Taxes do not bring much joy neither to individuals nor the businesses who have to pay them. But what if you could pay less? This would definitely put a smile on everyone’s face. If you have done taxes at least once in your life, you probably came across the terms credit and deduction. Although both of these can be good for your final tax returns, they are very different.
Today, we are going to discuss one of the tax credits your organization might want to look forward to because it reduces your overall tax liability. It is one of those tax credits that management and even tax preparers often simply look past because they are not very familiar with it and believe that it is applicable only to very few businesses.
The importance of business growth and, more importantly, the inventions and introductions of new goods, ways of doing something, and so on has long been studied and confirmed. The United States government in most states offers tax incentives for companies pursuing creations and inventions. It encourages innovation that brings about jobs growth, technological leadership, and global competitiveness to make this country’s economy even better.
Billions of R&D tax credits are claimed by businesses every year. At the same time, billions of dollars still remain unclaimed. Why? Because most business owners and even CPAs think of Research & Development as people working in labs doing scientific research.
Research and development cover a wide variety of business activities from simple research of what products will be in more demand among customers to developing new ways to extract fuels. When it comes to the IRS, the definition of these activities is also relatively vague, which allows business owners to save money big time when it comes to R&D wages, contractor costs, and supplies.
How does it benefit my business?
Every business is looking for tax-saving strategies that would significantly reduce their tax bill. The Federal R&D Tax Credit is such a strategy and it enables to put cash back into your hands or the hands of the shareholders and business owners.
As facts and court cases show, more businesses can apply this strategy than you might think. The savings are very well worth the time you will spend further researching and applying for this tax credit. A small engineering business, for instance, with annual revenue of $2.5 to 3 million, you could easily save around $15,000 to $50,000. If you are a larger business earning about $20 million in annual revenue, your tax savings could go up to $100K. The bigger your business, the more credit your company can generate, and there is no limit on how much credit you can receive.
As we will discuss later, if your business cannot use the whole sum during the current year, it can be carried forward up to twenty years. Are you already thinking about where you could apply the money saved by paying less taxes in your business? Is it more research and development or maybe you wanted to update your equipment for some time, but your business could not afford it?
The possibilities to enhance your cash flow are endless, and it would be sad if your business missed the opportunity to take advantage of this credit. This tax credit encourages business owners not only to innovate but also to earn as much profit as possible because the bigger this number is the more you will receive from the government. Despite this, CPAs are seeing many startups miss out on thousands or even hundreds of thousands of dollars of savings in the form of unclaimed R&D tax credits.
How does my business qualify for R&D Tax Credit?
You might have heard about it and even looked into it, but thought that this credit is not for your company. Initially, the credit was intended to incentivize large profitable multinational corporations to bring back high-tech jobs, which would bring more taxes from the increased taxable income, and innovation. The good news is that the complex rules were evolved over the past 40 years.
You don’t have to be a manufacturer to claim this credit. It is now available to all industries, such as manufacturing, including food manufacturing, engineering, programs, medical devices, electronics, aerospace, automotive, agriculture, clothing and apparel, and so on.
There are several requirements that you need to meet to be eligible for the R&D tax credit.
- There are business tests that you need to do first to check if you qualify. Is your research and development taking place in the United States? The answer should be a yes. Are you bearing any financial risk when performing these activities? Do you have rights to intellectual property?
- Next, you need to perform technical tests. First, your R&D must have technical uncertainty involved. Second, a process of experimentation must take place to find a solution to these uncertainties. To be able to claim the R&D tax credit, the research and development should also be technical inherently and relate to a new or improved business component.
- Finally, there are some documentation requirements. The R&D credit itself is a direct reduction of the amount of taxes you have to pay. The best part about it is that your business does not have to apply all of it in a single year. If it is not used during the current year, it can be carried forward up to twenty years.
It is also worth noting that even if your company fails to develop something new or improve its existing products, you are still eligible for these tax credits. If you are developing or formulating new or improved formulas or products or functionally enhancing existing ones, you should look more into this topic. Have you applied for a patent? You may qualify! Maybe you are assisting clients with technical problem-solving or developing new or better software for use or sale – the list of possible activities that may qualify is really endless.
