Federal and state R&D tax credits provide an outstanding opportunity for businesses to obtain dollar-for-dollar cash savings for performing activities related to the development, design, or improvement of products, processes, formulas, or software. Designed to incentivize innovation, R&D tax credits are available across a wide variety of industries, but also represent a widely misunderstood benefit many companies miss out on.
Businesses that fail at claiming the R&D tax credits usually have uncertainty regarding the necessary paperwork, the qualifying activities and expenses, and the credit application. As a result, due to common R&D tax credit misconceptions about qualification and the complexity of necessary documentation, less than 33% of eligible companies actually apply for and utilize the credit. To reduce a company’s tax burden and claim the R&D tax credit successfully, it is necessary to be clear on these issues and establish a good base to apply.
Costly R&D Tax Credit Misconceptions
R&D tax credits were created by Congress in 1981 to help keep the U.S at the forefront of innovation and to reward companies for pursuing research activities. Companies are reimbursed for what the Internal Revenue Service (IRS) deems to be qualified research expenditures (QREs) that meet the four-part test.
In reality, the R&D tax credit legislation is much more inclusive than people realize and almost any company can benefit regardless of industry, size or age. Here are some common R&D tax credit misconceptions causing business owners to erroneously disqualify themselves from claiming the tax credit:
1. The R&D credit is only for companies that do ‘real’ research and development.
The R&D tax credit is designed to encourage innovation. As such, it is equally available to companies that attempt evolutionary improvements to existing products or processes and companies that undertake revolutionary activities.
R&D happens in all industries, even those without a traditionally scientific basis. While the majority of claims come from high-tech industries such as IT or pharmaceuticals, a significant number of claims come from less research-intensive industries.
The regulations define research as activities constituting a process of experimentation intended to eliminate uncertainty based on information available to the taxpayer at the outset of the project. Even if companies do not have research labs or scientists, this does not mean that they are not performing qualified research activities in the view of the IRS. If they are attempting to develop a new product or process or enhance an existing product or process, they may well qualify for the R&D tax credit.
2. The tax credit is only for products and processes that have never existed before.
According to the Discovery Rule, companies could only obtain the R&D tax credit if they created a product or process that was new to the world. But in 2003, Congress replaced this rule because it was too restrictive. Consequently, products or processes companies are developing do not have to be brand new. Enhancements to existing products or processes can qualify as well. In addition to this, a new product or process does not have to be successful to qualify for credit. The effort invested in the development activity is the determining factor, regardless of whether it succeeds or fails.
3. Only companies with the required documentation to support the claim should pursue the credit
One of the common misconceptions refers to the necessary documentation. In order to claim the credit, business owners need to evaluate and document the research activities contemporaneously and establish the amount of research expenses paid by each research activity. However, it is important to make a difference between documenting and substantiating your credits.
In some cases, a combination of credible employee testimony supported by some documentation can be enough, but this does not mean that companies can substantiate R&D credits with no documentation.
4. The R&D credit is only for companies with enough time to claim it
Usually, conducting an R&D credit study involves site visits, factory tours and in-person whiteboarding sessions, so it is not surprising that business owners believe they are too busy building their company to spend time applying for a tax credit.
However, while some degree of involvement is necessary, the potential benefits of the tax credit outweigh the efforts. Companies with a robust time tracking system usually need to devote a smaller amount of time. Otherwise, allocated time is based on employee time surveys.
5. The R&D tax credit is not for companies conducting funded research
Another common misconception is that companies are automatically ineligible for the tax credit if they are paid through a contract. However, getting paid for research activities does not mean that the research is funded.
Before claiming the credit it is necessary to determine who has the rights to the research and who has the risk of loss if the research ultimately fails. If a company retains the rights to the research and has the risk of loss, it is possible to claim the tax credit despite being paid for some or all of that research through the contract.
6. The R&D credit is not for companies in losses or do not owe tax
Even if a company has no current tax liability, federal R&D tax credits can be carried forward for up to 20 years for use in reducing future tax liability and can also be retroactive for the prior three years. Also, start-up companies may be able to claim a credit against their payroll tax even if they pay no income tax and in some states, the tax credit can be carried forward indefinitely.
Recognizing Opportunities to Increase Cash Flow
As a strategic benefit, R&D tax credits can provide additional capital that companies can use for business development, such as hiring new employees, expanding facilities or simply gaining an advantage in today’s uncertain economic environment. However, to recognize these opportunities, it is necessary to overcome common R&D tax credit misconceptions characterizing the process as onerous and difficult, discouraging many businesses from making a claim.
Furthermore, the R&D tax credit landscape is constantly changing and business owners should not make any assumptions about whether their company may potentially qualify without a comprehensive understanding of the law. To that end, technology-powered tax credit management in combination with experienced tax professionals can help companies navigate the R&D credit, turn complex procedures into a streamlined experience and easily overcome common R&D tax credit misconceptions.