RD Tax Credits: How is it calculated?
If your business is eligible for RD tax credits, there are two basic methods for calculating it, which we will explain below.
The Standard Method.
With this method, the RD tax credits will be at 20% of the eligible research expenses of a business over a base amount determined by a predetermined percentage and the average yearly gross receipts for four years prior.
The Alternative Simplified Credit (ASC) Method.
The RD tax credits will be at 14% of the qualified research expenditures of a company that exceeds 50% of its average QREs over the last three years. If no prior year’s QREs exist, the RD tax credit is at 6% of the current year’s QREs.
How will you decide which method to use? While consulting with tax professionals can assist you in making the best choice, businesses that are new and inexperienced in claiming the credit will find that using the ASC method is slightly more straightforward than the standard method.
Claiming or Applying for RD Tax Credits
Learning how to claim RD tax credits and then applying them optimally to maximize the benefit can be a challenging process. Below, we have detailed how to determine your eligibility, how to claim the credit, how to apply for it, and the documentation you will need to do so.
The Process for Claiming RD Tax Credits
While claiming RD tax credits may appear to be a complicated and long process, it essentially consists of three major steps:
- Conducting a review of the processes.
You will want to conduct an internal audit of the research and development procedures that you intend to claim. What activities did you engage in, and at what cost? This process entails auditing and examining your accounting records and certain other internal business documentation.
- Presenting your case.
Once you have a complete grasp of the RD activities your business is engaged in, you will build your case by compiling the necessary evidence to serve as evidence for the IRS and filing the appropriate forms that detail the overall expenses you are claiming.
- Credit application.
You must complete and submit Form 6765 with your business’s federal income tax return to claim the credit.
Applying the Federal RD Tax Credits for Payroll Taxes
The RD tax credits can be used to offset a business’s federal payroll tax in particular cases. This may be an advantageous strategy for new businesses or startups, which often have lower tax responsibilities and higher research expenses. To qualify, a business must have had gross receipts for five or fewer years and gross receipts of less than $5 million in the year the credit is claimed for. Applying RD tax credits to your business’s payroll taxes must be done on a timely filed income tax return. The credit will then cover up to $250,000 of the employer’s Social Security payroll tax liability.
Four-Part Test in Determining If You Qualify to Claim for RD Tax Credits
Here is a straightforward four-part test that can guide you in determining whether your business is eligible for the federal RD tax credits and their associated advantages. To be considered as qualified research expenditures under the IRS Section 41, your business’ operations must meet these criteria:
- Section 174 Test.
Expenses must be made in the course of the taxpayer’s trade or business and must remove doubt related to the creation or enhancement of a product.
- Test for Discovering Technological Information.
The experimental procedure used to uncover information must primarily be based on engineering, physical or biological sciences, computer science, or engineering.
- Test for Business Components.
Businesses must intend to use newly discovered information to create a new or improved business component. A business must be able to relate the research that is claiming credits for to the essential business component.
- Experimentation Test.
It is a process designed to assess one or more alternative methods for getting a result when the capability or method for accomplishing the result, or the suitable design of the result, is unknown when the taxpayer’s research operations begin.
To count as a qualified research expense, a business must be able to demonstrate that all four of the aforementioned tests have been met.
RD Tax Credits: Documents Needed to Apply or Claim
Just like with any other credit, complete documentation is critical to obtaining the credit’s benefits while also minimizing the possibility of an audit. When claiming the RD tax credits, the following documentation and files should be kept:
- Form 6765. This is the standard Internal Revenue Service form used to calculate and claim credit for increased research activity.
- A comprehensive list of the R&D activities that are qualified for the credit, as determined by the four-part test outlined previously.
- Justifying information for qualified research expenses. These are supporting documents that can help substantiate your claims, such as salary reports, equipment, and all other research expenditures and receipts.
- Timekeeping records for employees whose taxable salaries on their W-2 are part of the credit that is being claimed.
- Contracts and other supplementary information if any aspects of the research and development process were outsourced.
What Are The RD Tax Credits’ Benefits?
The RD tax credits’ key aim is to promote economic activity by motivating businesses to develop and invest in new technology, products, and services. Small businesses who claim the RD tax credits benefit from the following:
- Increased cash flow.
- Federal and state taxes are reduced.
- Market value is increased.
- Reduced tax rate on a per-capita basis.
- Additional profits in hand.
What Businesses Qualify To Claim Or Apply For RD Tax Credits?
The RD tax credits are frequently unclaimed by businesses and individuals who qualify simply because it is so poorly understood. Indeed, some estimates indicate that there are approximately 6,000,000 businesses eligible for the credit in the United States, but on average, only about 20,000 businesses claim it each year. To put it another way, the National Science Foundation reports that the National Science Foundation claimed over $9 billion in R&D tax credits in 2010 — while another $4 billion went unclaimed.
Contrary to popular belief, RD tax credits are available to businesses of all sizes. Indeed, approximately half of all enterprises that claim credit qualify as small or medium-sized businesses. Your business must have spent money on eligible activities that the IRS deems to be part of research and development to qualify for the credit.