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Use Research and Development Tax Credit to Reduce Taxes

The research and development tax credit was introduced in 1981. It was created to help companies afford the cost of conducting research to develop their products and increase productivity. The tax credit was originally going to expire after five years, but it persists today after being revived 16 times.

r&d tax credit

Small businesses can use this credit to reduce their tax bill by claiming expenses made on employing researchers and engineers, or product testing costs. Startups can especially benefit from this tax credit, as they incur expenses to improve their product/service when their profits are relatively low. Prairie Business elaborates:

“The regular federal R&D tax credit equals 20 percent of QREs that exceed a base amount. The Alternative Simplified Credit (ASC) amount is 14 percent of QREs that exceed a base amount. The base amount limitation often decreases the maximum net federal credit benefit into the 6 to 7 percent range, before consideration of state R&D type credits which many states now offer. The credit results in a dollar-for-dollar reduction in federal tax liability. This can reduce an effective tax rate, improve earnings-per-share and improve cash flow.

“As noted above, the R&D credit is generally calculated using one of two different methods, the Regular Credit or the ASC. The Regular Credit relies on historical data that may require the taxpayer to go back over 30 years to compute a base amount. Use of the ASC eliminates ‘base period’ difficulties.

“The R&D tax credit is a business credit subject to the general business credit limitation rules. Any unused general business credits may be carried back one year and forward 20 years.

“Many companies take advantage of the R&D tax credit every year. The R&D tax credit is available for the development of a new product, process, formula or software design; the building and testing of prototypes or models (including computer-generated models); design related to construction or engineering activities; improving or enhancing existing production or manufacturing processes; developing, customizing or upgrading software; or automating or streamlining internal processes. Non-qualifying activities includes activities done outside of the U.S., market research and nontechnical research, such as consumer taste or styling.

“‘Qualified research activities’ are those activities undertaken specifically for the purposes of discovering information which is technological in nature, eliminating uncertainty in the development of a business component, relying on the process of experimentation or creating a new or improved function related to performance, reliability or quality.

“‘Technological in nature’ refers to the process of experimentation utilized in the research. Information is deemed technological if the process of experimentation fundamentally relies on principles of the physical or biological sciences, engineering or computer science.

“‘New’ means new to the taxpayer and is not freely available to the public.

“‘Qualified research expenses’ include in-house research expenses, which include wages paid to employees (including support and supervision personnel) for qualified research activities; and supplies purchased for use in qualified research activities (excluding land, improvements to land and depreciable property); or contract research expenses, which are amounts paid to a third party for purposes of conducting qualified research activities on behalf of the taxpayer.

“Indirect, general, administrative and overhead expenses do not qualify as ‘qualified research expenses.’

“Taxpayers who qualify for the R&D credit and have not claimed the credit can amend returns for any open tax years.”