How to Claim R&D Tax Credits

If you think your company might qualify for the R&D tax credit, don’t let the potential tax savings go unclaimed — and don’t be intimidated by the thought of an R&D tax credit study or the R&D tax credit documentation requirements. Qualifying activities exist across many different industries. If you’re willing to take a look, you could uncover non-dilutive funding to reinvest in your business and fuel your innovation with these tax savings. By claiming the R&D tax credit, you have a responsibility to make sure your tax documentation is defensible. The laws and regulations require it, and the penalties for not complying can be severe. Too often, we see companies claim the R&D tax credit without creating proper nexus between expenses and projects. Thorough documentation is the answer to this issue. That’s where Arvo can help. Our tax credit software automatically calculates the credit, as well as generates all required documentation. No more stress or confusion about how to claim R&D tax credits.

Arvo's software automatically calculates your R&D tax credit, as well as generates all IRS required documentation.

How to claim R&D tax credits

The federal research and development tax credit has been around since 1981 but was made permanent by the PATH Act of 2015. This legislation also opened the door for small businesses that were not profitable to benefit from the credit. In addition, new offsets for the alternative minimum tax and payroll tax made way for even more companies to receive a benefit for their research activities. Generally, large companies account for a significant portion of the overall research performed, and the credit dollars claimed each year. Yet, it’s important to note that the R&D tax credit isn’t just for large companies with established R&D departments. Any company that develops new or improved products, processes, or software could qualify and be eligible to claim the R&D tax credit under the US tax code – whether developed successfully or not.  

Eligibility to claim the R&D tax credit

Regardless of industry, size, or revenue, any business that performs activities meeting the following four tests qualifies for the R&D tax credit:

1. Permitted purpose: the purpose of a qualifying project must be related to creating a new or improving an existing business component.
2. Technological in nature: work needs to rely on principles of physical, biological, or computer science or engineering.
3. Elimination of uncertainty: when work on a qualifying project began there would have been uncertainty related to your capability to create the product or improvement, the methodology you would use, or the correct product design.
4. Process of experimentation: the project must involve a process by which you tested alternatives and resolved the uncertainty above.

What expenses qualify for the R&D tax credit?

Once you know your activities qualify, the next step is identifying which costs count toward the credit. Qualified research expenses can include:

• Employee wages: taxable wages for employees who perform qualified activities, plus those who directly supervise or support that work.
• Contractor costs: a portion of payments to US-based contractors.
• Supplies: materials used in qualified R&D activities.
• Contract research: research performed on your behalf by outside parties. 
• Computer leasing and cloud services: if the activity relates to R&D, such as testing or development in the cloud, a portion of those payments may qualify. 

Many states also offer their own R&D tax credit programs. Incentive amounts vary by state, and some state programs follow the federal rules for which activities and expenses are eligible.

Monetizing the claimed R&D tax credit

The R&D tax credits can be used to offset:

• Income taxes, if you are in a taxable position.
• Alternative Minimum Tax (AMT) if you have average annual gross receipts for the prior three years of $50 million or less, and you owe AMT in the current year.
• Employer portion of Social Security and Medicare taxes, up to $500,000 per year ($250,000 against each), if you are a qualified small business. This payroll tax offset lets qualified small businesses benefit from their research activities regardless of profitability.

What if I don’t have a tax liability?

If you are conducting qualified research and development projects, it’s beneficial to claim the R&D tax credit regardless of your company’s taxable income. R&D tax credits can be carried forward to offset future income tax liability. Typically, credits that can’t be used immediately will carry forward for up to 20 years. Also, companies can often claim the R&D tax credit retroactively by filing amended returns.

Can I offset payroll tax?

Qualified startups can apply up to $500,000 of R&D credits against payroll taxes each year: up to $250,000 against the employer share of Social Security tax and up to $250,000 against the employer share of Medicare tax. This offset is available for up to five years, for a maximum of $2.5 million in total credits used on quarterly federal payroll tax returns. Whether or not your startup is profitable, you may qualify if you have less than $5 million in gross receipts and are within five years of your first gross receipts. You must make the payroll tax election on your original, timely filed return (including extensions), so it can’t be added later on an amended return.

What about the Alternative Minimum Tax?

Claimed R&D tax credits can now immediately reduce a company’s tax liability, freeing up cash that can be reinvested in the company. Companies whose R&D tax credits may have been limited by the AMT in the past can now use the R&D tax credit to fully offset AMT without regard to tentative minimum tax. Eligible small businesses are sole proprietorships, partnerships, and non-publicly traded corporations with $50 million or less in average annual gross receipts for the prior three years. Arvo has a team of professionals to help you claim and monetize your R&D tax credit benefit.

Filing your claim for the R&D tax credit

The R&D tax claim needs to be submitted along with your annual corporate tax filing. Here is what you need to file:

• Form 6765, Credit for Increasing Research Activities.
• Form 3800, General Business Credit. This form has a line that asks for the amount of Credit for Increasing Research Activities.
• Each state will have its own form if it offers a state R&D tax credit program. If you qualify for the payroll tax offset, you will need to make sure you account for it on Form 941, Employer’s Quarterly Federal Tax Return. You will also need to fill out and attach Form 8974, Qualified Small Business Payroll Tax Credit for Increasing Research Activities.
• Documentation requirements as stated in I.R.C. § 41

Taxpayer documentation needed to claim the R&D tax credit

Start by reviewing all of your company’s activities for potential eligibility. Then begin tracking expenses and gathering documentation as the work happens. Good records are your best protection in an audit and help you avoid penalties. A number of factors go into claiming the credit, but the potential savings on the table make exploring the credit a worthy endeavor. The R&D tax credit may be claimed for current and prior tax years. As such, businesses need to document their R&D activities to ensure they are positioned to claim the credit. The taxpayer must document how they met the requirements to qualify for the credit and how the credit was calculated. To claim the credit, the taxpayer must contemporaneously evaluate and document their research activities to establish the amount of qualified research expenses paid for each qualified research activity. While taxpayers may estimate some research expenses, they must have a factual basis for the assumptions used to create the estimates. Your documentation should prove that the expenses you claim are eligible. It needs to:

• Be dated, to show the work happened in the tax year you are claiming
• Highlight the technical challenges you worked through, to show real R&D took place

Examples of such documentation include:

• Timesheets
• Version control for all technical documents
• Prototypes, including software and physical products
• Test documents
• Developer or Engineering Notebooks
• Meeting minutes
• Whiteboard photos
• Emails
• Invoices/ receipts
• General ledger notes
• Project notes
• Contractor agreement outlining statement of work
• Other documents a company produces throughout the regular course of business