R&D Tax Credit FAQs For Large and Small Businesses

• Increased cash flow
• Increased earnings per share
• Increased return on investment
• Reduced federal and state tax liability
• Reduced effective tax rate

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In general, activities qualify for the credit if they meet each element of a four-part test and aren’t specifically excluded.

Four-part Test

1. Qualified purpose. The purpose of the activity is to improve the functionality, performance, reliability, or quality of a product, process, software, technique, invention, or formula that is intended to be used in the taxpayer’s business or held for sale, lease, or license. 
2. Technological uncertainty. The taxpayer encounters uncertainty regarding whether it can or how it should develop the component, or regarding the component’s appropriate design.
3. Process of experimentation. To eliminate the uncertainty, the taxpayer evaluates alternatives through modeling, simulation, systematic trial and error, or other methods.
4. Technological in nature. The success or failure of the evaluative process is determined by the principles of engineering, physics, chemistry, biology, computer science, or similar natural or “hard” science, as opposed to the principles of, for example, economics and social sciences generally.

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No.

For activities to qualify, the taxpayer must be attempting to develop a new or improved process, product, software, etc. and experience uncertainty regarding the design, method, or capability that requires a systematic process of experimentation. The activity does not need to be new to the world or result in the discovery of new scientific information, nor does it need to be successful to qualify for the R&D credit.

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Excluded activities include: 

• Research conducted outside the U.S.
• Routine data collection or ordinary testing for quality control of existing components
• Market research
• Management
• Consumer preference testing
• Research funded by a third party if the taxpayer either doesn’t retain rights to the results of the research or bear the economic risk if the research is not successful.

Other activities that don’t qualify because, generally, they don’t meet the four-part test:

• Administration
• Training
• Repairs and maintenance
• Preproduction planning for a finished component 
• Tooling up for production 
• Trial production runs 
• Troubleshooting 
• Accumulating data relating to production processes 
• Activities relying on the social sciences, arts, or humanities
• Research after commercialization 
• Adapting existing components to a particular customer’s need 
• Duplicating an existing component via reverse engineering 

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Yes. Activities to develop software to be held for sale, lease, or license that meet the four-part test above and that are not statutorily excluded can qualify.

Activities to develop software intended “primarily for internal use” must meet additional requirements but can also qualify.

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1. Taxable wages for employees who perform or directly supervise or support qualified activities.
2. Cost of supplies used in qualified activities, including extraordinary utilities, excluding capital items or general administrative supplies. 
3. 65%-100% of contract research expenses for qualified activities, provided that the research was performed on behalf of the taxpayer and that the taxpayer must pay the contractor whether the research succeeds or fails.
4. Rental or lease costs of computers used in qualified activities, such as payments to cloud service providers (CSPs) for the cost of renting server space to develop or improve a component.

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In general, any company—in any industry and of any size—that invests in activities of the kind outlined in this FAQ can benefit if in the course of carrying on a U.S. trade or business the company paid, pays, or expects to pay:

1. Regular federal income tax;
2. A similar state tax in one of the more than 35 U.S. states that provide incentives for R&D and R&D-related investments; or
3. In certain circumstances outlined below, federal payroll tax; or
4. Similar taxes in one of the approximately 50 non-U.S. countries that also provide for such incentives. 

Industry generally doesn’t matter: Although most R&D credits are claimed by companies in the manufacturing sector (usually 60-70% of total credits claimed), information technology (15-20%), professional, scientific, and technical services (10-15%), wholesale and retail (5-10%), and financial and insurance (5%), millions of credits are claimed each year by companies in other industries, including: 

• Natural resources, such as mining and oil and gas; 
• Services, including health, entertainment, administrative, and hospitality; 
• Architecture and construction; 
• Real estate, rental, and leasing; 
• Transportation and warehousing; 
• Agriculture; 
• Forestry; and
• Fishing and hunting.
  
  

And size never matters: Businesses with $0 in sales can claim significant R&D credits.

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Any company, in any industry, that has devoted resources toward developing new products, processes, or software -- whether successfully or not -- is eligible. For examples and more detail, check out our resources for the following industries: manufacturing, technology, life sciences, and healthcare.

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Probably.

Even companies with a small R&D department – or no R&D department at all -- may benefit from the credit. In fact, many taxpayers who benefit from the R&D credit don’t have departments explicitly named “R&D Department.”

