For businesses, the tax code provides a tax credit of up to 20% of qualified expenditures to encourage businesses to develop, design or improve products, processes, techniques, formulas or software and similar activities. In the past, this credit—called the Credit for Increasing Research Activities—had to be reauthorized by Congress yearly, but as part of the 2015 PATH Act, this credit was made permanent.
Calculated based on increases in research activities and expenditures, the purpose of the credit is to reward businesses that pursue innovation by continually increasing investment in research activities. Even so, an alternative simplified method allows taxpayers to claim research credits if research costs remain the same or even decline compared with prior years.
There are two methods used to compute the credit: the regular method that provides for a 20% research credit or the simplified method, which is easier to document but results in a reduced credit of 14% of eligible expenses.
Regular Method: Under the regular research credit method, the credit equals 20% of qualified research expenditures for a tax year over a base amount established by the business entity in 1984–1988, or a later period for companies that started subsequent to that period. This method may be best for companies that can document a low base amount.
Simplified Method: Under the alternative simplified method, the credit equals 14% of qualified research expenses over 50% of the average annual qualified research expenses in the three preceding tax years. If the taxpayer has no qualified research expenses in any of the three preceding tax years, the alternative simplified method credit may be 6% of the tax year’s qualified research expenses. This method may be the best choice for taxpayers with incomplete records from the mid-1980s, those complicated by mergers and acquisitions, taxpayers with a high base amount from that period or smaller business entities.
The term “qualified research” means research undertaken for the purpose of discovering information that is technological in nature, the application of which is intended to be useful in the development of a new or improved business component of the taxpayer, and relates to:
- A new or improved function,
- Performance, or
- Reliability or quality.
However, certain purposes that are not qualified include style, taste, cosmetic or seasonal design factors. The definition is relatively broad and encompasses such activities as:
- Developing new or improved products, processes or formulas;
- Developing prototypes or models;
- Developing or applying for patents;
- Certification testing;
- Developing new technology;
- Environmental testing;
- Developing or improving software technologies;
- Building or improving manufacturing facilities; and
- Streamlining internal processes.
The credit adds to the general business credit; business incentive credits are combined into one “general business credit” for purposes of determining each credit’s allowance limitation for the tax year. A general business credit may generally be carried back one year by filing a refund claim for that earlier year, and if not used in that prior year, it is carried forward for a maximum of twenty years. This credit will not normally offset the alternative minimum tax. However, eligible small businesses with $50 million or less in gross receipts may claim the credit against their alternative minimum tax liability.
No Double Dipping
The business expense that created the credit must be reduced by the amount of the credit.
Payroll Tax Election
In the case of a qualified small business, one with gross receipts of less than $5 million may elect to claim a portion of its research credit, not to exceed $250,000, against the employer’s share of the employees’ FICA withholding requirement (the 6.2 percent payroll tax). To be eligible for the payroll tax credit, the business may not have had gross receipts in any tax year preceding the five-tax-year period that ends with the tax year of the election.
If you would like more details related to this credit or would like to discuss whether your company qualifies for this credit, contact the Experts at Henssler Financial: