Every day, business owners in nearly every industry conduct research and development work. This work aims to create and improve their products and services. Still, many of them miss out on the valuable Research & Development (R&D) tax credit, a credit intended to incentivize and stimulate research and development.
According to a report from the Mercatus Center at George Mason University, the largest tenth of a percent of all organizations (0.13 percent) claims 82 percent of all R&D tax credit dollars. At the same time, the smallest 95 percent of firms claim less than five percent of credit dollars. So the small and start-up firms that are often considered to have the most socially beneficial research are often the ones receiving the least benefit.
A Tale of Two Bills
Two bills currently in the Senate and House aim to help more small organizations take advantage of the R&D credits.
Until recently, the R&D tax credit could only be used to offset a company’s income tax liability. That meant that many startups who were not yet profitable and had no income tax liability received no benefit from the credit. In 2015, the R&D credit was expanded to allow small businesses to claim the credit against employment taxes or the alternative minimum tax. However, many small businesses and entrepreneurs remain unaware of their ability to claim the credit.
S. 650, Support Small Business R&D Act of 2017
S. 650 requires the Small Business Administration (SBA) to create a program within the IRS to educate and train owners of small businesses and innovative startups about the availability of the tax credit. The House bill, H.R. 1543, would do the same.
Senator Chris Coons, D-DE, and Senator Pat Roberts, R-KS, co-sponsored S. 650, which has bipartisan support. The Senate Small Business and Entrepreneurship Committee unanimously advanced the bill on August 2, 2017.
If passed, the bills would require that the SBA and IRS develop partnership agreements to provide training no later than 180 days after the bills’ enactment.
What activities qualify?
Many people think of lab coats when they hear the term “research and development.” However, many more industries qualify for the R&D credit. This includes software development (whether for sale or for internal purposes); developing processes, patents, formulas, techniques, or prototypes; improving or redesigning existing products; hiring scientists, designers, or engineers; devoting time and resources to manufacturing or developing new and innovative products; and developing patents.
To qualify, the business must meet four tests:
- Elimination of uncertainty. The activity performed must eliminate technical uncertainty about the development or improvement of a product or process. In other words, you need to go beyond just making cosmetic changes.
- Process of experimentation. Activities must involve experimentation performed through modeling, simulation, systematic trial and error, or other methods.
- Technological in nature. The process of experimentation replying on the hard sciences, such as engineering, physics, chemistry, biology, or computer science.
- Permitted purposes. Creating or improving a product or process that results in increased performance, function, reliability, or quality.
Once you’ve determined that your innovation is eligible, you need to know what expenses qualify for the credit. These are:
- Salaries for those who work directly on the innovation and first-line managers
- Legal fees for patents
- US-based contractor fees
If the company doesn’t have a tax liability but its activities qualify, it’s important to maintain documentation. R&D tax credits can be carried forward for up to 20 years or carried back for three years by filing amended returns.
If the business has had gross receipts for five years or less and average gross receipts of no more than $5 million within the last five years, it can use the credit to offset up to $250,000 of the Social Security portion of the employer’s FICA taxes.
Documentation is essential. If your company’s activities could potentially quality, start documenting potential projects, products or processes, and then begin tracking those expenses.
While Congress looks at comprehensive tax reform, several deductions and tax credits are on the chopping block. The R&D credit is one that should be preserved and expanded. The support for this bill shows that’s likely to happen.
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