Taxes: Unlocking Cash Flow with the R&D Tax CreditBy
Many businesses will leave hundreds of thousands of dollars in research and development credits on the table this tax season.
The Credit For Increasing Research Activities, also known as the research and development (R&D) tax credit, is a nondilutive, dollar-for-dollar cash incentive for U.S.-based businesses that “innovate,” but many eligible businesses are missing out because of some key misconceptions. Initially created as a temporary credit in the Economic Recovery Tax Act of 1981, the now-permanent, expanded incentive is meant to reward businesses for investing in technical research in the United States. Some accountants are familiar with the credit, but many wrongly assume their clients don’t qualify. Others may lack the niche expertise needed to uncover the maximum amount they’re eligible to receive.
One reason for this misconception is a limited view of innovation. The term “R&D” is commonly associated with scientists in white laboratory coats. Yet Internal Revenue Service (IRS) guidelines allow for a much broader definition of R&D for tax purposes. For example, if a company makes a new or improved product, process, or technique, it will likely qualify regardless of its size or industry. Moreover, success or failure to make or improve the product, process, or technique has no impact on eligibility.
So, the question is, how can you help uncover instances of everyday innovation within your or your client’s organization?
BENEFITS FOR BUSINESS OWNERS
Start-ups that are eligible for the R&D tax credit can qualify up to $250,000 in reduced payroll tax offsets per year as long as they meet the definition of a “start-up.” In this context, start-ups are defined as having fewer than five years of gross receipts and less than $5 million in the year the credit is elected. There’s no cap or limit on companies utilizing these credits against actual tax liability.
This offset can boost overall cash flow and unlock financial flexibility. In fact, it isn’t uncommon for companies that have previously paid taxes to get a refund when they later discover and claim the R&D credit. Companies can reinvest in further R&D activities, expanding the benefits across multiple tax years. For venture-backed start-ups that aren’t yet generating revenue or profits, securing and utilizing a credit can help extend the company’s runway for growth without diluting equity. For small businesses like sole proprietorships or partnerships, the credit reduces the taxes an owner or shareholder owes.
The main challenges for eligible businesses, however, continue to be parsing the definition of “qualified research” in Internal Revenue Code (IRC) §41(d), commonly known as the four-part test, and knowing how to substantiate the credits claimed.
THE FOUR-PART TEST
The IRS uses four criteria to determine whether a business’s research activities are eligible for the R&D tax credit.
Permitted purpose: Research expenses claimed for R&D must be related to a new or improved product, process, or design. This means the activity can’t be “research for the sake of research.”
To qualify, a company’s activities should set a goal to develop a new or improved functionality, performance, or reliability. For example, a footwear company developing a boot that doesn’t squeak and a manufacturer seeking to reduce the amount of wasted materials (scrap) in its processes both meet this standard. By contrast, university research or purely superficial changes in color, appearance, or preference of a product wouldn’t qualify.
Technological in nature: The activity performed must fundamentally rely on “hard” sciences and principles, specifically computer science, physics, chemistry, mathematics, and other natural sciences. This is in contrast with “soft” social sciences like economics, sociology, or philosophy.
While we tend to think of these hard sciences in the context of drug discovery or quantum engineering, many businesses in other industries also unknowingly utilize them in their day-to-day work. For example, an apparel company working to improve the sustainability of its products by trying different material sciences or an e-commerce beauty company redesigning its packaging to reduce the spatial parameters could also qualify. Other overlooked industries include manufacturing, food and beverage, and consumer packaged goods.
Elimination of uncertainty: At the outset of a project or activity, a company must be technically unsure about whether it could do something, how to do something, or how to most appropriately do something. In other words, the company must be uncertain of whether it could solve a problem or how to best go about solving it. The emphasis here is whether the uncertainty is technically or “technologically” challenging. As a comparison, business uncertainties (e.g., can we come in under budget?) don’t meet this standard.
Of the four tests, this is the most misunderstood because success or failure to solve the technical problem has no impact on eligibility. In fact, failures often indicate and exemplify just how technical the activity is.
Uncertainties that align with this definition include a manufacturer determining whether (and how) it can increase output or a packaging company determining how to change a recipe to increase a product’s shelf life.
Process of experimentation: The activity must relate to experimenting with possible alternative solutions, testing, and/or trial and error.
This is one of the most important aspects of the four-part test and relates directly to eliminating uncertainty. Some examples might include testing three solutions and determining which is the most appropriate (and, therefore, deciding why the other solutions are not).
The complex language around the four-part test is a common source of confusion, but financial professionals can start by simply asking: “Does your organization sell a new or improved product?” If the answer is yes, it’s highly likely that the company has expenses that qualify for the R&D credit.
Given the complexity and uncertainty around the tax credit, it may be worthwhile to enlist a specialist for assistance. In the same way that we wouldn’t expect or want a primary care physician to perform open-heart surgeries, niche tax areas like the R&D tax credit would benefit from specialists helping with the more complicated calculations. Focusing very deeply on one area, specialists often know which stones to look under first and will find more tax credits for the expenses that get overlooked, misclassified, or even dismissed.
By expanding our understanding of what qualifies for R&D tax credits, financial professionals can take the first step in helping to identify whether there might be undiscovered tax benefits for their organization or clients.
© 2022 A.P. Curatola