The time and cost to estimate your company’s R&D credit is generally very small relative to the benefit in many cases.

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Your company may still be able to benefit currently from the R&D credit.

Startup taxpayers in certain circumstances may offset up to $500,000 of their federal payroll tax liability using R&D credits.

Many states provide credits that are refundable, i.e., states pay the amount of the credit as a refund whether your company pays income tax currently or not.

And if your company does not owe income taxes in a given year but paid income taxes the previous year, the company can carry back the credit to the preceding year to offset some or all of that year’s tax liability.

If your company does not owe income taxes for the current year or the prior year, it can carry the credit forward to future years, up to 20 years for federal and some state R&D credits, and indefinitely in other states, including California.

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Startups may use R&D credits against up to $500,000 of their payroll taxes in five separate taxable years—a total of $2,500,000—if they have:

• Gross receipts of less than $5 million in the tax credit year; and
• No gross receipts for any of the four preceding tax years.

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Smaller companies may use R&D credits against the alternative minimum tax (AMT) provided they:

• Are not a public company; and
• Have $50 million or less in average gross receipts for the preceding three tax years.

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Some aren’t eligible. Many more, though, are eligible but misunderstand the credit.

Common misconceptions about the R&D credit that are incorrect or overstated:

• Not doing “groundbreaking” work
  • Far from needing to be “groundbreaking” to qualify, activities don’t even have to succeed to qualify.
• Audit concerns
  • Claiming credits doesn’t require a tax audit.
• Company is too small to benefit
  • The size of a company isn’t directly relevant to the amount of the credits it may claim, which is calculated based on qualified spending, not sales. In the last year for which the IRS has published statistics, almost 250,000 corporations with receipts under $25,000,000 reported claiming R&D credits.
• Lacking the necessary documentation
  • There are no specific documentation requirements to claim the credit; numerous court cases—including by the U.S. Tax Court—have affirmed that R&D credits can be substantiated with oral testimony. However, claims are most effective when supported by contemporaneous documentation and other corroborating evidence.

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Generally, there are two methods for computing the QREs-based credit, the regular credit (RC) method and the alternative simplified credit (ASC) method.

The two methods are similar in that they both calculate the credit as a percentage of the excess of qualified spending in the year for which the credit is being calculated over a “base amount.” For this reason, these credits are sometimes called “incremental” credits.

The credits are different in three ways.

1. Rates - The RC’s statutory rate is 20%; the ASC’s is 14%.
   • Important note: The RC’s higher rate does not mean that a particular taxpayer’s RC will always be higher than its ASC rate. Its RC could be higher, but it could be much lower, because the “base amounts” are calculated differently under the RC and ASC methods.
2. Base Amounts – The RC’s base amount is calculated using the taxpayer’s gross receipts and QREs; the ASC’s base amount uses just QREs, hence its name, “alternative simplified credit.” In some cases, the gross receipts a taxpayer needs to calculate its RC relate to tax years from as far back as the 1980s, which is part of the reason more and more taxpayers are electing the ASC.
3. Election - The ASC must be elected for a tax year either on an original return by simply completing the ASC section of the Form 6765 on which all federal R&D credits are reported, or on an amended return, whereas the RC does not have to be elected under any circumstances, just reported or claimed.
   • Important note: A taxpayer may elect the ASC on an amended return only if (1) the taxpayer has not previously claimed an RC on its original return or an amended return for that tax year, and (2) that tax year is not closed by the period of limitations on assessment under IRC Section 6501(a).

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Yes.

Most states offer a credit for expenditures to attempt to develop or improve a product, process, or software, and most  follow rules similar to those of the federal R&D credit.

Some states require taxpayers to file an application in addition to the tax return on which the credit is claimed to be eligible for their credits. Some also limit their credit to certain industries or the credit amount that will be allowed each year.

In many cases, however, state credits are even more generous than the federal credit. For example, some states have higher credits rates, allow taxpayers to sell or to transfer their credits to other taxpayers, pay taxpayers the value of their state credits even if the taxpayers aren’t currently paying taxes, or have refundable credits.

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Identify and gather support for the credit to which you’re legally entitled. Report the credit on a timely filed (including extensions) or amended federal tax return using Form 6765. If the entity reporting the credit is a pass-through, the partner or shareholder will report their share of credits on Form K-1 of their 1040 returns to monetize the credit.

