What is the The Research and Development Tax Credit?

In 1981, in an attempt to boost business and technological advancement, the federal government initiated the Research and Development Tax Credit. The idea is simple. Give business an incentive to develop and improve new products by reducing their tax burdens. Most states offer the credit on their taxes as well, although some of the guidelines may differ.

What is the R and D Tax Credit?

For each dollar of qualifying expenditures, businesses can claim a deduction of up to 13.5 cents. This is a credit against taxes, not a deduction that reduces the actual amount of the tax burden. According to the IRS website, businesses can choose to claim the benefit in the tax year in which they incurred the expense or amortize it over a five year period. They could also decide to write off the expense in ratable amounts over a ten year period, which means that a greater amount would be allowed at the beginning of the write-off period.

What is a Qualifying Expense?

A qualifying expense for the credit, according to kbkg, a website for tax professionals, is one that involves the development of a new product, a process or a formula. The expense involved with experimentation and research into product or process improvement also qualifies, with some restrictions.

Other expenses that companies may claim include beta testing, maintaining research equipment, creating modeling processes, money spent on supervising research project personnel, expenses connected with documentation and other research expenses.

Corporations may not include money spent on quality control testing, advertising, product promotions, consumer or efficiency surveys or management studies. Companies cannot claim expenses incurred in studying historical products or processes, literary research or the study of similar products already in existence. Research involved in acquiring the patent of another company’s product or process is excluded too.

Who Benefits From the Credit?

Examples of corporations that may reap the benefits of this credit are: manufacturing or fabrication companies; software developers; architecture; automotive corporations and others. Obviously, businesses with greater gross revenues benefit the most.

Small to medium companies are aided by the credit too. Start-up businesses, those with less than $5 million gross income per year, especially benefit; they can claim their payroll taxes for up to five years. The Alternative Minimum Tax turnoff means that more small businesses, which are those with less than $50 million in annual gross income, can avoid the cumbersome paperwork of the AMT and take advantage of the R and D credit.

Although states generally follow federal guidelines, some have their own standards for qualifying or for claiming expenses. Companies must reach a certain threshold of percentage of research expenses before they can claim the credit. Connecticut lowers this threshold for state taxes. Similarly, the basic definition of gross income is all income before any deductions or expenses. Within that definition, however, are variances in what constitutes income, but in California gross income only includes sales of “real, tangible or intangible, property held for sale to customers in the ordinary course of business operation.” That excludes some federally-taxed income.

The R and D credit has resulted in savings of billions of dollars each year. Benefits if the credit begin at the conception of the product or process and continue through the point at which it is available commercially. Although large corporations certainly spend millions of dollars on research, it is well worth the time for small businesses to investigate whether they qualify for the Research and Development Tax Credit.