Research and Development Tax Credits - How Does It Work for Businesses?

Tax season is the timeframe when individuals and businesses in Los Angeles, or other metro cities file their income taxes. Tax prep can be a time-consuming process for businesses because they are inclined to follow U.S. tax codes, and failure to comply may result in stiff penalties. Whether you are the owner of a smaller or larger company, you may be eligible to claim tax credits. They reduce the amount of income tax your business owes to the state and federal governments. As the tax deadline approaches, companies may be eligible for the Research and Development Tax Credits.

Founded in 1981, the federal Research and Develop (R&D) Tax credit is a two-year incentive that offers an offset for the federal and state income tax liability. It is available in over 30 states, and its purpose is to reward companies for increased investments in their current tax year. This tax credit is available to companies that develop new or improved business elements such as products, processes, computer software, and techniques that improved quality, reliability, functionality, and performance. Although the Tax Cuts and Job Act (TCJA) in 2017 paved the way for businesses, the R&D Tax credit has provided opportunities that limit tax liabilities that have helped companies save thousands of dollars.

Companies can benefit from the R&D Tax credit because it is a dollar-for-dollar credit that reduces a company’s tax liability. There is no limit on the amount of credit that can be claimed per year, however, if the credit cannot be used immediately, it will be carried over depending on the state’s carryover regulations.

The Protecting Americans from Tax Hikes (PATH) Act of 2015 permanently expanded the R&D Tax credit. The purpose of this expansion was to create a tax benefit for start-ups and small businesses. After December 31, 2015, smaller businesses were allowed to utilize the R&D tax credit against their alternative minimum tax (AMT) restrictions. Furthermore, the PATH Act allowed startup businesses to use the tax credit if they did not have federal tax liabilities or gross receipts of less than $5 million. It gave smaller companies in Los Angeles, or other metro cities a refundable credit limit of $250,000 for up to five years.

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Many companies believe this tax credit only applies to product development purposes. Moreover, eligibility for startups can apply this tax credit for up to five years. Your organization may qualify if it:

• Improves quality of existing products
• Develops patents, prototypes, or processes of software
• Hires engineers, designers, or scientists
• Devotes time to creating new and improved products

To qualify, a company must meet the criteria in a four-part test.

1. Qualified purpose. The purpose of this research is to create a new or improved business component that results in the functionality, performance, reliability, or quality of a product. A business component can be a process, product, software, technique, or formula.
2. Elimination of technological uncertainty. A company must confirm its attempt to eliminate uncertainty regarding the development or improvement of a business component. Uncertainty occurs if the company is incapable of establishing a method to develop or improve a business component.
3. Process of experimentation. The company or taxpayer must evaluate alternatives through modeling, simulation, systematic trial and error, and other alternatives for achieving the desired result.
4. Technological in nature. The experimentation process is determined by the “hard sciences” such as chemistry, biology, physics, engineering, and computer science.

Some activities do not meet the criteria in the four-part test. Some activities include:

• Research conducted outside of the U.S.
• Market research
• Routine data collection
• Funded research by an unrelated third party. In other words, the taxpayer either does not possess rights to the results or has to pay for the activity
• Management & others.

Other activities that do not qualify are:

• Troubleshooting
• Maintenance or repairs
• Administration
• Activities that rely on social sciences, art, or humanities
• Reverse engineering

Your company located in Los Angeles, or other metro cities does not have to employ scientists to qualify for the R&D tax credit. Architecture, engineering design firms, and software development companies also qualify.

A company can claim the R&D tax credits by filing an IRS Form 6765, Credit for Increasing Research Activities. During the process, they need to identify qualifying expenses and provide documentation that states how these costs meet the requirements. As previously mentioned, R&D tax credits develop an offset towards income tax liability. Companies can take advantage of the credit by looking over their previous tax years. If a business does not have a current taxable income or has a limit on tax credit, the federal credit can be carried forward for up to 20 years.

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Businesses must complete four sections:

• Section A is used to claim regular company credits.
• Section B regards the Alternative Simplified Credit (ASC).
• Section C identifies any additional forms and schedules regarding business structure.
• Section D only applies to qualified smaller businesses (QSBs).

To claim the R&D tax credit, companies must document an estimate of expenses from qualified research. Examples of documentation include:

• Payroll records
• Project lists and project notes
• Ledger expenses
• Lab results
• Emails or other documentation produced throughout the course of business

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Expenses include:

• Taxable wages are given to employees who perform, supervise, or support qualified research and activities.
• The cost of supplies used for qualified activities and research. This excludes administrative supplies and capital items.
• About 65%-100% of contract research expenses for qualified activities. The taxpayer must preserve rights to results and pay the contractor whether the activity succeeds or fails.
• Rental and leasing costs of computers that are used in qualified activities and research.

Any sized U.S. companies in Los Angeles, or other metro cities from any industry can benefit from the R&D tax credit if they pay or are expected to pay:

• A regular federal income tax.
• A state tax in one or more than 40 U.S. states related to R&D investments.
• Federal payroll taxes.
• Similar taxes outside of the U.S. that provides incentives for R&D.

Here are a few ways the R&D tax credit can benefit your business:

• It improves your cash flow.
• Companies can carry forward credit up to 20 years.
• It reduces tax rates.

The RRC is a credit that is 20% of a company’s current yearly qualified research expenses (QRE) over the base amount. To calculate the credit, a business needs the average annual R&D receipts over the previous four tax years and if the business was established before 1980.

The ASC is one of four tax credits that make up the research tax credit. Unlike the RRC, it does not require annual gross receipts. This method allows companies to claim the R&D credit if they lack prior company records to document their base amount. Companies that are not eligible under the regular tax credit might qualify for the R&D tax credit.

As of 2009, the ASC is equal to 14% of QREs earned in the current tax year, and over 50% of the average QREs in the last three years. If a taxpayer did not have QREs over the last three years, the credit is 6% of the QREs in the current tax year. Here is the four-step calculation process:

1. Identify and calculate the average QREs from the previous three years.
2. Multiply the average QREs from the previous three years by 50%.
3. Using Step 2, subtract half of the three-year average QREs from the current average QRE.
4. Multiply Step 3 by 14%.

Businesses may not qualify for the RRC credit if they experienced a decline in R&D spending. They can still qualify for the ASC credit. For instance, if the R&D credit becomes more efficient with lesser costs, it could have a negative impact on R&D spending. A business in Los Angeles, or other metro city may not meet the requirements in the base period, making it ineligible for credits under the regular tax method.

Unlike the ASC, the RRC tax credit may result in a larger credit in some cases if the base amount is low. Other circumstances for using this method occur when a business is a startup or if the R&D spending is recent. The RRC method is more complex because it requires a great deal of time and effort to gather data.

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