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The credit is claimed on a timely filed (including extensions) federal income tax return for the year in which the qualified expenses were incurred. The credit may also be claimed by amending a previously filed return on or before the statute of limitations date to report credits related to expenses incurred during that period. The statute of limitations generally grants three years after the original deadline or filing date (whichever is earlier) to amend returns.

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Tax years that are open to amendment under relevant statutes of limitations may be amended to include credits. This period is generally three years from the unextended due date or the return filing date, whichever is later.

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1. IRS exam. Like with any other tax position, it is possible that the IRS will examine an R&D credit position.  If examined, R&D credits may be allowed or disallowed, in whole or in part. If credits are allowed, the IRS may consider the taxpayer’s other tax positions to identify additional tax liability, but only to the extent of offsetting the credit. This has been an uncommon occurrence.
2. Disallowed credits. It is possible the IRS would examine and disallow some or all the R&D credits claimed. Credits that have been appropriately identified and supported are generally allowed. Credits related to vague or undocumented activities often are not.
3. IRS penalty and interest. If the IRS disallows a credit, it may assess a penalty if it finds that the credit was either claimed through negligence or the disregard of rules or regulations, or results in a substantial understatement of income tax. Generally, this penalty equals 20% of the credit disallowed, i.e., of the tax the IRS believes was underpaid. The IRS may also assess interest from the date that the tax should have been paid. 

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A taxpayer claiming a federal R&D credit on an original return must retain records in sufficiently usable form and detail to substantiate that the expenditures claimed are eligible for the credit.

However, the IRS takes the position that a taxpayer must provide more specific documentation when filing an amended return or other refund claim based on the federal R&D credit. This IRS-mandated documentation includes, for example, a list of each business component and research activity to which the R&D credit claim relates.

BDO can help determine whether and to what extent your records meet the standards IRS examiners typically apply and, if they don’t, what other evidence you may be able to present to support your credits.

Although IRS agents are not required to follow them, the standards outlined in IRS audit techniques guides provide a roadmap to the auditors.

• Audit Techniques Guide: Credit for Increasing Research Activities
• Research Credit Claims Audit Techniques Guide (RCCATG): Credit for Increasing Research Activities § 41
• Audit Guidelines on the Application of the Process of Experimentation for All Software
• Pharmaceutical Industry Research Credit Audit Guidelines

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Based on our experience, many companies that have claimed R&D benefits have not taken full advantage of them, even if an “R&D study” has been conducted. BDO offers the following complimentary services to help companies determine whether they could claim their R&D credits more efficiently and effectively:

• Cost & Calculation Review: Like a tax examiner, we look for errors and red flags, including those caused by the use of outdated data and regulations. We also look for understated, missed, and nonqualified costs to enhance both your company’s credit’s materiality as well as its creditability.
• Documentation Review: R&D benefits are often only as valuable as the documentation available to support them. As part of a documentation review, we assess whether and how tax examiners may accept—or disallow—your credit in light of the nature and extent of your documentation and make recommendations to improve that documentation, for both current and future tax years.
• Systems & Technology Review: We help companies develop and implement procedures and technologies to identify, document, and calculate future credits more efficiently and more effectively.

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No. It just has to have:

1. Gross receipts equal to less than $5 million in the tax credit year;
2. No gross receipts for any tax year preceding the five-tax-year period ending with the tax credit year; and
3. R&D credits it can use in that year. 

So even companies that have been around for more than five years and have spent billions of dollars to try to develop or improve a component could be eligible; for example, a significant percentage of life science companies with $0 gross receipts for long periods of time before their drug receives U.S. Food and Drug Administration approval may qualify.

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Yes. If the company meets the criteria noted above, it can benefit, regardless of when it was formed.

Although the law is intended to benefit small businesses, large businesses could also potentially benefit.

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Yes.

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The payroll tax offset is available on a quarterly basis beginning in the first calendar quarter that begins after a taxpayer files its federal income tax return.

For example, companies need to file their Q1 federal income tax returns by March 31 to apply the payroll tax offset to the second quarter. As a result, the earliest taxpayers are likely to see a benefit is July, when they file their quarterly payroll tax returns for the second quarter (Form 941).

