Many small- and medium-sized businesses (SMBs) may be missing out on an opportunity to reduce their payroll taxes through research and development (R&D) tax credits. While HR typically defers to the finance team when it comes to taxes, the unique vantage point of HR can contribute a different perspective.
R&D doesn’t apply just to organizations doing hard-core science. In fact, any business in any industry that is investing time, effort and resources to improving products, processes or solutions is eligible for the federal R&D tax credit and possibly state R&D tax credits.
In this ever-changing economic environment, what is your organization doing to stay competitive? Where are you innovating? What are you developing internally or for your customers? How are you making your business grow? Any of these activities could be eligible for R&D tax credits.
What is the federal R&D tax credit?
The R&D tax credit was first established in 1981 through the Economic Recovery Tax Act (ERTA). It was an effort to incentivize businesses to devote more resources to research and development, which would increase productivity and strengthen the U.S. position in the global marketplace. After years of being a temporary provision, Congress permanently extended the credits, starting with the 2015 tax year, through the Protecting Americans from Tax Hikes (PATH) Act of 2015.
The act also allowed qualified small businesses to apply the research tax credits against any alternative minimum tax they may owe and against the employer share of the Social Security tax owed for each employee, which is significant because not every business pays income taxes. This “cash back” advantage is aimed at helping companies reinvest and continue to grow their business.
The PATH Act was significant in many ways but especially for smaller companies that aren’t necessarily doing pure science or technology. It also incentivizes domestic-based R&D activities rather than those happening abroad.
How it works
The federal R&D tax credit is a dollar-for-dollar reduction of a company’s tax bill based on qualified domestic expenses related to the design, development or improvement of products, processes, techniques, formulas or software. By the time it works its way through the tax compliance process, that net dollar-for-dollar ends up being about 6% to 8% of the total qualified research expenditures. Also, a dollar-for-dollar tax credit is more beneficial to a business than a deduction.
Activities that may qualify for the R&D tax credit include, but are not limited to, the development or improvement of:
- Products (tangible or intangible)
- Processes (manufacturing processes, technical processes, etc.)
- Software (intended for either external or internal use)
- Formulas
- Techniques
- Inventions (patentable activities)
As part of the process, businesses need to identify qualifying expenses and provide adequate documentation that shows how these costs meet the requirements under Internal Revenue Code Section 41. Financial records, business records, oral testimony and technical documents may be used for this purpose.
A taxpayer who has qualified research activities should first perform an R&D study to determine eligibility for the credit and satisfy the substantiation and documentation requirements required by the IRS. Once the credit amount is determined, the credit is claimed by completing Form 6765 and including it with the taxpayer’s income tax return.
The R&D credit can be claimed either on an originally filed return or, in the case of credits generated in prior years, on an amended return. A credit that cannot be utilized in the year in which it is generated can be carried back one year, then carried forward up to 20 years, in accordance with general business credit carryover rules. For example, some companies bank the credits because they know there’s going to be a future transaction that might generate a lot of taxes and they can use those credits to offset that coming event.
Not just for the big guys
You don’t have to be a large company to take advantage of this credit, either. Any business that is innovating to remain competitive and or to grow market share may be performing qualified research and development. Specifically, if your company is designing new products or processes, modifying your systems or even supporting research in a partner company, you might qualify for the R&D tax credit.
For example, a California-based machine shop has 10 employees with an average annual revenue of $2 million. Working with their payroll provider, they identified $134,800 in federal and state R&D tax credits related to business activities from 2016-2019. A pest control business that developed new software for internal use reaped $265,000 in R&D tax credits.
Many states are also offering R&D tax credits, which typically follow federal regulations and IRS guidance on what constitutes Qualified Research expenditures (QREs). Check with your state for more information.
Preparing for the future
As an HR leader, you keep your finger on the pulse of changing demographics and other economic waves that will impact your business. Although the next few years promise graduation rates higher or on par with recent levels, the overall working population will continue to shrink in the coming decade due to declining birth rates. More workers are retiring, and because the younger generations are smaller, they will not replace these workers one for one.
Add to this environment other economic factors like high interest rates, a tight labor market and overall higher costs of doing business. Companies today are looking at ways to make their business work more efficiently, more streamlined, smarter and with fewer employees. If your company is engaged in any of these activities, you may be eligible for R&D tax credits.
