Understand the Basics of the R&D Tax Credit

R&D Tax Credit Basics

The research and development tax credit was enacted in 1981 and allows taxpayers to claim the research and development tax credit through the R&D tax credit basics defined in the tax code. The R&D tax credit creates an incentive for taxpayers to invest in research and development activities within the United States by offsetting federal tax liability. R&D tax credit basics in the tax code provide an outline for taxpayers to determine what is the R&D tax credit and how to claim the R&D tax credit. When claiming the research and development tax credit in 2022, taxpayers will need to file Federal Form 6765 with their federal tax returns. Serving as a basis of the R&D credit calculation, taxpayers can claim qualified research expenses, including wages, supplies, computer leasing, and contract research expenses. R&D wage expenses are Box 1 W-2 wages of those individuals who are directly or indirectly involved in the design, supervision, or support of qualified research activities outlined in the R&D tax credit basics. Supply costs included in the R&D credit calculation are tangible, non-depreciable materials used in qualified activities deemed acceptable based on the tax code. Contract research costs used in R&D credit calculations include any third-party consultants or sub-contractors who are assisting the taxpayer in qualified research while the taxpayer bears the economic risk during the qualified research activities. Each of these potential expenses must be supported by documentation that fulfills the R&D tax credit documentation requirements. The R&D credit calculation relies on the selection of the appropriate calculation method. The methods for calculating the research and development tax credit 2022 include the Standard Calculation method, the Start-up calculation method, and the Alternative Simplified Credit method. Each of these R&D credit calculation methodologies relies on previous years’ R&D tax credit documentation and data to determine the R&D credit calculation.

R&D Tax Credit Qualifications

R&D tax credits are available to organizations that are investing in qualified research and development. The R&D tax credit qualifications are laid out in the tax code through a four-part test for research and development tax credit qualifying activities. The first part of the R&D tax credit qualifications states that the research and development tax credit qualifying activities must be centered around developing a new or improved business component, such as a process, product, technique, software, or formula. Research and development tax credit qualifying activities must be technological in nature, meaning the activities must rely on the hard sciences, including, but not limited to, biology, chemistry, physics, engineering, or computer science. After determining the first two parts of the R&D tax credit qualifications are met, the McGuire Sponsel team continues to assist clients with the R&D tax credit qualifications. The third part of the R&D tax credit qualifications says that research and development tax credit qualifying activities related to the business component must have some technical uncertainty. Clients can ask themselves the following questions to determine if the research and development activities exhibit technical uncertainty: Can the project be accomplished? How will the project be accomplished? What will the final design be once completed? The fourth and final aspect of the four-part test involves conducting testing or experimentation such as computer simulation, engineering calculations, physical testing, or systematic trial and error. Determining the research and development tax credit qualifying activities is the first step when conducting a R&D tax credit study. There are four potential quantifying costs to the R&D tax credits: wages, supplies, computer leasing, and contract research costs. Wages, specifically the Box 1 W-2 amount of technically involved individuals is the largest driver of the R&D tax credits. Following the R&D tax credit qualifications listed above, each individual must determine the amount of time spent on research and development tax credit qualifying activities during the tax year of interest through time-tracking data or a R&D tax credit questionnaire. If time-tracking data is not available, the McGuire Sponsel team provides an R&D tax credit questionnaire which is an estimation tool of an employee’s amount of qualified time in a given tax year. Taking the Box 1 W-2 amount and multiplying that amount by the qualifying percentage determined above, the qualifying wage expense is calculated. After qualifying wages are calculated, the taxpayer and the McGuire Sponsel team will also analyze the other three potential qualifying expenses. Supplies, which include any tangible, non-depreciable materials used during research and development tax credit qualifying activities is a potential qualifying expense. Computer leasing, which includes any amount paid or incurred for the rental or lease of computers, including cloud computing, used in conducting the research and development tax credit qualifying activities, is a potential qualifying expense. Contract research, which includes any third-party consultant or sub-contractor costs incurred during the research and development tax credit qualifying activities, is a potential qualifying expense. An R&D credit limitation with contract research expenses is the taxpayer must bear the economic risk of the outsourced qualified research, and that research must be performed in the United States.

How To Calculate R&D Tax Credit

Businesses may have more than one way to perform their research and development tax credit calculation. Using an R&D tax credit excel spreadsheet to serve as an R&D tax credit calculator, the McGuire Sponsel team educates the client on the qualified research expenses and how to calculate R&D tax credit. The qualified research expenses include wages of qualified employees, supplies, computer leasing, and contract research expenses. The wages of directly, technically involved individuals are the main driver of the research and development tax credit calculation. Qualified supply expenses include any tangible, non-depreciable materials used in the qualified research activities. Computer leasing expenses include any rental or lease of computers or cloud computing used in the qualified research activities. Contract research includes the expenses incurred by a third-party consultant or sub-contractor assisting with developmental activities. An R&D credit limitation with contract research is the taxpayer must bear the economic risk of the research being performed by the third party. Another R&D credit limitation is that the third party must be performing the qualified research activities within the United States. The research and development tax credit calculation is performed using the most appropriate method based on the history of the taxpayer. The three possible research and development tax credit calculation methods include the Standard method, the Start-Up method, and the Alternative Simplified Credit method. Each of these methods relies on historical financial data and historical qualified research expenses to calculate a R&D credit base amount.

