How to Collect R&D Tax Credits in 2024

Government-issued research and development (R&D) tax credits are a great way for businesses of all sizes to help fund their innovation efforts.

In this article, we’ll provide an overview of R&D tax credits, including the benefits it offers to businesses, the types of tax credits available, and how to collect R&D tax credits in 2024.

We will also delve into the history of R&D tax credits in US law and discuss the criteria that businesses must meet in order to qualify for these credits.

Finally, we will provide guidance on how to calculate and apply for R&D tax credits, as well as the documentation that is required to recoup these credits.

An Overview of R&D Tax Credits

What Is an R&D Tax Credit?

An R&D tax credit is a tax incentive that allows a company to reduce its income tax liability on a dollar-for-dollar basis. It is designed to encourage businesses to engage in research and development (R&D) activities, which are activities that seek to create new or improved products, processes, or technologies.

Why the Government Issues Tax Credits

The government issues R&D tax credits as a way to encourage businesses to engage in research and development (R&D) activities. The goal of these credits is to help businesses offset some of the costs associated with R&D, which can be expensive and risky.

What Benefits does a Company Receive from the R&D Tax Credit?

The R&D Tax Credit under IRC Section 41 can provide a number of benefits to a company, including:

1. Reduction in tax liability: The credit can be used to offset a company’s federal and (in some cases) state tax liability, potentially resulting in a significant reduction in taxes owed.
2. Increased cash flow: By reducing tax liability, the R&D Tax Credit can increase a company’s cash flow, which can be used to invest in further research and development or other business activities.
3. Enhanced competitiveness: By encouraging companies to invest in R&D, the credit can help businesses stay competitive by developing new products, processes, or technologies.
4. Increased earnings-per-share (EPS): By allowing a company to reduce its income tax liability on a dollar-for-dollar basis, the credit can directly increase the company’s net income and therefore its EPS.
5. Attraction and retention of talent: The credit can make a company more attractive to highly skilled workers, such as engineers and scientists, who may be drawn to the opportunity to work on cutting-edge R&D projects. It can also help retain valuable employees who may be interested in working on innovative projects.
6. Reduction in Payroll Taxes: Qualified Small Businesses who are still in any Net Operating Loss (NOL) position can utilize the credit to reduce payroll taxes.

A Brief History of R&D Tax Credits in U.S. Law

Internal Revenue Code (IRC) Section 174

IRC Section 174 is a provision in the Internal Revenue Code (IRC) of the United States that allowed businesses to claim a tax deduction for certain types of research and experimentation (R&E) expenses. This section was first enacted in 1954 as part of the Internal Revenue Code of 1954. Prior to 1954, R&E expenses were treated as capital expenses, which means that they could not be deducted from a business’ income in the year that they were incurred. Instead, they had to be recovered over a period of time through depreciation. The purpose of Section 174 was to encourage businesses to engage in R&E by allowing them to claim a deduction for these expenses in the year that they were incurred.

IRC 174: 2022 and Beyond

Prior to 2022, businesses were able to fully deduct qualified research expenses (QREs) in the year when they were paid or incurred. However, starting in 2022, businesses are no longer able to immediately expense the full amount of QREsas defined by Section 174 and must instead choose between capitalizing or amortizing them over a period of five years for U.S.-based R&E activities or 15 years for foreign-based R&E activities.

Economic Recovery Tax Act of 1981

The Economic Recovery Tax Act of 1981, also known as the “ERTA,” was a tax cut bill that was enacted by the U.S. Congress in 1981. The purpose of the ERTA was to stimulate economic growth and reduce inflation by providing tax relief to individuals and businesses. One of the provisions of the ERTA was the creation of the Research and Development (R&D) Tax Credit, which known as Section 41 in the Internal Revenue Code (IRC).

IRC Section 41 Research Tax Credit

Internal Revenue Code (IRC) Section 41 is the provision in the U.S. tax code that allows businesses to claim a credit for qualified research expenses (QREs) that are paid or incurred in connection with a trade or business. IRC Section 41 has four components:

1. Regular Research Credit (RC): This component of IRC Section 41 provides a credit for QREs that are paid or incurred in connection with qualified research. The credit is calculated using a formula that takes into account the company’s QREs, the amount of gross receipts that the company has received, and the amount of time that has passed since the company first began receiving gross receipts.
2. Alternative Simplified Credit (ASC): This component of IRC Section 41 provides a simplified alternative to the regular research credit. It allows companies to claim a fixed percentage of their QREs as a credit, without the need to perform the calculations required under the regular research credit.
3. Basic University Research Credit: This component of IRC Section 41 provides a credit for QREs that are paid or incurred in connection with qualified research that is conducted at a qualified university.
4. Credit for Collaborative Energy Research: This component of IRC Section 41 provides a credit for QREs that are paid or incurred in connection with qualified energy research that is conducted in collaboration with one or more other businesses.

