What is a R&D Tax Credit?

Updated for 2024

Research and development are essential in the world of startups—how else will you discover and perfect the thing that makes your company distinctive and innovative? To incentivize more startups to innovate, the federal government offers a research and development tax credit that offers companies significant cash savings.

 

R&D Tax Credit 101

In general, an Internal Revenue Service tax credit is a source of cash, a dollar-for-dollar tax savings, a way to offset future federal and state tax liabilities, and, in certain circumstances, payroll tax liability. An R&D tax credit, specifically, is only available to companies that are developing new or improved business components or projects that result in new or improved functionality, performance, reliability, or quality. This can include products, processes, computer software, techniques, formulas, or inventions.

You can use the IRS R&D tax credit in one of two ways:

• To reduce your company’s federal income tax liability. If your company does not have a federal income tax liability and therefore, cannot be used immediately or completely, then any unused credit can be carried back one year or carried forward for up to 20 years.

• Alternatively, startup companies and qualified small businesses may be eligible to apply up to $1.25 million—up to $500,000 each year for up to five years—of the federal R&D credit to offset their employer paid portion of FICA (also known as social security tax) of their payroll taxes each year (i.e., Qualified Small Business Payroll Tax Credit for Increasing Research Activities).

 

Is your company eligible for a federal R&D tax credit?

Now that you know what the R&D credit is, your biggest question is probably “Do I qualify?” That’s a great question, and we’re here to help you answer it. 

To be eligible for the qualified small business payroll tax credit for R&D, your company must meet two requirements:

1. Have less than $5 million in gross receipts for the year in which you are claiming the credit.

    

2. No gross receipts in any tax year preceding the five-tax-year period that ends with the tax year of the election (For example, for the 2023 tax year, no gross receipts prior to 2019).

   If you do not qualify for the Payroll Tax Credit, you may still be eligible to offset your federal income tax liability (approximately 40 states provide incentives for the R&D tax credit) for R&D or carry it forward up to 20 years, but only if you owe no income tax for the year.

If you do not qualify for the Payroll Tax Credit, you may still be eligible to offset your federal income tax liability (approximately 40 states provide incentives for the R&D tax credit) for R&D or carry it forward up to 20 years, but only if you owe no income tax for the year.

How do I apply for an R&D payroll tax credit?

You’ve made it this far, so your answer to “Do I qualify?” is likely a resounding “Yes!” Now let’s turn that qualification into action.

Before you can even apply, your company and your research and development processes must pass a four-part test:

1. Qualified Purpose.The purpose of the R&D 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 by your business or held for sale, lease, or license (component).

    

2. Technological Uncertainty. Your company 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, you evaluated 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 principles of, e.g., economics, social sciences generally.

The IRS, of course, requires contemporaneous documentation to be submitted to back up your R&D tax credit claim. Need help doing your R&D tax credit analysis and filing for your credit? Shameless plug: Reach out to Graphite! We only charge you if we actually get you a credit.

To establish exactly how much was spent on qualified research activities, we highly recommend that you rigorously document any activities you wish to claim toward research. The burden of proof lies with the taxpayer—that’s you! —so, as a result, we suggest you keep documents such as:

• Payroll records for employees involved in R&D.
• Expenses, receipts and accounts for supplies and equipment related to R&D.
• Contracts and invoices paid to any third-party partners involved in R&D.
• Blueprints, patents, designs, drawings, and prototypes related to research.
• Project and meeting notes related to research.

If you need a little help organizing and managing all this documentation, our tax experts at Graphite are here to help. We’re ready to assist you in finding and documenting qualified R&D expenses like:

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% of contract research expenses for qualified activities, provided the taxpayer retain substantial rights to the activity’s results and must pay the contractor whether it succeeds or fails.

    

4. Rental or lease costs of computers used in qualified activities, e.g., payments to cloud service providers (CSPs) for the cost of renting server space to develop or improve a component.

Take the first step in getting the R&D tax credit for your company. Get started with our R&D tax credit calculator and determine if your company qualifies for a credit.