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The R&D Tax Credit (more formally known as the “Credit for Increasing Research Activities”) is a federal and state tax credit that enables companies to capture a dollar-for-dollar reduction of taxes owed. Now permanent as a result of the Protecting Americans from Tax Hikes (PATH) Act of 2015, the R&D Tax Credit was enacted in 1981 under the Economic Recovery Tax Act (ERTA).

Originally introduced to incentivize innovation and keep technical jobs in the United States, the R&D Tax Credit aims to promote R&D by providing much-needed cash-flow to companies based on the expenses spent on employee wages, supplies necessary for R&D, cloud-hosting, and contractor costs. Beginning in 2017, eligible start-ups or small businesses may elect to apply the R&D Tax Credit against their quarterly payroll tax liability.

The R&D Tax Credit is for businesses of all shapes and sizes. Although Bunsen burners, test tubes, and lab coats may be the epitome of R&D, many other companies are eligible.

How do I know if I qualify for the R&D Tax Credit?

Under the Internal Revenue Code, activities that qualify for the R&D Tax Credit must meet what is known as the “Four-Part Test.”

The “Qualified Research” Four-Part Test is set forth below:

Research which is undertaken for the purpose of discovering information which is technological in nature;
The application of which is intended to be useful in the development of a new or improved business component of the taxpayer;
Substantially all of the activities of which constitutes elements of a process of experimentation for a permitted purpose; and
Involves specific qualified research expenses.

To be considered “qualified research," the taxpayer must be able to establish that the research activity being performed meets ALL four parts of the Four-Part Test. The test must be applied separately to each business component of the taxpayer.

What is a "Business Component"?

A business component is any product, process, computer software, technique, formula, or invention, which is held for sale, lease, license, or used in the taxpayer’s trade or business.

What is a "Process of Experimentation"?

A Process of Experimentation (“POE”) is a process designed to evaluate one or more alternatives to achieve a result. The POE is the heart of the R&D Tax Credit analysis and must rely on the principles of hard sciences, such as engineering or computer science. Additionally, the POE must relate to a permitted purpose. In other words, the POE must relate to a new or improved function, performance, reliability, or quality of the business component. It cannot be related to style, taste, cosmetic, or seasonal design factors.

What are "Qualified Research Expenses"?

Generally, there are four categories of research expenses that can be claimed towards the R&D Tax Credit:

Wages — any wages paid to an employee for qualifies services performed along with the wages paid to the employees who directly supervise or support the research.
Supplies — Supplies and raw materials used or consumed in the R&D process by an employee or a contractor of the taxpayer.
Contract Research — 65% of any payments made to a contractor that is involved in the R&D process.
Cloud Computing — software developers that use a cloud environment to perform development work may claim cloud computing costs if:
- The cloud computing server is owned and operated by someone other than the taxpayer;
- The server is located off the taxpayer’s premises; and
- The taxpayer must not be the server’s primary user.

What are some examples of Qualified R&D Activities?

Developing a new or improved product or prototype;
Developing a new patent;
Improvements to manufacturing production processes;
Testing new materials, compounds, or components;
Designing a new manufacturing facility;
Designing a new school;
Automating processing via technology improvements; and
Developing or improving upon a computer software or system.

What are some examples of activities that are excluded from the R&D Tax Credit?

Certain software developed for internal use;
Projects that adapt or duplicate an existing business component (e.g., reverse engineering);
Research after commercial production of the final product;
Research funded by another party;
Research related to arts, social sciences, or humanities; and
Surveys, studies, market research, routine data collection, routine testing, and quality control.

I am a startup and have been operating in losses — can I take the credit?

Yes! Qualified Small Businesses may elect to use the R&D Tax Credit to offset payroll tax liabilities. The total benefit is up to $250,000 per year for up to five years. In order to be considered a Qualified Small Business, a company must meet the following requirements:

The company has gross receipts of less than $5,000,000 for the taxable year, and
Did not have gross receipts for any taxable year before the five-year period ending with the taxable year that the payroll tax offset will be used.

Does my state offer an R&D Tax Credit?

The majority of states currently allow taxpayers to claim some form of the R&D Tax Credit. Although each state’s definition of “qualified research activities” largely mirrors the definition outlined in the Internal Revenue Code, each state’s R&D Tax Credit calculation methodology varies.

Below is a list of the states that do not offer the R&D Tax Credit:

Alabama
District of Columbia
Mississippi
Missouri
Montana
Nevada
North Carolina
Oklahoma
Oregon
South Dakota
Tennessee
Washington
West Virginia
Wyoming

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