R&D Tax Credit Claim Example: A Step-by-Step Guide
How do you know if your company qualifies for the Research and Development Tax Credit (R&D tax credit)? Companies of various sizes, from startup businesses to multinational companies, can tremendously benefit from this tax claim. Determining which activities and expenses to maximize this claim is key. We’ve simplified this process through this step-by-step guide.
Industry-Specific R&D Tax Credit Claim Examples
Contrary to what some might assume, research and development activities aren’t limited to those conducted by scientists in a laboratory. This tax credit extends to various industries. Here are helpful examples interested entities can refer to:
Manufacturing
Suppose that ABC Manufacturing Company is a medium-sized company specializing in carpets. This business invested in an automated technology to streamline its weaving processes.
With this new technology, this company has reduced its manufacturing period by 25% and decreased its overall labor costs. The company spent $250,000 in qualified research expenses, permitting the company to claim a federal R&D tax credit of $25,000.
Software & Technology
PetCo is a California-based technology startup. Its primary product, for which the company raised $2.8 million, enables veterinary clinics to monitor clients’ pets remotely and notify their staff when their symptoms change.
In 2022, the company spent $1 million of the capital it raised to fund qualified research expenses, including employee wages, software development supplies, and contracts with third parties that aid in developing the company’s products. Therefore, the company’s estimated tax credit is $100,000.
Aerospace & Defense
Let’s suppose Company 123 is an expert in optimizing manufacturing processes for aerospace products. The company invested an additional $500,000 in improving its existing software, and with this additional investment, it can claim a federal R&D tax credit of $50,000.
Automotive
Company FAST is an automobile company that makes electric vehicles. The company specializes in creating software that enables cars to run efficiently and precisely.
The company invested $10,000,000 to fortify its products’ safety features to avoid accidents. In turn, this company could claim a tax credit of approximately $1,000,000.
Healthcare and Biotechnology
An example of a qualified company in the healthcare industry is MedPharmCo. This company specializes in developing two different device and delivery systems and has an annual revenue of about $4 million.
Because the company is developing new medical devices, creating prototype versions of these products, and eliminating previous system errors, it is eligible for a $400,000 tax credit.
Energy and Sustainability
The G company specializes in sustainable energy. To lower electricity costs for its customers, the business allocated $20,000,000 to research new ways to improve its current processes.
Because the company allocated this amount to research costs, the company is eligible to claim an approximate $2,000,000 in R&D tax credit.
How to Claim R&D Tax Credits?
Navigating through qualified research activities, federal income tax liability, and the like can be time-consuming and complex. That’s why companies should invest in partners familiar with qualifying expenses for R&D tax credits.
Companies must file IRS Form 6765 for this tax benefit. This process includes identifying qualifying research activities and providing documentation proving these costs meet the Internal Revenue Code Section 41 requirements. Companies may use business records, financial records, oral testimonies, and technical documents.
Before you complete this form, you should familiarize yourself with the instructions mandated by the IRS. The PDF version of this form can be easily downloaded from the IRS website.
In general, the IRS Form 6765 has four sections:
- Section A is used to claim the regular credit and contains 11 lines of required information.
- Section B applies to the Alternative Simplified Credit method or ASC.
- Section C identifies additional forms and schedules that require reporting based on one’s business structure.
- Section D only applies to qualified small businesses or QSBs making a payroll tax election.
The IRS recommends that companies calculate their credit using both regular and simplified credit methods, and then they fill out the section (A or B) that would result in the greatest tax benefit.
Qualifying Four-Part Test
How can a company determine qualified research activities? In general, companies must pass a four-part test.
Permitted Purposes
The activity must relate to a new or improved business component’s function, performance, reliability, quality, or composition. It should intend to develop a new or improved product, process, or software. Moreover, it ensures that the research is not conducted for non-commercial purposes, such as social science or arts-related endeavors.
Technological in Nature
To qualify for research credits, the activity should fundamentally rely on principles of physical sciences, biological sciences, computer science, or engineering and scientific methods. This requires the use of technology or engineering in a field of science.
Moreover, it aims to develop or improve a product, process, or software’s functionality, performance, reliability, or quality. Examples include developing new materials, improving manufacturing processes, or enhancing software functionality.
Elimination of Uncertainty
The activity must be intended to discover information to eliminate uncertainty concerning a particular method or capability for developing or improving a product or process. Uncertainty exists if the capability, method, or design of the product, process, or software is uncertain or not readily known.
Process of Experimentation
The activity must constitute the process of experimentation involving simulation, evaluation of alternatives, confirmation of hypotheses through trial and error, testing and modeling, or refining or discarding of hypotheses. It should involve a systematic process designed to evaluate one or more alternatives and include testing hypotheses, modeling, prototyping, and iterative analysis. It also needs to identify uncertainties and test potential solutions to resolve them.
Qualifying Research Expenditures for Small Businesses
Generally, there are three types of qualified research expenses: wages, supplies, and contract research expenses. In-house research expenses include salaries paid to employees for any qualifying activities performed, supplies purchased to conduct qualified research, and contract research expenses paid to conduct qualified research.
To clarify, only wages that include all taxable wages reported on an employee’s W-2 form can be declared as qualifying research expenditures. In addition, it should be highlighted that only employees involved in qualified research activities or directly supporting these initiatives are qualified.
Any tangible property bought to conduct qualified research can be considered a supply for this tax credit. A business firm working to improve the quality of a product may declare the materials used for that project as supply expenses.
Contract research expenses are when a business performs qualified research on behalf of the taxpayer. In this case, 65% of the amount paid to the non-employee can be considered a qualified expense.
Claim R&D Tax Credits Today
Companies need to partner with experts familiar with alternative minimum tax and other intricacies of this tax claim to navigate R&D tax credits and tax savings efficiently. Tax regulations are periodically updated by legislative actions, and the IRS may issue new guidelines that can affect eligibility criteria, calculation methods, and credit amounts. Miscalculations and insufficient documentation can be time-consuming and incur additional expenses.
FAQs
What expense can qualify for R&D credit?
The R&D tax credit covers two categories of qualified research expenses: in-house research expenses and contract research expenses.
How to calculate the R&D tax credit?
You need to follow this simplified method to calculate the credit:
- Identify and calculate the average QREs for the prior three years
- Multiply average QREs for those three years by 50%
- Subtract half of the three-year average (Step 2) from current year QREs
- Multiply the result of Step 3 by 14%
What documents do I need to claim R&D tax credits?
This would depend on the expenses that you’re submitting. You must present timesheets and employee descriptions if you’re claiming wages. If you’re claiming supplies, you need to show invoices and official receipts about these objects. For contracted services, you need to show contracts and other documentation.