s profit and loss account may be affected, proper documentation and evidence are needed to support the change.

Final Words

R&D Tax Credit is a highly effective mechanism that firms can use to minimize their tax obligation but at the same time invest in innovation. However, it is crucial that you provide meticulous records and observe GAAPs if full advantage of this will be taken.

Engaging an experienced accountant could make all the difference, meaning that your firm not only gets to maximize its tax credit claims but also complies with all the accounting standards.

A CPA can help you navigate through the complexities of taxation laws, gain optimum financial rewards, and help you focus on your core expertise.

FAQs

How to record R&D tax credits on the balance sheet?

R&D credits are recognized below the line in accounts, meaning they’re non-taxable and can potentially impact the taxes you pay to the government.

How do you account for R&D in accounting?

You can explore various R&D tax credit claims methods, including the flow-through and deferral methods.

How do I account for my R&D refund?

Calculating your qualified research expenses would be best to determine the refund you’re entitled to.

Is the R&D tax credit a deferred tax asset?

The R&D tax credit is not considered a deferred tax asset in one’s balance sheet.