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The R&D Tax Credit – Potential Cash Infusion For Start-ups And Established Businesses

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As businesses continue to innovate and hire during the Covid-19 health crisis, the Research and Development (R&D) tax credit remains one of the most valuable and meaningful tax incentives to businesses.

Often overlooked and misunderstood, the Federal R&D tax credit can provide an immediate dollar-for-dollar tax savings to businesses and applies not only to traditional science based research entities working in labs, but also well-established and start-up businesses in a variety of industries including software development, engineering, life sciences, manufacturing, architecture, and construction.

The R&D tax credit has been around since early 1980s and has been rewarding innovative businesses for almost four decades now. The R&D tax credit incentivizes companies for increased investment in developing or designing new products and processes with employees and contractors within the US; wherever there is innovation and experimentation, the R&D tax credit may apply. The innovation and experimentation that may qualify does not have to be a brand new issue to qualify, it merely has to be new to the company exploring the innovation. With changes under the PATH Act of 2015, the credit is now a permanent component of U.S. tax law and has been opened up to small and mid-sized businesses, including the option to reduce Alternative Minimum Tax (AMT) and an option for entities to offset payroll taxes if certain hurdles are met.

How is the R&D Tax Credit Calculated and What Costs Qualify?

The Federal R&D tax credit is determined by taking a percentage of Qualified Research Expenses (QREs) each year, generally resulting in a tax credit of around 6% of qualified expenses. One requirement of the credit is increased spending on R&D costs (over the average of the last five tax years) and it’s also a wage based credit so that only U.S. based payroll is eligible. This helps to encourage companies to keep jobs in the U.S. and also allocate more business spending each year towards R&D. Generally, the best approach to claiming the R&D tax credit is to have a formal R&D Tax Credit Study completed, as the tax savings often far outweigh the cost of having the study prepared.

To be eligible for the R&D tax credit, your business spending must meet each of the IRS criteria known as the “Four-Part Test.”

(1)  Uncertainty

(2)  Process of Experimentation

(3)  Technological in nature

(4)  Qualified purposes

R&D Credit as a Reduction in Payroll Taxes

With the startup ecosystem in the Seattle and Puget Sound Area continuing to flourish, we are seeing many new small to mid-sized businesses benefit from the R&D tax credit in the form of a payroll tax reduction (against future employer portion of Social Security taxes). With the common lack of taxable income in early years, this is a huge benefit for increased cash flow during the early years of a business.

The R&D payroll tax credit is available for the first five tax years following the first year the business had earned income. So for example, if an entity had no revenue in years one and two, the entity would be able to claim the R&D payroll tax credit for seven years. The maximum amount of payroll taxes in a given year that can be offset is $250,000. For purposes of the R&D payroll tax credit, a qualified small business (QSB) is a taxpayer with gross receipts in the current tax year of less than $5 million and with no gross receipts in any year preceding the five-year tax period ending with the current tax year. As an example, company A wants to use the R&D payroll tax credit in tax year 2020. In order to qualify, company A must have less than $5 million in gross receipts in 2020 and must have zero gross receipts in 2015 and any year prior to 2015.

The outline below illustrates the process for taxpayers to claim the R&D tax credit as a payroll tax reduction:

Step 1 – Determine eligibility for R&D tax credit available for current year, which may include an R&D Tax Credit Study.

Step 2 – Elect on original and timely filed income tax return the portion of credit to offset the employer portion of payroll taxes.

Step 3 – Work with your payroll provider/accounting team to claim R&D tax payroll credit on quarterly Form 941 with Form 8974 attached.

Step 4 – Carryover any unused R&D tax payroll credit indefinitely as a reduction in future employer portion of FICA taxes.

For more information on eligibility and how best to use the R&D tax credit, please contact your Berntson Porter representative at 425-454-7990. We are here to help!

Berntson Porter is here to help businesses navigate these challenging times. Visit our Resource Center for up-to-date information about COVID-19 legislation that impacts you and your business. 


     

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