R&D Tax Credit Examples

Taxpayers may have more than one way to perform their research and development tax credit calculation. Each R&D tax credit example relies on different historical data and utilizes a different base amount and credit percentage. A projected R&D tax credit calculator would estimate taxpayers to receive about 5-7% of qualified research expenditures in credit return. The first R&D credit calculation example is called the Standard method. This approach can be complex to utilize because it relies on historical qualified research expenses and gross receipts from the years 1984 to 1988, presenting an R&D credit limitation. The R&D credit base percentage is calculated using the ratio of historical qualified research expenses and gross receipts from the years 1984 to 1988. The R&D credit base amount is calculated using the gross receipts from the four prior years multiplied by the determined base percentage. The credit percentage for the Standard calculation method is 20 percent. The second R&D credit calculation example is called the Start-Up method. This method, like the Standard method, rewards taxpayers for increasing qualified research expenses as a percentage of gross receipts to historical data. The R&D credit base percentage is calculated based on the first year the company had qualified research expenses and cannot exceed 16 percent. The McGuire Sponsel team assists the client in calculating what is the fixed-base percentage for the R&D tax credit based on historical data provided. The R&D credit base amount is calculated using the gross receipts from the four prior years multiplied by the determined base percentage. The base amount cannot be less than the 50 percent of the qualified research expenses for the tax year of interest. The difference between the Start-Up and Standard methodologies is that the Start-Up is the years examined when determining the fixed-base percentage. The credit percentage for the Start-Up calculation method is 20 percent. The most common R&D tax credit calculation example is called the alternative simplified credit calculation. The simplified R&D credit calculation relies on the previous three years’ qualified research expenditures, allowing taxpayers that lack historical data necessary to calculate the R&D credit base amount to still file for the research and development tax credit. This R&D credit calculation for the research and development tax credit in 2022, for example, relies on calculating the company’s average of three previous years’ qualified research expenditures and multiplying that average by fifty percent. The next step in the Alternative Simplified Calculation method is to take the average amount previously calculated and subtract that value from the tax year 2022 qualified research expenditures. Finally, multiplying the amount in the previous step by 14 percent will yield the gross federal research and development tax credit for 2022.

R&D Tax Credit IRS

Put into law in 1981, R&D tax credit is a tax credit that rewards taxpayers for investing in domestic research and development. The IRS lays out a set of guidelines and qualifications within the tax code to guide taxpayers to successfully claim the research and development tax credit. When determining if a taxpayer is conducting qualified research, the projects of interest must pass a four-part test specified in the tax code. The qualified research must be related to a new or improved business component, be technological in nature, possess some sort of technical uncertainty, and require a process of experimentation to eliminate the technical uncertainties. After the activities have been deemed qualified, the R&D tax credit calculation can be completed by gathering the related expenses: qualified wages, supplies, computer leasing, and contract research. Form 6765 is the research and development tax credit form filed with the taxpayer’s returns for the tax year and amended tax years of interest. The IRS Form 6765 instructions define the R&D credit calculation methods. Taxpayers must also be aware of R&D tax credit limitations, such as all qualified research must be performed in the United States and must be unfunded by another taxpayer or governmental entity. Following the R&D tax credit calculation finalized values, Form 6765 is filled out accordingly and included in the R&D tax credit report example.

R&D Tax Credit 2022

During 2022, the IRS provided new guidance about the R&D tax credit reform with respect to R&D tax credit 2022 studies and beyond. The biggest R&D credit updates relate to the R&D capitalization for 2022 and R&D tax credit AMT limitation. In 2017, the Tax Cuts and Jobs Act (TCJA) benefitted taxpayers by lowering the corporate tax rate, but it also eliminated the ability for taxpayers to immediately deduct R&D expenses in the tax year incurred, impacting the research and development tax deduction. The TJCA further influenced the R&D tax credit AMT limitation for corporations and individual taxpayers. Effective January 1, 2022, taxpayers are required to capitalize and amortize U.S. based R&D credit expenses over a period of five years. International costs are required to be amortized over a 15-year period. All software development costs are also now regulated by the new amortization rule.

R&D Tax Credit California

The California R&D credit instructions are very similar to those of the federal R&D tax credit with some modifications. Qualified research expenses included in the California research and development tax credit must be conducted in the state of California. While there is no alternative simplified credit method used when calculating the California R&D credit, the state still allows for the alternative incremental research calculation method with a reduced incremental credit rate of 1.49%, 1.98%, and 2.48%. The regular California calculation method takes 15 percent of the excess of California research expenditures for the tax year of interest and divides that by the calculated base year research expenses calculated using California R&D credit gross receipts. University-based research expenses for the tax year of interest are includable at 24% in this calculation method. California R&D credit gross receipts are needed for the previous four years in the standard method. Unused California research credits can be classified as California R&D credit carryforward and can be carried forward indefinitely, whereas unused federal credits can only be carried forward 20 years. Many states impose a dollar limit on the amount of expenses claimed, but that CA R&D credit limitation does not exist. Taxpayers wanting the California R&D credit utilization must fill out California research and development tax credit form FTB 3523 and file the form with their federal returns. C-Corporation, S-Corporations, LLCs, and Partnerships in California are eligible to claim the California research and development tax credit.