What are R&D Tax Credits?

R&D Tax Credit Origins & Background

Although there are many ways the U.S. government attempts to increase research activity (e.g. government research agencies, research project grants, protection of intellectual property rights), tax incentives are another method used to increase the after-tax return for research investment to U.S. taxpayers.

Originally enacted in 1981, the Credit for Increasing Research Activities (“R&D tax credit”) had been temporarily extended 16 times before finally becoming permanent in the U.S. tax code through the Protecting Americans from Tax Hikes (PATH) Act of 2015.


While the credit is usually assumed to be a single credit, it actually consists of three discrete credits taxpayers are eligible to claim provided it meets the requirements for each: (1) the regular research credit or alternative simplified credit (ASC), (2) a basic research credit, and (3) an energy research credit

For additional details on essential R&D tax credit components and audit protection, see below.

Historically, the U.S. has also often provided incentives for R&D spending through the tax code. Since 1954, the tax code has also allowed the deduction or amortization of research expenditures (in lieu of capitalization), in order to eliminate uncertainty concerning tax accounting treatment of research expenses and to promote research and development by U.S. taxpayers.

The R&D tax credit is classified as a general business tax credit. It was created as an incentive to U.S. companies to develop new and improved products and processes. The credit was designed to subsidize increases in R&D investment expenses above a baseline amount. In addition to the federal tax credit, many states provide their own similar R&D tax credit benefits, and often are nearly identical to the federal rules to calculate.

Recently, the Office of Tax Analysis (OTA) released its estimated R&D tax credit expenditure impact to the U.S. Treasury budget as $148.0 billion for fiscal years 2017-2026 (average of $14.8 billion in annual credits estimated to be claimed). As acknowledged by the U.S. Department of the Treasury, the R&D credit is one of the largest business tax expenditures available under the U.S. tax code. Any federal R&D credits not used in the current year receive a one-year carryback or a 20-year carryforward to offset potential tax liabilities.

Every year, companies claim billions of dollars in U.S. R&D credits, directly offsetting their tax liability. However, every year billions of dollars in credits also go unclaimed because many companies (particular mid-to-small corporations) fail to realize that they are also eligible. For example, the U.S. Department of the Treasury (Office of Tax Analysis) noted the following credit claim disparity between which taxpayers were actually claiming R&D credits in 2012. 

Total of $11.6 billion of current-year R&D credits were reported on corporate and individual returns for 2012 

  • Corporations accounted for $10.8 billion (93%) of the total  

    • Manufacturing was by far the largest sector claiming the research credit

      • 6,219 corporate manufacturers claiming almost $6.6 billion of tax credits, comprises 39% of the 15,873 corporate returns and 61% of the $10.8 billion in total current-year credits.

  • Larger corporations with gross receipts of $250 million or more:

    • accounted for 14% of all corporate tax filers claiming the R&D credit, but represented 84% of the total amount of R&D credits claimed.

  • Mid-market corporations with gross receipts less than $50 million:

    • accounted for just over 72% of the returns, but represents less than 11% of the current-year R&D credit.

  • Smaller corporations with gross receipts less than $5 million:

    • accounted for 42% of the returns, but these small taxpayers generated less than 6% of the current-year R&D credit.

See Citations & Links for additional information:

R&D Tax Credit Facts & Potential Benefits

There are several benefits to realizing the federal and/or state R&D tax credit and may include the following:

  • Approximately 7.9 to 15.8 cents for every qualified dollar spent may qualify for R&D tax credit tax savings

  • Dollar-for-dollar reduction in your federal and/or state tax liability

  • Potential immediate cash savings ($250,000 per year) against federal FICA payroll taxes

  • Federal and state R&D tax credit available

  • Increase earnings-per-share valuation

  • Increase asset reporting on financial statements

  • Reduction of your effective tax rate

  • Increase cash flow in current and/or future years

  • Excess federal credits can be carried forward to future tax periods 

  • Recent regulatory and IRS developments (ASC 730 IRS Directive, FICA payroll offset, etc.) make claiming and substantiating the R&D tax credit much more feasible

  • Look back R&D credit studies can recognize unclaimed credits for open tax years (generally 3 or 4 years) for potential cash refunds

  • Designed to stimulate job creations, innovation, growth, and global competition by U.S. companies

  • Most industries contain R&D credit opportunities, including qualified expenses outside of core R&D cost centers or departments

  • Applicable for both established businesses and first year ("start-up") companies

  • Annually more than $14 billion in federal and state credits are claimed by U.S. taxpayers

  • High majority of potentially eligible businesses are not currently claiming the R&D credit

Common Reasons Companies Mistakenly Fail to Claim the R&D Tax Credit

Not Paying Federal (or potentially state) Income Taxes

Start-up companies and small businesses may be eligible to apply up to $1.25M ($250K annually for up to 5 years) of the federal R&D credit to offset the Federal Insurance Contributions Act (FICA) portion of their payroll taxes each year.

To be eligible, a company performing qualified research activity must meet two requirements:

  • Have less than $5 million in gross receipts for the current credit year; and 

  • Have no gross receipts before the fifth prior tax year.  

 

R&D credits used to offset payroll taxes is allocated from the amounts reported on the federal income tax return and may be applied against payroll taxes starting the quarter after the credit is claimed. 