It is important to note that all of these credits are nonrefundable, meaning that they can only be used to offset the company’s tax liability and cannot be refunded to the company if the credit exceeds the tax liability. The federal credit can also be carried forward 20 years if unused. State rules vary, but CA allows the credit to be carried forward indefinitely.

2015 Protect Americans from Tax Hikes (PATH) Act

The Protect Americans from Tax Hikes (PATH) Act of 2015 made several changes to the Research and Development (R&D) Tax Credit, which is codified in Internal Revenue Code (IRC) Section 41. One of the main provisions of the PATH Act was the expansion of the credit for small-to-midsize businesses. Prior to the PATH Act, many small businesses had difficulty monetizing the credit because they did not have sufficient income tax liability to fully utilize it.

The PATH Act revised the credit to allow taxpayers to elect to apply up to $250,000 of the credit against their share of the Social Security, or FICA, tax for their employees, rather than against income tax. This revision became effective for tax years that began after December 31, 2015.

Under the PATH Act, a qualified small business (defined as a business with less than $5 million in gross receipts per year and no gross receipts for any tax year before the five-tax-year period ending with the current tax year) can elect to apply its R&D credit against only the 6.2% Social Security tax. This allows small businesses to take advantage of the credit even if they do not have sufficient income tax liability.

In addition to expanding the credit for small businesses, the PATH Act also allowed the R&D credit to be applied against the Alternative Minimum Tax (AMT) for taxpayers with $50 million or less in average annual gross receipts over the three preceding tax years.

Tax Cuts and Jobs Act (TCJA)

The Tax Cuts and Jobs Act (TCJA)changed the treatment of research and development (R&D) expenses under Internal Revenue Code (IRC) Section 174. Previously, businesses had the option to either deduct all qualified R&D expenses in the same tax year they were incurred or to spread out the deduction over five years through amortization. The TCJA eliminated the option to expense R&D costs in the current tax year and instead requires businesses to amortize their Section 174 deductions over a period of five years for expenses incurred in the United States or 15 years for expenses incurred outside of the United States. This change applies to expenses incurred in tax years beginning after December 31, 2021.

It’s important to note that the amortization of R&D expenses under Section 174 is distinct from the research and development tax credit under IRC Section 41. Qualified expenses for the R&D tax credit include direct costs such as wages, consumable supplies, and contract research amounts, while the broader definition of R&D expenses under Section 174 includes both direct and indirect costs such as legal and overhead expenses. These indirect costs are not eligible for the R&D tax credit under Section 41.

Inflation Reduction Act of 2022

The Inflation Reduction Act of 2022, signed into law by President Joe Biden in August 2022, made significant changes to the research and development (R&D) tax credit. One of the main provisions of the act is the increase in the amount that a qualified small business can potentially claim as an R&D tax credit to offset its payroll tax.

Prior to the act, the maximum credit a qualified business could claim was $250,000 over five years. Under the Inflation Reduction Act, this amount was doubled to a maximum of $500,000 over five years.

In addition to increasing the maximum credit amount, the Inflation Reduction Act also expanded the types of payroll taxes that the R&D tax credit can be applied against.

Under the PATH Act, a qualified small business could only apply its R&D credit against the 6.2% Social Security tax. However, beginning with the 2023 tax year, eligible businesses will now be allowed to apply an additional $250,000 against their 1.45% Medicare tax liability, in addition to the 6.2% Social Security tax. This means that the total maximum credit is now $500,000, which can be bifurcated and applied against both the Social Security and Medicare tax liabilities, up to a maximum of $250,000 for each prong.

Overall, the Inflation Reduction Act of 2022 has significantly increased the potential benefits of the R&D tax credit for qualified businesses.

Which Businesses Qualify for R&D Tax Credits

The Research and Development (R&D) Tax Credit is available to businesses of all sizes that engage in qualified research and development activities. To qualify for the credit, a business must meet certain requirements, including:

1. The business must have engaged in qualified research and development activities. These activities must meet certain criteria, such as being intended to create a new or improved product, process, technique, or formula.
2. The business must have incurred expenses for these qualified research and development activities. These expenses may include wages paid to employees who are involved in the research and development activities (hands-on involved, directly supervising those involved or directly supporting those involved), as well as certain supplies, third party contractors and icloud leasing expenses used for research.
3. The business must have performed the research and development activities within the United States.
4. The business must have solid support of research and development activities, including documentation of the expenses incurred.

