R&D Credit – Does it Apply to You?

It comes as no surprise that R&D credit has been retroactively extended for the 2014 tax year. According to sciencemag.org the credit has been extended 15 times and has undergone five major rewrites. It is likely to be extended again later this year to include 2015 and possibly future years.  Due to the federal government’s budget process, making the R&D credit permanent has proved elusive. However, California has managed to make their R&D credit rules permanent.

Almost every prospect we meet is working on a technology idea that will have a significant impact on our daily lives.  Most often we are asked if the R&D credit is available for the technology they are developing.

R&D Tax Credit

The credit is only available with regard to research expenses paid or incurred in carrying on your trade or business. The research must be conducted in the United States. Often US companies will use labor in foreign markets to supplement their R&D efforts in the US.  In this scenario, the US entity does not qualify for the credit on expenses incurred for the research activity conducted outside of the United States. The credit applies primarily to research and development in the experimental or laboratory sense. The research must be to discover technological information and its application should be useful in developing a new or improved business product.

The research credit is an incremental credit that equals 20 percent of a taxpayer’s excess qualified research expenses (QRE’s) (if any) for the taxable year over their base amount. Qualified research expenses include wages allocable for the time spent on conducting research, supplies and the payments to the contractor to conduct the research. The base amount is the product of the “fixed-base percentage” and your average annual gross receipts for the four tax years preceding the tax year for which the credit is being determined.

Another method of calculating the credit is to elect an alternative research credit regime in which a three-tiered percentage approach is taken. In June 2014, IRS issued temporary regulations permitting taxpayers to elect alternative simplified credit (ASC) on an amended return, as long as the taxpayer did not make an election to use any other method of calculating the research credit on an original or amended return for that year.

A new and significant development is the recently issued IRS proposed regulations addressing expenses incurred for the development of internal use software. The regulations provide a definition for internal use software and safe harbor criteria to distinguish between internal and non- internal use software. This has been an area of controversy for many years.

The research and development credit is provided as an incentive to companies to encourage innovation and technological development.  An article in Forbes, Eight Myths That Keep Small Businesses From Claiming The R&D Tax Credit, explains the eight myths that keep small businesses from claiming the credit. Since the credit can run into substantial amounts and reduces the tax dollar for dollar, it is highly scrutinized by the IRS. Credible documentation is the key to support the credit calculations.