A Primer on Research & Development Tax Credits
Questions about the Research & Development Tax Credit? We’ve got you covered.
What is the Research & Development Tax Credit?
Enacted in 1981, the Research & Development (R&D) Tax Credit is a federal tax incentive that functions to encourage companies to make R&D investments within the United States. It offers a broad definition of “research & development” that allows companies engaged in a wide variety of activities to qualify for the tax credit. Many states also offer additional R&D incentives.
How Does the R&D Tax Credit Work?
The federal R&D credit offers a dollar-for-dollar reduction in income tax liability on qualifying expenses in a given year. The credit can be carried back one year and forward 20 years. The R&D Tax Credit is annual, meaning companies can take advantage of it every year. The statute of limitations for the credit is generally three years; if a company is in a Net Operating Loss, however, it can look back more than three years.
Who Can the R&D Tax Credit Help?
Generally speaking, companies that invest in qualified R&D activity can benefit from the R&D Tax Credit if they have paid, currently pay, or expect to pay federal income tax (and/or a similar state tax, if performing qualifying activity in a state with R&D incentives). Broadly speaking, companies that fit one of the following descriptions qualify to take the R&D Tax Credit:
- Companies that develop brand new products, processes, software, or formulas
- Companies that develop material improvements to existing products, processes, software, or formulas
- Companies that hire employees for their technical backgrounds (e.g., software developers, engineers, etc.)
As a result of the Credit’s broad definition of “research & development,” a wide variety of companies and industries can benefit from the tax incentive. A non-exhaustive list of qualifying industries includes:
- Aerospace & Defense
- Food Science
- Hardware Development
- Software Development
What Activities Qualify for the R&D Tax Credit?
The R&D Tax Credit uses a four-part test to evaluate the qualification of activities. An activity must meet each element of the test, and not be on the list of exclusions. This test asks whether an activity does one of the following:
- Eliminates a technical uncertainty regarding a product’s capability, method or design
- Is technical in nature (i.e., relies upon physical science, biological science, computer science, and/or engineering)
- Uses the process of experimentation, including evaluating alternatives
- Involves the development of new or improved products, processes, software, or formulae
Since the goal of the R&D Tax Credit is to incentivize increased research and development within the United States, exclusions exist for activities that:
- Are conducted outside of the U.S.
- Rely on the social sciences, arts, or humanities (rather than the sciences listed in #2, above)
- Exist only to collect routine data or perform ordinary testing for quality control of existing components
- Can be defined as market research (e.g., consumer preference testing)
- Are funded by an unrelated third party, resulting in the taxpayer not retaining the rights to the results of the activity, and/or exist only to develop or improve software intended primarily for use by the taxpayer (there are some exceptions to this exclusion)
A non-exhaustive list of activities that qualify for the federal R&D Tax Credit includes the following:
- The development or testing of new products or materials
- The development of new or enhanced formulations
- The testing of new concepts
- The improvement of existing products
- Experimentation by trial and error
- The design of tools, jigs, and molds
- The design and analysis of prototypes or models
- The development or improvement of production or manufacturing processes
- The development, implementation, or upgrading of systems or software
- Payments to outside consultants or contractors to perform any of the above-mentioned activities.
What Expenses Qualify for the R&D Tax Credit?
According to the regulations of the federal R&D Tax Credit, qualifying costs include:
- Any supplies used and consumed during the development process (must be non-depreciable property)
- Wages paid for employees involved in the qualifying activities (either performing, supporting, or supervising the qualifying activities)
- 65%-100% of the amounts paid to non-employees (e.g., contractors) involved in the qualifying activities
- The rental or lease costs of computers used in the qualifying activities.