There are some exclusions and limitations that apply to the R&D Tax Credit. We highly recommend that you consult with a R&D tax specialist or refer to IRS guidance to determine if your business is eligible.

Qualified Small Businesses

To qualify for the expanded credit outlined in the Inflation Reduction Act of 2022, a small business must have under $5 million in gross receipts in the current year and no more than 5 years of generating gross receipts, including the current year. New businesses, meanwhile, can offset payroll taxes for up to five years.

What Activities Are Eligible for R&D Tax Credits

To qualify for the R&D tax credit, businesses must be able to properly support claimed qualified research expenses (QREs).

The 4-Part Test

In order to qualify for the R&D Tax Credit a 4-Part test needs to be met:

1. Permitted purpose: The activity must be related to developing or improving the functionality, quality, reliability or performance of a business component, such as a product, process, software, technique, formula, or invention.
2. Technological in nature: The business component’s development must be based on a hard science, such as engineering, physics, chemistry, or the life, biological, or computer sciences.
3. Elimination of uncertainty: The company must have faced technological uncertainty when designing or developing the business component, and activity must be undertaken to eliminate this uncertainty.
4. Process of experimentation: The company must evaluate multiple alternatives or applied specific testing methods to overcome the technological uncertainties. The activity must be part of this process of experimentation in order to qualify for the credit.

Examples of Research Activities That Qualify for Credits

Here are some examples of activities that may be considered qualified research expenses and therefore be eligible for the research and development (R&D) tax credit:

• Investing time and resources in the creation of innovative products
• Developing new or improved processes, patents, formulas, techniques, prototypes, or software
• Incurring expenses for salaries, supplies, contract research, and cloud hosting related to qualified R&D activities
• Improving the functionality, quality, reliability, or performance of existing products
• Hiring individuals with expertise in science, engineering, or design to work on qualified activities
• Conducting research and development efforts to create intellectual property

It’s important to note that these are just a few examples, and other activities may also qualify as QREs depending on how they meet the four-part test established by the IRS to determine eligibility for the R&D tax credit.

Research Which Does Not Qualify for Credits

According to Internal Revenue Code (IRC) Section 41(d)(4), the following activities do not qualify for the research and development (R&D) tax credit:

• Research conducted outside the United States
• Research in the social sciences, arts, or humanities
• Research funded by any grant, contract, or other funding from another person (or government entity)
• Surveys or studies including market research, testing, or development (including advertising or promotions), routine data collection, and routine or ordinary testing or inspection for quality control
• Research that’s done after commercial production of the business component has started
• Research to adapt an existing business component to a specific customer’s requirements or needs
• Research to reproduce an existing business component (in whole or in part) from a physical examination of the business component or from plans, blueprints, detailed specifications, or publicly available information about the component.

It is important to note that this list just contains examples and is not exhaustive. Other activities may not qualify for the R&D tax credit. We recommend consulting an R&D Tax Credit professional to ensure all activities are indeed qualifying in nature.

Expenses That Qualify for Credits

Under IRC Section 41(b)(1), certain expenses related to in-house and contract research may be eligible for the R&D Tax Credit. In the case of in-house research performed by a company as part of its trade or business, the credit may apply to the following expenses:

• Taxable Wages (Form W-2, Box 1) of employees who are hands on with the research, employees directly supervising or supporting employees that are involved in qualified research;
• The cost of supplies used in qualified research (this can not be depreciable – e.g. equipment)
• iCloud leasing expenses used in qualified research (e.g. AWS, Google Cloud)

These expenses must be incurred in connection with in-house research that is being performed by the company as part of its trade or business. The research must also meet the requirements for being considered “qualified research” under IRC Section 41(d). This includes the requirement that the research be intended to develop or improve a product, process, or technique and that it involve a process of experimentation.

Expenses Which Do Not Qualify for R&D Tax Credits

Not all R&D expenses are eligible for IRC Section 41’s credit. Some of the expenses that do not qualify for the credit include:

• The cost of depreciable tangible assets used in qualified research, such as buildings and equipment
• Overhead expenses, such as heating, electricity, rents, leasing fees, insurance, and property taxes
• Fringe benefits for research personnel, such as health insurance and retirement benefits.

These expenses may represent a significant portion of a company’s R&D spending, potentially ranging from one-quarter to one-half of the total. However, they are not eligible for the R&D Tax Credit.

How to Calculate R&D Tax Credits

There are two ways for a business to calculate its Research and Development (R&D) Tax Credit: the Regular Credit (RC) and the Alternative Simplified Credit (ASC).

