Maximize Your R&D Tax Credit Benefits

According to data from McKinsey, companies with a culture of innovation are 3.5 times more likely to outperform their competitors in revenue and overall business performance. If your business plans to invest in innovation, the Research and Development (R&D) tax credit is a valuable opportunity to enhance your market position and reduce your tax liability.

This federal credit allows you to offset the costs of developing new products, processes, or software. By claiming this credit, you can reinvest those savings into your business, driving further innovation and growth. This guide will look at the available tax credits for R&D, explain the expenses that qualify under this credit, highlight the benefits to your business, offer steps to claim tax credits, and answer frequently asked questions.

What is the Research & Development Tax Credit?

The R&D tax credit is a federal incentive designed to reward businesses like yours for investing in innovation. Whether improving existing products, processes, or software or developing entirely new technologies, you can qualify for this credit by engaging in activities promoting innovation. The R&D tax credit encourages businesses to invest in research and development by offsetting a percentage of those expenses through tax savings.

The credit applies to a wide range of qualifying expenses, such as wages, supplies, and contract research, all of which are outlined under Section 41 of the Internal Revenue Code. Typically, 6% to 8% of your company’s annual qualifying R&D expenses can be applied against your federal income tax liability, providing a significant financial edge.

In addition to federal R&D credits, many states offer their own R&D incentives, creating even more opportunities to reduce tax liabilities at both levels. Smaller businesses and startups may also be eligible for an annual R&D payroll tax offset of up to $250,000. This offset allows these companies to reduce their quarterly payroll taxes even if they are not yet profitable.

What Qualifies as R&D?

If your business is involved in activities to create or improve products, processes, or software, you can qualify for the research and development tax credit. The IRS defines qualifying research as activities intended to develop or improve a product or process's functionality, performance, reliability, or quality. Some common examples of qualifying activities include:

Developing new or enhanced products or technologies: Whether you're creating a completely new product or improving an existing one, the work involved in research and development often qualifies.
Experimenting with prototypes: Testing new designs or processes to solve technical challenges is a key component of qualifying R&D work.
Improving manufacturing processes: If your company works to enhance efficiency, quality, or cost-effectiveness in your production methods, those efforts may qualify.
Researching to resolve technical uncertainties: If you are developing new technologies or processes and face technical challenges requiring experimentation and problem-solving, this can qualify as R&D.

Research tax credits can benefit businesses across a wide range of industries, including manufacturing, technology, pharmaceuticals, engineering, and more. Even small and mid-sized companies can benefit, particularly with the added flexibility provided by the Protecting Americans from Tax Hikes (PATH) Act of 2015. The PATH Act expanded access to the credit for small businesses, allowing more companies to take advantage of this incentive.

Eligibility Requirements

To claim the research and development tax credit, your business must meet specific criteria outlined by the IRS. According to IRS guidelines, your research activities must:

Be aimed at creating or improving a product, process, or software. The goal of your research should be to enhance or develop new products, processes, or technologies.
Your work must be based on principles of science, engineering, or technology and involve scientific or technological concepts.
Experimentation is required to eliminate technical uncertainties. The research must address technical challenges that require testing, modeling, or trial-and-error to resolve.
Have a clear research objective. The activities should improve the product or process's functionality, performance, or reliability.

By meeting these requirements, you can take advantage of the significant tax savings offered by the tax research credit.

Types of Expenses that Qualify

Not all expenses are eligible for the R&D tax credit, so it's important to understand which costs can be claimed. Qualifying expenses must be directly related to your research and development efforts. Here’s a breakdown of the types of costs that qualify for the R&D tax credit.

Qualified Research Activities

Qualified research activities that meet IRS standards can qualify for the R&D tax credit. This includes:

Developing or improving products or processes: If you're working to enhance the functionality or performance of a product or process, these efforts likely qualify for the tax credit.
Experimenting with new prototypes or formulas: Testing new designs or formulations as part of the development process can count as R&D.
Conducting research to solve technical challenges: If your team is conducting research and experiments to address technical uncertainties, these activities are generally eligible for the credit.

Qualified Research Expenses

When it comes to qualified research expenses, the R&D tax credit covers several types of costs. These include:

Wages: Compensation paid to employees directly involved in qualified research activities is eligible for the credit. This includes the salaries of engineers, scientists, researchers, and support staff who assist with the research.
Supplies: The materials used to develop a new product or process can be claimed as qualified research expenses. This includes costs related to prototypes, testing, and materials necessary for experimentation.
Contract Research: Payments to third-party contractors performing qualified research on your behalf can also be included as qualified research expenses. Those costs are eligible if you work with outside experts or firms to assist with R&D.

Common Expenses and Activities That Don’t Qualify

While many expenses can qualify for the R&D tax credit, several activities and costs do not qualify. It's important to understand these limitations to avoid claiming ineligible expenses. Some common examples of expenses and activities that are not eligible for the R&D tax credit include:

Routine maintenance or quality control tasks: Regular maintenance of equipment or quality control measures do not count as R&D activities.
Research conducted outside the United States: Only research activities performed within the United States or its territories qualify for the federal R&D tax credit.
Market research, surveys, or polls: While these activities are important for product development, they do not qualify as research activities under IRS guidelines.
Reverse engineering of existing products: Reverse engineering a product for replication does not qualify as research and development for tax credit purposes.

Focusing on the right activities and documenting your eligible expenses properly can help you maximize your tax savings while staying compliant with IRS regulations.

How R&D Credits Benefit Your Business

Claiming R&D tax credits can positively impact your bottom line and your company’s future innovation. Here’s how these credits can benefit you.

Financial Advantages

An R&D tax credit can directly reduce your taxable income, which means you’ll have more cash available to reinvest in other areas of your business. These tax savings can also help you fund future R&D projects, enabling your business to remain competitive in agile markets.

Innovation Incentives

The R&D tax credit encourages businesses like yours to take calculated risks and invest in new technologies, products, and processes. Whether you're working to improve an existing product or launching a new one, the credit rewards your efforts to innovate. These incentives can help you maintain a leg up in your industry by allowing you to explore new opportunities while reducing financial risk.

Steps to Claim Tax Credits for R&D

The process of claiming R&D tax credits requires careful preparation and documentation. Follow these steps to ensure you maximize your benefit.

Documentation Requirements

You’ll need to keep thorough records of the work you’re doing. Make sure you have:

Employee time tracking: Keep detailed records of how much time employees spend on R&D activities. This will allow you to allocate wages accurately when claiming the credit.
Research process documentation: Document your research processes, experiments, and testing outcomes. This will show the IRS that your activities meet the eligibility requirements for the credit.
Financial records: Maintain records of the costs associated with R&D activities, including wages, supplies, and any expenses related to contract research. Keeping these organized will simplify the claiming process.

Common Pitfalls to Avoid

Many businesses miss out on R&D tax credits due to common mistakes, such as:

Failing to maintain adequate documentation: Without proper records, you may not be able to claim the full credit you're entitled to.
Overlooking qualifying activities: Sometimes, businesses underestimate which activities qualify for the R&D tax credit. Consult with a tax professional to identify all eligible activities.
Misclassifying expenses or overclaiming credits: Incorrectly categorizing expenses or overestimating the amount of credit can lead to issues with the IRS.

Working with a tax professional can help you avoid these pitfalls and ensure you claim the credits you deserve.

Get R&D Tax Credit Help Today

Don’t leave valuable tax credits on the table. At Porte Brown, we’re here to help you navigate the complexities of claiming R&D tax credits. Our team of experts will work with you to ensure that your business gets the full benefit of these credits so you can focus on what you do best: driving innovation.