Take Credit for Innovation – Understanding Federal R&D Tax Incentives and Deadlines

The federal government provides a tax credit benefit to businesses that are working to develop or improve new and existing products or technology through the Research and Development (R&D) tax credit. This federal tax credit provides a benefit of up to 10% of qualifying spend on employee wages, contracted research, and supply costs related to new development efforts. Many innovative businesses are eligible to claim this tax credit but miss out because they are not aware that it exists, assume the tax credit does not apply to the work they are doing, or feel like they do not receive a real benefit because they are not profitable. 

In reality, small and medium-size businesses (SMBs) are realizing cash benefits from the R&D tax credit regardless of whether or not they are a part of a traditionally scientific industry, and regardless of if they are profitable and paying income tax or are pre-revenue.

The R&D tax credit was written into the tax law in the early 1980s to help encourage businesses to invest in developing technology in the U.S. by companies employing U.S. workers. Given that there may be costs associated with this type of work, the government created the tax credit to help encourage innovation from businesses. While the tax credit was originally written as a benefit that could only be used against business income tax liabilities, the Protecting Americans from Tax Hikes Act (PATH Act) provides a new avenue for startup companies that are not yet profitable to help realize a cash benefit.

The PATH Act did two important things: it made the R&D tax credit a permanent incentive program (it was previously subject to extension by Congress every year), and it changed the qualification parameters to enable early-stage companies to use the tax credit against payroll tax liabilities. This meant that a qualifying early-stage business—that is a business in its first five years of having any gross receipts with less than $5 million in gross receipts in the tax credit year—now can be eligible for the tax credit to help offset its payroll tax liabilities. Early-stage companies are often generating losses in the first years of operation, and therefore may not have an income tax liability against which an income tax credit could be utilized. The PATH Act greatly expanded the R&D tax credit, allowing newer, smaller companies to take advantage of a benefit that they were previously unable to.

Businesses in industries that might usually come to mind when thinking about eligibility for the R&D tax credit include those in pharmaceuticals, automotive manufacturing, software development, and development of medical devices, but businesses in many other industries often are able to claim this tax credit as well. Businesses developing improved or new formulas of consumer products, companies licensing SAAS platforms, or even craft breweries may have qualifying work and may be able to receive the tax credit.

Businesses eligible for the tax credit need to document that they have done the work and meet the requirements of a four-part test to qualify for the tax credit:

• Permitted Purpose: the purpose of a qualifying project must be related to creating a new or improving an existing business component.
• Technological in Nature: work needs to rely on principles of physical, biological, or computer science or engineering.
• Elimination of Uncertainty: when work began on a qualifying project, there would have been uncertainty related to your capability to create the product or improvement, the methodology you would use, or the correct product design.
• Process of Experimentation: the project must involve a process by which you tested alternatives and resolved the uncertainty above.

After identifying qualifying activities for the tax credit, the business then needs to determine the eligible spend related to those activities. This eligible spend may include employee wages for time spent on R&D activities, 65% of costs paid to contractors working in the U.S., supplies used up in the development process, as well as some software licenses and cloud-based data storage spend.  The resulting federal tax credit is generally 7% to 10% of the total qualifying spend. Additionally, many states may have their own research tax credit for similar work and spend within the state. 

The tax credit is claimed on IRS form 6765 and is filed with the business income tax return by the return’s original or extended due date. It is important that businesses looking to claim this tax credit complete the required R&D tax credit documentation and tax credit calculation ahead of the income tax return filing due date so that the supported tax credit can be included with the filing.

There can be some exceptions to typical filing deadlines that also apply to businesses claiming the R&D tax credit. The IRS generally provides relief for timing of filings and in some cases payment of taxes to taxpayers in affected disaster-areas. There were a number of significant events around the country throughout the year for which the IRS provided additional time in recognition of disaster relief needed in those affected areas. Events including floods, fires, hurricanes, and droughts have been identified as hardships to individuals and businesses, and typical deadlines were extended to as late as October 15, 2023, or February 15, 2024, to assist taxpayers in those communities. Taxpayers in the affected areas are permitted the additional time without filing any extension paperwork, and they do not need to call the IRS to qualify for the extended time.

It is important to note that the relief is generally provided based on the county of an individual or business address. Taxpayers should refer to notices on the IRS website to help determine what relief may be available to them. Detailed information on tax relief in disaster areas can be found on the IRS website. 

If navigating one of the country’s largest tax incentives seems like uncharted territory, it doesn’t have to stay that way. Take a deeper dive into the topic and find more useful information in our previous blog, Hidden Money: Tips for Taking Advantage of the R&D Tax Credit. Also, consider teaming up with TriNet Clarus R+D to help guide you through the tax credit process, and contact our tax experts today.

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