Regular Credit

To calculate the Regular Credit (RC), a business will need to follow these steps:

1. Determine the qualified research expenses (QREs) for the current tax year
2. Calculate the base amount which is determined using a formula provided in the Internal Revenue Code (IRC) and is based on the company’s QREs in prior tax years, as well as its historical gross receipts.
3. Calculate the RC by multiplying the incremental QREs by the credit rate. The credit rate is 20%.

The tax credit calculation is complex, so it is important to consult with an R&D Tax Credit professional, such a Tributan, prior to calculating your regular credit potential.

Alternative Simplified Credit

To calculate the Alternative Simplified Credit (ASC), a business will need to follow these steps:

1. Determine the qualified research expenses (QREs) for the current tax year and the prior three tax years.
2. Calculate the base amount, which is equal to 50% of the company’s average QREs in the past three tax years.
3. Subtract the base amount from the company’s QREs for the current tax year. This is the incremental amount of QREs that are eligible for the credit.
4. Calculate the ASC by multiplying the incremental QREs by the credit rate. The credit rate is 14% for companies with QREs in at least one of the past three tax years, and 6% for companies with no QREs in any of the past three tax years.

The ASC is generally easier to calculate compared to the Regular Credit method, as it does not require the calculation of the fixed base percentage or prior 4 years gross receipts.

How to Apply for R&D Tax Credits

To apply for the R&D Tax Credit, you will need to file a claim with the IRS. This can typically be done by including the credit on your tax return for the year in which you incurred the eligible R&D expenses. To claim the credit, you will need to complete the Federal Form 6765, Credit for Increasing Research Activities, and include it with your tax return filing.

You will also need to maintain documentation of your eligible R&D expenses, as the IRS may request this information to verify your claim. This documentation should include receipts, invoices, and other records showing the nature and amount of the expenses.

We highly recommend reaching out to an experienced R&D Tax Credit service provider such as Tributan to ensure that you are completing the necessary forms and providing the required documentation to claim the credit correctly.

What Documentation is Needed to Recoup R&D Tax Credits?

If you are a business claiming the research and development (R&D) tax credit under IRC Section 41, it is important to retain documentation that substantiates the eligibility of the expenditures you are claiming for the credit.

According to Treasury Regulation 1.41-4(d), a taxpayer claiming the credit must retain records in sufficiently usable form and detail to support their claim. This documentation must be contemporaneous, meaning it must be documented at the time the R&D was done, and it must be dated to prove that the work occurred in the fiscal year for which the credit is being claimed. Additionally, the documentation should highlight the technical challenges faced during the R&D process and should demonstrate the efforts made to overcome these challenges.

To be considered sufficient, a refund claim under IRC Section 41 must identify all the business products and processes to which the credit claim relates for the relevant year, and it must provide details about the research activities performed, the individuals who performed them, and the information that was sought to be discovered. It must also provide the total qualified employee wage expenses, total qualified supply expenses, and total qualified contract research expenses for the claim year, which may be done using Form 6765.

Financial records, business records, oral testimony, and technical documents may be used for this purpose.

It is important to preserve these documents, including payroll records, lab results, details about projects, and any other documentation related to your R&D, even after receiving the credit, as an audit may occur and the IRS may request to analyze the supporting documentation. If you are unable to produce relevant records upon request during an audit, the credit may be denied or the credit amount reduced significantly.

Acceptable Documentation Formats

Documentation for your R&D tax credits can come in a variety of formats. Generally speaking, you’ll want to keep solid documentation that you have pertaining to your qualified research expenses. Some examples of acceptable documentation formats for your employee, supply, and contractor expenses include:

• Timesheets
• Developer or engineering notebooks
• Emails
• Invoices
• Employee W-2 forms
• Purchase orders
• Form 1099-NEC (for contractors)
• Service contracts
• Meeting minutes
• Technical documents, including those related to prototypes
• Presentations
• Patents
• JIRA Code

How ClickTime Can Help You Maximize R&D Tax Credit Claims

ClickTime helps companies maximize their R&D tax credits by providing accurate and detailed time tracking and labor cost calculation tools. Our platform reduces the time it takes to track, estimate, calculate, and document your qualified research expenses.

By using ClickTime, companies can track the time that employees and contractors spend on R&D activities, as well as the supplies used in those activities. This information can then be used to accurately calculate the amount of R&D expenses that are eligible for the tax credit.

In addition, ClickTime’s project management features can help companies organize and manage their R&D projects, ensuring that all eligible expenses are properly documented and tracked.