One of the best incentives available to technology companies comes in the form of The Credit for Increasing Research Activities or as its more commonly know the Research and Development (R&D) tax credit. These credits can help serve as a catalyst for innovation and growth, offer the business case opportunities to advance technological frontiers while benefiting from significant tax incentives. Enacted as a permanent fixture under the Protecting Americans from Tax Hikes (PATH) Act in 2015, the R&D tax credit incentivizes research and development activities within the United States. Its scope extends beyond established corporations, embracing startup ventures and nurturing a culture of innovation across industries.
Qualifying Research Activities – Four Part Test
For expenditures to be eligible for the R&D Credit they first must meet all parts of a four-part test.
- New or Improved Business Component: The IRS considers a business component to be any product, process, computer software, technique, formula or invention to either be held for sale or used in the business of a taxpayer.
- Elimination of Uncertainty: Activities must intend to discover information that was unknown to the taxpayer as to the design, methodology or capability of the business component.
- Process of Experimentation: The taxpayer must perform an evaluation of alternatives, including testing, modeling or systematic trial and error to eliminate the uncertainty. The key here is that the expenses must represent research and development expenses in the experimental or laboratory sense, which are undertaken for the elimination of uncertainty.
- Technological in Nature: The expenses must rely on scientific principles or similar, such as engineering.
For most early stage and technology companies, these activities will often revolve around their product offering, both in its initial development and then ongoing features.
Eligible Expenditures for R&D Credits
Eligible expenses include qualified wages, supplies and contract research expenses.
- Wages can be for both employees that are directly performing research and their related supervision; it does not however include any benefits or other costs. The calculation for employees is usually based on what percentage of their time is spent doing Research and Development activities; if 80% or more of their time is spent on these activities, then it is considered substantially all is spent in Research and Development and their time is allocated at 100%.
- Supplies are for items of tangible personal property (which can include software) used in the Research and Development process. However, specifically excluded from this category are capitalized items.
- Contract research expenses are for amounts paid to 3rd parties for research and can be included generally at 65% of the incurred amount.
Crucially, one of the requirements of claiming these expenditures is that the activities must be performed in the United States.
Claim Process:
To claim the R&D tax credit, businesses must file IRS Form 6765, “Credit for Increasing Research Activities,” with their timely tax return. Additionally, retroactive claims can be made by amending prior tax returns within the previous three years.
When claiming the credit, taxpayers have the option of either the Regular or Alternative Simplified Method. Additionally, the amount of the credit claimed would need to be taken as income in the year of the claim; however, in a post-Section 174 capitalization world most taxpayers will opt to take a reduced credit in exchange for the addback given its interaction with the capitalization.
After claiming on a tax return via Form 6765, technology companies can either use the credit to reduce current taxes, carry forward to future years or under certain circumstances, claim as a reduction of payroll taxes due. Many early-stage technology firms will choose to, assuming they qualify, take against payroll taxes, as this provides the fastest monetization of the credit.
Documentation:
Like with most other tax matters, strong documentation is critical for the taxpayer claiming a Research and Development Credit. The documentation should include:
- What business components were being worked on
- Who is working on them and what time was spent on these
- Research activities performed
- The information sought to discover
In software development, the use of an Agile Fibonacci process is one of the most common approaches to keeping this documentation, including the story and process points which help document both the component and the activities performed, as well as time. The tax court has recently allowed estimates to be used for the time allocations as well, however, they are subject to more controversy.
Section 174 Capitalization:
In a sense counterintuitive to all of the above, starting in tax year 2022 as part of the Tax Cuts and Jobs Act businesses were required to capitalize and amortize research and development costs (over 60 or 180 months), rather than expense outright. The prior law which allowed expensing also intentionally used a broad definition of Research and Development costs under Section 174 as to allow these to be deducted easier and quicker. This change has now impacted firms in the complete opposite manner of the R&D Credit, by increasing tax bills in an artificial manner by delaying these deductions. While the R&D Credit and this capitalization are thought of in unison, they are in fact different tax code sections; said differently, even if a taxpayer does NOT claim an R&D Tax Credit, they still may be subject to this capitalization which will require much of the same analysis. This provision has proven to be wildly unpopular and features bipartisan support for repeal, but as of 2024 still has yet to be repealed.
Jacob Lutz, CPA
Director, Tax
Jacob joined Cerini & Associates in January of 2013 and has been actively providing tax, compliance, and business advisory services to a wide variety of both for-profit and non-profit clients.
