Research and Development Tax Credits for Businesses
The PATH Act of 2015 includes some increased incentives in the form of tax credits for small businesses who use the R&D (Research and Development) tax credit.
What Qualifies as Research and Development?
Many types of businesses do research, and you may not even be aware that the activities of your business may be available as tax credits. Your business may be able to qualify for a tax credit for activities such as:
- development of proprietary products, including inventions,
- improving product quality, reliability, or functionality
- work on developing or improving software products
- research to improve business performance
- payments to third parties who conduct research for your business
- payments to employees who work on research projects in your business
The IRS says that research that qualifies for the tax credit must be
undertaken for discovering information that is technological in nature, and its application must be intended for use in developing a new or improved business component of the taxpayer. In addition, substantially all of the activities of the research must be elements of a process of experimentation relating to a new or improved function, performance, reliability, or quality....
What Tax Credits are Available? How Do These Tax Credits Work?
Usually, a tax credit is taken directly against the income of the business, as shown on the business tax return.
In this case, as noted above, the PATH Act has expanded the tax credit for smaller businesses, effective beginning in 2016, and makes the credit permanent. This removes the guess-work of businesses trying to make plans.
More specifically, newer businesses (under 5 years old) and small businesses with under $5 million in gross receipts for the tax year may be able to qualify for a credit of up to $250,000 a year.
Here's how these tax credits work: a business spends money, then makes an application for a tax credit. The credit is applied directly against business income, which is better than taking a deduction for the expense.
There are three types of tax liability against which the tax credit can be taken. The 2015 legislation allows small businesses to take the tax credit against:
- business federal income tax liability (the amount owed for federal income tax.
- the employer's share of Social Security taxes (but not Medicare taxes) for employees, or
- the Alternative Minimum Tax.
These options allow businesses more flexibility in where they apply the tax. Newer small businesses, for example, may not have enough income tax liability against which to apply the tax, so the business can select one of the other options.
Taking the credit against the employer's share of Social Security taxes means you might be able to take the credit even if your business isn't making a profit.
Note that the R&D tax credit can be taken against Alternative Minimum Tax. This alternative tax is applied to the owner's personal tax return, so it would only be available for pass-through taxes. These are business taxes that pass through to the personal tax return of the business owner and would include sole proprietorships, LLC's, and partnerships.
How to Apply for This R&D Tax Credit
You would apply for the credit for a specific tax year by filing IRS Form 6765- Credit for Increasing Research Activities. The form offers you two options for taking the credit:
- Taking the "regular" credit, or
- Using the alternative simplified credit.
Each option includes a list of included costs (like wages, computer costs, and cost of supplies) and calculations. It's best to read the details in the instructions for form 6765 before you begin. The IRS suggests working through both methods to see which results in a greater credit.
Deducting or Amortizing These R&D Tax Credits
You may also want to look into deducting or amortizing (spreading out) the cost of these research activities. The IRS has guidelines for deducting or amortizing research tax credits.
In Conclusion: Check With Your Tax Professional
As usual with these types of tax benefits, the qualifications and the process are complicated.
The purpose of this article is not to give you tax advice, but to provide you with general information to use in your conversation with your tax professional.