A startup or a small business can claim the federal R&D tax credit in the amount of up to $1.25 million (or $250K for five years on yearly basis) if they have less than five million dollars of revenue and it had no income or interest before 2015 no matter when the business was started. The actual amount will be a percentage of your R&D spendings, the limit of which is different for companies that are making a profit and businesses that are experiencing losses. The greater either one is the more credit you will receive. This credit can be used to cover the payroll taxes they need to pay or the FICA portion, to be more specific.
Of course, it would not be real if there were no exclusions for what type of work can qualify for this credit. These include any research that is done after commercial manufacturing has begun. Adaption duplication of existing business components or claiming someone else’s activities, also known as reverse engineering are also not suitable reasons to claim the tax credit.
There are some other exclusions, such as market research, quality control, surveys, and computer/mobile programs that you developed to use within your company, that you should familiarize yourself with before you try to claim the R&D tax credit.
How is it claimed?
Even if your company is not making any money yet, it is important to take advantage of this opportunity to get credit now because there are some documentation requirements involved that you need to take care of before you get the credit. The process of documenting the R&D Tax Credit takes more work than you might think.
Your first step would be figuring out what is eligible for the R&D tax credit. You can go to the official IRS website to get more information on activities that it deems to be appropriate to qualify for this tax credit. An accountant can perform an audit of your business to make sure that you are actually doing qualified research activities and estimate the amount you can get, which depends on the amount you spent on your qualified activities, so make sure you do not miss any receipts as they add up really quickly.
It is best to have a consultation with an auditor who already has experience with the R&D tax credits.
Once you figure out the projects or work that qualify for this tax credit, you need to figure out the expenditures involved with this research or development process, who is involved and how much time they spend on research and development, which contractors you have to bring in, and how much material you had to buy to create your product.
Besides determining if you are eligible or not, you also need to study the rules on what type of expenses and costs you can include in your calculations. For example, phone bills of researchers, travel, meals, and entertainment are some of the expenses that you cannot claim. Relocation or rental/lease expense also falls under exclusions. Each year, you would need to wait for the tax credit to be approved for the foreseeable future and while there is time to react, you need to do the preparation.
Once all the preparation work is done, you will file Form 6765 along with your company’s annual income tax return. Just like the taxes you pay on the money your business brought, the credit you will receive is based on your business activities for the year that has already passed. This means that you need to plan ahead if you want to take advantage of these savings in the future. You will have two years to claim the credit since the time you had the expenditures, so do not set this task aside and get that well-deserved cash back into your business.
Just like was mentioned above, this tax credit has nothing to do directly with income taxes. Instead, the government hopes that you will hire more people and pay the specialists a higher salary to accomplish your research and development goals. Thus, you get the money back through payroll. This is a credit against your Social Security taxes. So, once you paid all your taxes and the quarter is up, your business will receive a refund check or deposit from the IRS. It is also possible to use the credit every time you run the payroll.
Does unused credit expire? Yes, it does eventually expire. The unused portion of the initial amount will roll over, but only for twenty years. Nonetheless, it is a period that is long enough for any company to use up all the credit given by the government.
What change did tax reform bring?
Not everyone knows that this credit was a temporary measure that should have lasted only until 1985. However, it has been extended multiple times and currently still exists. Significant tax legislation at the end of 2015 has greatly increased the applicability of the credits. Now, almost every, if not all, business can now receive a refund for the research and development activities they are performing.
What has changed since 2015? There was one huge problem that prevented many companies from getting tax credits. This is because the company had to have taxable profits to be able to apply, which meant that only already developed and stable companies benefited and had an opportunity to expand further. Fortunately, Congress realized that it was the startups that were innovating and creating more high-tech jobs than other organizations.
The changes passed in the new law meant that high-tech companies that are not making large profits yet could suddenly access huge savings – up to a quarter of a million dollars of tax savings a year that could be applied towards their FICA portion of the taxes owed on the payroll. Although companies could apply these credits only when filing in 2017 and it took a lot of effort to make sure all the documentation meets the requirements, the changes benefited the businesses that really needed a helping hand to stand strong on their feet and grow.
Author: Charles Lutwidge