The Research and Experimentation Tax Credit, also known as the Research and Development (R&D) credit, is one of the most misunderstood parts of the U.S. tax code. The credit is over 30 years old, but has never been made permanent and, over its many renewals, new rules and regulations have been tacked on. Though the R&D Tax Credit hasn't been renewed for 2014, it was renewed through 2013 and qualified business can claim it on their returns by filling out Form 6765. However, the R&D credit remains one of the most closely scrutinized credit claims, so if you plan to use it, you should know exactly what you are getting into and be able to produce proof to back your claim up.
Exclusions to the R&D Credit:
Only qualified research counts towards the R&D credit, so you first need to ensure your research isn't excluded right out of the gate. The adaption, duplication or reverse engineering of any existing business component does not count. Nor does any research started after the beginning of the component's commercial production. Research into the arts or humanities is excluded, as is any research already funded by a grant or government entity. You cannot claim any market research or routine testing either. And, finally, while software normally counts for R&D credit, it does not if it is developed solely for use within your company.
The Four-Part Test:
In order for your research to qualify for an R&D credit, it has to fulfill four important requirements. First, your research has to be technological in nature -- so, as we mentioned above, you cannot research the arts or humanities and claim an R&D credit. Rather, you must rely on physical science, biology, engineering and/or computer science. Secondly, the purpose of your research or project has to be to create or improve the functionality, reliability, quality, or performance of a product, technique, invention, formula or piece of software. Thirdly, there has to be some degree of uncertainty that you hope to eliminate through your research. Uncertainty can be hard to define, so before you begin your research you need to figure out what questions you hope to answer with it -- are you sure the benefits of this new product will outweigh the risks? Do you know if this new process or product will even work as intended? A lot of times you cannot answer these sorts of questions until you have working prototype of whatever process or product you are developing. In those cases, you are researching to eliminate uncertainty. And, finally, there must be a process of experimentation to eliminating the uncertainty. So you need to have a theory or hypothesis, test it, build alternatives, and refine your theories as you carry out your research.
The Four Eligible Expenses:
Typically, there are four different types of expenses that can be claimed using a research and experimentation credit. The first, and likely largest, expense is wages. The wages of any employee engaged in, supporting, or supervising qualified research can be claimed. The supervisor has to be directly above the researcher, so you cannot claim any higher manager's wages. Since wages are where the bulk of your credit will come from, you need to closely document the connection between the employee and the project, so even if your researchers are salaried, you should keep time sheets that connect them to the project. Along with wages, you can claim the full cost of supplies, 65 percent of any research that was contracted out for the project, and 75 percent of any amount paid for basic research -- research by tax-exempt scientific groups, universities or grant organizations that wasn't completed for any specific commercial purpose.
Calculating Your Credit:
There are two ways to calculate your tax credit -- the traditional way and the alternative, simplified way. Most accountants recommend the simplified method. If your company is new, you simply claim six percent of qualified research expenses. If your company is over three years old, you find the average amount you've spent on qualified research over the past five years, halve it, and then claim 14 percent of any amount over that baseline. The traditional method remains an option, but it is very complicated, and while you can use the worksheet on Form 6765 to figure out your traditional credit, it may be a better idea to leave that up to a tax professional.
According to the IRS, large corporations and brand new start-up are the primary claimants of the R&D tax credit. Smaller businesses, it seems, will do most of their research right when they first start-up, claim their credits and then stop once the research slows down. In fact, if your company spent a lot on research during its early years, your baseline may be way above what you are currently spending on research and development. Still, if you paid for any qualifying research, you should calculate, and if possible claim, your R&D credit. Look through your employee files, review your research and talk to your accountant.