By: Gene Barinholtz, CPA
Key Takeaways:
- The R&D tax credit is a valuable incentive to encourage businesses to innovate that has been in the federal Internal Revenue Code for more than 40 years.
- It supports private industry research and development activities in diverse sectors such as manufacturing, agriculture, architecture, engineering, pharmaceuticals, aerospace, and software development.
- To qualify for the R&D tax credit, businesses must fulfill criteria including developing or improving products or services; eliminating uncertainty; technological experimentation; and technological discovery.
- There are four components to the credit: regular credit; alternative simplified credit; energy research credit; and basic (or university) research credit.
- The Tax Cuts And Jobs Act of 2017 changed how R&D expenses can be deducted but not the actual amount of the R&D tax credit.
R&D Credit Broadly Used by Many Industries
Innovation that feeds the growth of technology and expands our understanding of how things work is at the heart of economic growth. So, it is no surprise that government policies that support innovation are seen as crucial to the nation’s well-being.
That is why the research and development (R&D) tax credit has been a critical – and very popular – provision of the federal Internal Revenue Code for more than 40 years. It is a valuable incentive to encourage businesses to innovate, allowing them to lower tax liability in exchange for investing in technological advancements, improving products and processes and contributing to economic growth.
Although the rules around the R&D tax credit have changed over the years, its status as a symbol of the government’s support for innovation has not. In this article, we will discuss how the credit works and which industries benefit from it.
First, a Little History
In the post-World War II decades, the U.S. saw an explosion of innovation both in the public and private sectors, much of it an outgrowth of research and development done to advance the war effort. By the 1960s, the U.S. was investing approximately 2.5% of Gross Domestic Product (GDP) in research and development. Of that amount, the federal government was fueling an amount equal to 1.75% of GDP and private business about 0.75%.
By 1980, the federal government’s R&D activity had dropped significantly and that of private industry had remained steady at about 1% of GDP. Concerned that U.S. economic performance had fallen below its potential and would continue to languish, Congress in 1981 created the R&D tax credit to incentivize and reward innovation by private industry.
Private innovation took off like a shot, and by 2018 R&D activities by private industry stood at about 2% of GDP, while federal government activities had fallen to just over 0.5%.
What Industries Can Claim the R&D Credit?
While commonly associated with scientific research and high-tech sectors, such as pharmaceuticals, aerospace and software development, the credit is not limited to these fields. Innovation happens in various sectors, including manufacturing, agriculture, architecture and engineering. Therefore, businesses from diverse industries can leverage the R&D tax credit to support their research and development initiatives.
For example, KRD represents many manufacturing companies that commission annual R&D studies that have collectively saved millions of dollars in taxes over the past 10 years.
How To Qualify and Claim the R&D Tax Credit
Claiming the R&D tax credit requires careful record keeping and reporting of expenses. Most importantly, R&D activities must meet four criteria set out in IRC Section 41 in order to qualify for the credit:
- Permitted purpose: R&D activities must develop or improve the functionality, performance, reliability or quality of a new or existing business component (product, process, software, technique, formula or invention).
- Elimination of uncertainty: The development or improvement of the business component must seek to discover information that would eliminate uncertainties about its appropriate design or the capability or method of its development.
- Process of experimentation: Taxpayers are required to identify technological uncertainty and then properly evaluate one or more alternatives to eliminate it.
- Technological in nature: Experimentation has to rely on the principles of engineering, physical or biological science, or computer sciences and seek to discover information that is technological in nature.
The R&D tax credit is typically designed to offset a portion of the expenses incurred in qualifying research and development projects. These expenses can include wages, supplies, and contract research costs directly related to eligible R&D activities. The credit reduces a company’s tax liability, resulting in lower taxes paid and providing additional funds that can be reinvested into further innovation.
The R&D tax credit has four separate elements: the regular credit, the alternative simplified credit, the energy research credit and the basic (or university) research credit. In any year, taxpayers can take the energy research credit and the basic research credit, along with either the regular credit or the alternative simplified credit. The credit base varies with each type:
- Regular credit – 20% of qualified research expenses (QREs) above a base amount.
- Alternative Simplified Credit – 14% of QREs above half of average QREs over the previous three years.
- Energy Research Credit – 20% of QREs.
- University Research Credit – 20% of QREs above a base amount.
The R&D tax credit is complex and many companies engage an outside consultant to perform an R&D study to help determine the expenses they have that will qualify and to build the documentation they will need.
Are There Any Recent Updates or Changes to the R&D Tax Credit Legislation?
The R&D tax credit has been subject to many changes over the years, and one of the biggest – wrought by the Tax Cuts and Jobs Act (TCJA) – just took effect for the 2022 tax year.
Under the new rules, R&D expenses must be capitalized and amortized over five years (domestic expenses) or 15 years (international), rather than being immediately deducted. This has the effect of significantly reducing the value of the R&D tax credit, though the credit itself was not affected by the rule change.
While there is some appetite in Congress to revert to the old rules, no legislative action has yet taken place.
How We Can Help
If your company engages in innovation activities in an effort to develop new and better products, improve processes or make advances in safety, contact your KRD advisor to discuss how the R&D tax credit may benefit you.
