Any company that faces and overcomes technological challenges may be eligible for research and development or R&D tax credits. Having said that, eligibility is, for the most part, decided by the degree to which the work completed by a firm conforms to the criteria established in a four-part test that is included in both the Internal Revenue Code (IRC) and Treasury Regulations.
How to Determine R&D Tax Credit Eligibility
Four tests will help you determine whether or not the activity is qualified to claim R&D tax credits or not, and these are the following:
1. The Commercial Activities That Are Being Carried Out Are For a Qualified Purpose
It is recommended that the study be carried out to develop a new or better business attribute, which will ultimately result in a new or improved function, performance, reliability, or quality. A business component can be an object, a technique, a software program, a methodology, a formula, or an idea; this is an all-encompassing definition that covers a wide range of industries.
2. The Commercial Activity Removes Any Sense of Uncertainty Regarding Progress or Advancement
When developing or improving a business sector, a company has to demonstrate that it has gone to reasonable lengths to clear up any confusion that may arise as a result of its actions. Uncertainty arises when the company’s knowledge does not adequately define the capacity or technique for manufacturing or updating the business unit or the component’s right design. This can lead to a loss of confidence in the company’s ability to meet its objectives. However, the design is seldom stated at the beginning of a project, even though many companies are confident in their ability to accomplish technical objectives and even have well-established procedures for finding solutions to difficulties.
3. The Commercial Activity Involves an Experimentation Process
A company has to be able to demonstrate that it has evaluated one or possibly more than one alternative strategy for accomplishing the desired result by making use of models, simulations, rigorous experimentation, or any other approach. Certain activities are naturally iterative in their structure. For example, the fields of engineering, software development, and clinical research all require a methodology that can evaluate one or more possible courses of action. In addition to this, the idea is so all-encompassing that it may be used for a large number of distinct kinds of pursuits.
4. The Nature of the Commercial Activity Is Technological
Experiments need to be carried out utilizing techniques from the hard sciences, such as engineering, physics, chemistry, and biology, in addition to computer science. It is essential to keep in mind that companies are not required to go beyond, expand upon, or improve already recognized scientific concepts.
An initial step that a company has to do is to perform an audit of its operations to determine whether activities have the potential to be qualified. Companies who want to take advantage of the benefit should be prepared to define records and provide support for their qualifying research and development initiatives.
Documentary Requirements When Claiming R&D Tax Credits
By being able to record R&D activities, businesses may profit from it by optimizing the amount of tax credit that they can claim which are available for both the current and prior taxable years.
To claim this tax credit, taxpayers must analyze and document their research activities to calculate the number of eligible research expenditures spent for each qualified research activity. Taxpayers must still have a factual basis for their tax credit computations even though they can use estimates in their research expenses.
Emails and other documents that a company creates in the usual course of business when complemented by credible employee testimony can serve as the basis for a successful R&D credit claim.
Claiming R&D Tax Credits Needs Proper and Accurate Documentation
In this instance, the court denied a request for roughly $235,000 in R&D tax credits for the 2010 and 2011 tax years. This disallowance was mostly the consequence of the taxpayer’s inability to maintain and provide documentation demonstrating that the company’s activities met all four requirements for qualifying research costs.
The claimant contended that its expenditures on creating new flour products and enhancing its production process qualify for the R&D credit. Unfortunately, the company did not give any proof that the acts represent scientific testing.
The court decided that the taxpayer’s conclusory assertion that it participated in product innovation, which included technical activity, was insufficient evidence on its own. It was not sufficient to simply list the steps taken to demonstrate that the company employed a systematic strategy consisting of a series of experiments to evaluate offered hypotheses to develop new goods and processes.
The Impact of Tax Reform on R&D Tax Credits
Before the tax reform, IRC Section 174 did not permit taxpayers to claim a deduction equal to the R&D tax credit thereby preventing corporations from getting double tax benefit and thus requiring taxpayers to reduce their R&D expenditures by the amount of the credit. A decrease in expenditures led to an increase in revenue and corresponding taxes.
This reduction in the taxpayer’s R&D expenditure can be avoided by electing to take a lower credit as provided in the IRC Section 280C(c)(3), which was maintained in the TCJA and computed using the highest corporate tax rate. This reduction in the corporate tax rate which was from 35% to 21%, resulted in larger tax credits for taxpayers due to the elimination of AMT.
However, one remaining restriction on R&D credits precludes taxpayers from reducing their tax burden entirely. The restriction, often known as the 25/25 limitation, bans taxpayers with an annual tax burden above $25,000 from using the benefit to offset more than 75% of their annual tax payment.
- Maintenance of Credits for Qualified Small Businesses
Previously, firms or proprietors of pass-through enterprises with a three-year average revenue of less than $50 million were eligible to use the R&D tax credit to offset AMT. The provision will then affect local taxpayers who are getting R&D tax credits from businesses they own with the TCJA’s repeal of the corporate alternate minimum tax.
- Payroll Credit Preservation for Eligible Small Businesses
In the first five years of operation, startups with revenues of less than $5 million will continue to have the option to postpone up to $250,000 in payroll taxes. Payroll credit must be selected on the initial return starting in 2017
- Utilization by Individual Taxpayers Increased
Before the tax reform, individual taxpayers were sometimes prohibited from claiming the credit because of the individual AMT. AMT exemptions for individuals are currently growing thereby resulting in individual taxpayers to expect utilizing a larger amount of the R&D credits that their companies forward to them.