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Grow Your Business Finances

Understanding Small Business R&D Tax Credits

science instruments

If your company is engaged in R&D of any sort, you may be missing out on a big tax break.

Whether you're developing products, creating software or engaging in engineering, scientific or technical services, you may qualify for a tax credit according to Sean Haggard, a tax manager with Kaufman, Rossin & Co.

The Federal Research Credit, commonly referred to as the R&D credit, was first enacted by Congress in 1981, Haggard said.  Yet many businesses do not know about this credit.  Others mistakenly believe that qualifying is too complicated, or that this type of subsidy is only available to the largest corporations, he said.

Haggard offers five things business owners should know about research credits.

How do I qualify?

You may qualify for the credit if you’re doing research to develop a new or improved business component.  The research must be technological in nature – research or development in the hard sciences such as computer science, physical or biological sciences and engineering. 

It must include the process of experimentation. This does not mean you need clean rooms, lab coats, petri dishes and microscopes.  The process of experimentation generally involves "trial-and-error" where you test more than one alternative to achieve a result that (at the outset) you were uncertain could be achieved. The R&D element is the elimination of the uncertainty. 

This experimentation must be related to a product's new or improved function, performance, reliability, quality or durability. 

Which expenses qualify?

It starts with the wages for personnel directly involved with the projects. Not surprisingly the credit rewards U.S. companies for hiring people performing R&D in the U.S. Next, add supplies utilized directly in the R&D process -- consumable supplies like raw materials for molding prototypes.  Computers and software needed in the design or improvement process also qualify. Costs incurred for securing a patent qualify as well, plus 65 percent of the costs for outside contractors such as engineering firms and subcontractors work performed in the U.S qualify.

What’s the tax benefit?

Generally about 6 percent to 14 percent of R&D expenses will translate to bottom line tax credits. The newest method for calculating the credit, the Alternative Simplified Credit (ASC), was instituted in 2007 and enhanced in 2008. The ASC regime greatly simplified the process and allowed more companies to claim the credit than ever before. 

What if I can’t use the credit this year?

The R&D credit carries over for 20 years. Capturing the credit now to offset taxes in the future for up to 20 years is "no-brainer" tax planning, Haggard said.

The R&D credit can be transferred. The credit transfers, with limitations, in the event of exit. Tax credits are a sweetener for potential investors and can boost a company's value if you sell the business.

Will the cost of compliance eat up any credit I get?

It is important to substantiate the technological challenges and individuals’ contributions to the R&D, but no more documentation is required than for any other deduction.  Document retention enhancement and a bit more stringent time-keeping for the R&D work are minor internal costs that should not deter a company from the credit.