I have mentioned about the R&D credit to some small business owners, and they are confused and asked me “isn’t the R&D credit only for big companies like Google?” The answer is no. The business of all sizes may be eligible to apply for R&D credit up to $1.25 million or $250,000 each year for up to 5 years of the federal R&D credit to offset the Federal Insurance Contributions Act (FICA) portion of their payroll taxes each year
We are going to learn about more R&D credit and qualification. I will share my personal experience of applying for R&D credit on behalf of my client.
What is the R&D Credit?
The Research and Development Tax Credit is a government-sponsored tax incentive that rewards companies for conducting R&D in the United States. The purpose of implementing this tax credit is to incentive innovation throughout the economy and to keep technical jobs in the U.S. Furthermore, the R&D credit is for business of all sizes, not just major corporation with research labs or a large research and development team.
Who are qualified for the R&D Credit?
Companies want to claim R&D credit, they must meet each element of a “Four-part test”.
1. Qualified purpose: The purpose of the research must be to create a new or improved product or process, resulting in increased performance, function, or quality.
2. Technological uncertainty: A company must encounter uncertainty regarding whether it can or how it should develop the component, or regarding the component’s appropriate design.
3. Technological in nature: The success or failure of the evaluative process must be determined by hard sciences, such as engineering, physics, chemistry, biology, or computer science.
4. Process of experimentation: A company must demonstrate the research through modeling, simulation, systematic trial, and error, or other methods that are has evaluated alternatives for achieving the desired result.
Companies that are planning to claim the credit must also prepare the documents to identify and support the above “Four-part test”.
Other than the “Four-part test”, companies still need to meet the qualification for the following two rules:
1. Gross receipts less than $5 million in the taxable credit year
2. No more than 5 years of gross receipt
What expenses are qualify for the R&D credit?
1)Taxable wages for employees who perform or support qualified activities. 2) cost of supplies used in qualified activities 3) 65%-100% of contractor expenses for the qualified activities 4) rental or lease costs of computer and machines used in qualified activities.
Qualified activities are covered by 3 major concepts:
· Develops or designs new products or processes
· Enhances existing products or processes
· Develops or improves upon existing prototypes and software
How to claim the R&D Credit
As mentioned above, you can claim the credit against the expenses for the qualified activities. Most companies will claim the R&D credit against the taxable wage for employees because it is the largest portion of the expense for the research and development activities. The company need to file a Form 6765, Credit for Increasing Research Activities, regardless of offsetting the credit payroll expense or other expense, this form is necessary to fill in in order to claim for the credit. Next, the company needs to file a Form 8974, Qualified Small Business Payroll Tax Credit for Increasing Research Activities. Finally, the company needs to file Form 941, Employer’s Quarterly Federal Tax Return as necessary for withholding payroll tax for the employee. When submitting Form 6765 and 8974, both form must accompany with Form 941.
The payroll tax offset is available on a quarterly basis beginning the first calendar quarter that begins after a taxpayer files their federal income tax return.
My personal experience
In 2017, I was hired as a tax consultant and preparer for a startup software company in New York. The company is launched in 2016, and the main business is to develop software to sell to retail companies. The company incurs $300,000 in developers’ salary, supplies, and lease for high-end computers in an attempt to develop its flagship software. The company has not generated any gross receipts before the software is fully developed.
On behalf of my client, I filed the form 6785 with all the information and backup documents. As a result, the eligible expense generates a credit of approximately $24,000. The company files quarterly Form 941 on a quarterly basis, so I decided to use $24,000 of credit to offset its FICA payroll tax on its quarterly Form 941.
The entire process of claiming the credit could be complicated, but we have a very organized system to keep every document on file, so it was quick and easy when the IRS asked for any supporting documents. Also, when offsetting credit again payroll tax, it could be done with a payroll agency to simplify the process.
Bottom Line
The R&D credit is highly recommended for startup technology companies to apply. They spent a lot of financial and human resource to develop a product to sell the market, why not take the tax credit to lower the financial burden. However, if you are not familiar with the tax rules, you should work with a tax professional to walk through the process.