 

Certain state jurisdictions may provide a refundable R&D credit regardless of income tax liability, allow offset against other state specific taxes, or permit the sale / transfer of R&D credits to outside parties.

 

The Tax Cuts & Jobs Act (TCJA) limits the net operating loss (NOL) deduction for a given year to 80% of taxable income, effective to losses arising in tax years beginning after December 31, 2017.

  • TCJA also repeals the prior law carryback provisions for NOLs arising in tax years ending after December 31, 2017.

  • However, it does permit a new two-year carryback for certain farming losses and retains present law for NOLs of property and casualty insurance companies. In addition, the Act provides for an indefinite carryforward of NOLs arising in tax years ending after December 31, 2017, as opposed to the prior 20-year carryforward.

  • Consequently, corporations with NOLs arising after 2017 will have regular tax liability (e.g. remaining 20% not offset by NOLs) that can be reduced by the research credit and/or other beneficial tax attributes.

 

Not Focused on "Traditional" R&D

R&D tax credits may be available to almost all industries, not only life sciences or advanced technology companies with dedicated R&D cost centers. Often, most companies that do not utilize traditional R&D laboratories may still be eligible to claim the R&D credit.

Performing qualified R&D activities through alternative procedures (e.g. testing prototype models or processes on production floors, trial & error experimentation, computer model simulations) may still qualify for the credit. As long as technical research and/or experimentation occurs, qualified R&D expenses directly associated may be present to claim the R&D credit.

Limited Employees with "Engineer/Scientist" Job Titles or Aren’t Degree-Holding

In general, companies with large departments of degree-holding engineers or post-doctorate degree scientists performing qualified research may likely qualify for the R&D tax credit. However, the R&D credit encourages qualified research activities based on hard sciences, in consideration of all facts and circumstances.

 

Whether an employee(s) holds specific degrees does not solely determine if they are actually performing qualified research activities. Extensive technical work experience, technical certifications, among varying job titles and backgrounds, may still qualify for the credit depending on their performing activities. A common example includes Bill Gates (who notoriously never completed his degree) and his computer programming and coding development to create Microsoft's operating system would likely still be classified as performing qualified research. 

 

Qualified employees performing qualified research may also include non-core R&D job title employees or collaborative department personnel performing either of the following

  1. "Direct Support"; or

    • Direct Support may include activities like a machinist machining a part of an experimental model used in qualified research or an employee typing reports describing laboratory results derived from qualified research. Technical Sales employees working with customers and company engineers to assess equipment needs and to develop new and/or improved system requirements may also qualify as direct support.

    • Direct Support, however, doesn’t include general and administrative services (time tracking, budgeting, resource allocation, etc.) or other services that only indirectly benefit research activities regardless of if general and administrative personnel are part of the research department.

  2. "Direct Supervision"

    • Direct Supervision may include immediate technical supervision (first-line management) of qualified research (as in the case of a research scientist who directly supervises laboratory experiments, but who may not actually perform experiments). However, as mentioned above, purely general and administrative supervisory services generally do not qualify.

 

Not Developing Anything New 

R&D tax credits are available to taxpayers that design, develop, or improve products, processes, techniques, formulas, or software. For example, designing new techniques, formulas, or protocols in developing a similar product or service through substitute materials or machining processes and undergoes experimentation to resolve technical issues to improve output or lower costs may still qualify for the credit.

 

R&D doesn't have to be new or revolutionary to the industry. It simply needs to be new and/or an improvement in some form (consistency, reliability, cost reduction, output enhancement, etc.) to the specific company, pursuant to performing qualified research activities (meet the "four-part test").

 

Subject to the Alternative Minimum Tax

Historically, many companies performing R&D haven’t benefited fully from the credit because the company—or its shareholders, in the case of pass-through entities—were subject to the alternative minimum tax (AMT).

 

The Protecting Americans from Tax Hikes (PATH) Act of 2015 provides for tax years beginning on or after January 1, 2016, individuals or eligible small businesses (ESBs) who are subject to AMT can offset regular taxes and AMT using the R&D tax credit.

  • ESBs are non-publicly traded companies with average revenue of $50 million or less over the previous three years.

  • This means R&D credits that may have been previously unusable for ESBs can now be applied to reduce AMT.

 

The Tax Cuts & Jobs Act (TCJA) of 2017, eliminated for tax years beginning on or after Jan. 1, 2018 the federal corporate alternative minimum tax (AMT) pursuant to IRC § 55 and amended IRC § 38(c)(6) for corporate taxpayers as having zero tentative minimum tax. These amendments removed a prior constraint that prevented some corporate taxpayers from using credits under IRC § 41(a), due to the IRC § 38(c) tentative minimum tax limitation.

 

For tax years beginning on or after Jan. 1, 2018, the TCJA of 2017 also increased the AMT exemption for individual taxpayers, as well as the phaseout amount, for tax years beginning after Dec. 31, 2017, until 2026. These changes, coupled with the new IRC § 164(b)(6) limitation on deducting state and local taxes (preference item for AMT), may provide non-corporate taxpayers additional ways to use the credit. As such, the research credits of an eligible small business may now offset both regular tax and AMT liabilities.​

 
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