If a company requests an extension to file its income tax return, it’ll be able to take advantage of the offset in the quarter after it files the federal return: file the return by June 30, take the offset on the October 31 Form 941 filing; file the return by September 30 and take the offset on the January 31 Form 941 filing.

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1. Identify and gather support for the credit to which you’re legally entitled.
2. Report the credit on a timely filed federal tax return and elect the payroll offset.
3. Claim no more than $500,000 of the credit annually on your quarterly Form 941. 
   • A company’s payroll tax offset can be applied against its liability for the employer portion of Social Security tax (up to $250,000) and, beginning after December 31, 2022, an additional offset may be applied against Medicare tax (up to $250,000). However, companies may not use the payroll tax offset against any other employment tax liability, and the offset may not be refunded in the absence of liability.

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There are three things to consider regarding gross receipts.

1. Businesses that are related or under common control must aggregate their gross receipts.
2. Gross receipts for any taxable year of less than 12 months must be annualized by multiplying the gross receipts for the short period by 12 and dividing the result by the number of months in the short period.
3. What should be included as “gross receipts”?
   • Current guidance from the IRS defines gross receipts for purposes of this provision as total sales (net of returns and allowances) and all amounts received for services. In addition, gross receipts include any income from investments and from incidental or outside sources. As currently defined, a company that reported interest only on its tax return would need to consider amounts as gross receipts in evaluating whether or not it meets the criteria to take the payroll tax offset. 

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If a company can’t use the credit to offset its payroll taxes in a given quarter, it may carry the credit forward to subsequent quarters in which it can use it, provided the $500,000 annual cap isn’t exceeded. Amounts over $500,000 can be carried forward for 20 years to offset future regular tax liability on the company’s tax return.

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For businesses with a short tax year—for instance, businesses that started up in the current tax year—gross receipts must be annualized. This is true for all short tax years that affect the determination of whether a company is eligible for the payroll offset. For more on the definition of gross receipts, please see this section.

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Up to $250,000 of the employer portion of Social Security payroll tax liability and up to $250,000 of the employer’s Medicare payroll tax liability can be offset by R&D credits.

Generally, companies are required to pay Social Security (6.2%) and Medicare (1.45%) taxes on each employee’s salary. As an example, a company that employs 100 employees with an average salary of $95,000 per person would pay approximately $589,000 in Social Security payroll taxes and $137,750 in Medicare payroll taxes. Thus, a company would need more than $9 million in annual payroll subject to Social Security and Medicare taxes and $5 million in eligible R&D costs to offset the maximum $500,000 in payroll taxes each year.

Most employers are required to remit their payroll taxes to the federal government on a monthly or semiweekly basis and file a quarterly payroll tax return (Form 941). The credit is applied against employment tax on the quarterly return, or against amounts when the tax is deposited monthly or semiweekly.

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Example 1. A company incurs $300,000 in eligible costs in an attempt to develop its flagship software product. The company was founded in 2020 and has generated no gross receipts to date. Eligible expenses generate a credit of approximately $30,000. Because the company meets the criteria, it can use $30,000 of credits to offset its FICA payroll tax on its quarterly Form 941 filings. 

Example 2. A company incurs $5,000,000 in eligible costs related to developing a new medical device. The company was founded in 2013 and has generated no gross receipts, not even interest income, prior to 2023. In 2023, they generated $4,000,000 in gross receipts. Eligible expenses generate a credit of approximately $500,000. Because the company meets the eligibility criteria, it can use up to $250,000 in credits to offset its Social Security tax and up to $250,000 in credits to offset its Medicare payroll tax on its quarterly Form 941 filings. 

Example 3. A company incurs $6,000,000 in eligible costs related to developing and improving its new line of consumer products. The company was founded in 2023 and has generated $500,000 in gross receipts each year to date. Eligible expenses generate a credit of approximately $600,000. Because the company meets the eligibility criteria, it can use $500,000 of these credits to offset FICA payroll tax on its quarterly Form 941 filings. The remaining $100,000 in credits will be carried forward for 20 years to offset future regular tax liability on the company’s tax return. 

In each example, should the companies continue to meet the payroll offset criteria in future tax years, they can use up to $500,000 in credits each year for five years to offset their FICA payroll taxes, for a potential of $2,500,000 in cash savings.

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