Many people are vaguely aware of something called a “research and development credit.” It may bring to mind pharmaceutical research, manufacturing processes, or other traditional processes that businesses have been improving and creating for generations.
What people don’t realize is that the benefit of the R&D Credit doesn’t end there. Video game developers, software companies, and other entrepreneurs in emerging industries can often take advantage of these credits for potentially large benefits.
What is the R&D Credit?
The United States Research and Development Credit was first introduced as a temporary benefit in 1981 to stimulate long-term investment in the US economy. Since then, it’s been made a permanent fixture of the US tax system and many states have individually chosen to adopt a similar credit to apply to taxes in that state.
These credits allow companies that invest in the creation of new and innovative products, improve existing products, sharpen their internal systems, hire designers and engineers, and solve technological challenges to reap the reward of that effort.
What’s the value of the credit?
The R&D Credit is a tax credit like any other. That means it reduces the income taxes owed by a company dollar-for-dollar. $1,000 of income taxed owed with a $500 credit? $500 of taxes owed.
The exact amount of a company’s credit is based on “qualified research expenses” which includes everything from wages paid to employees working on R&D, to contracted research from third parties, all the way to supplies used or consumed to realize the end product. These expenditures are modified based on statutory requirements and allocated based on how people spent their time and what all the supplies were used for, to arrive at the end credit amount.
How does a business qualify?
Under Section 41 of the Internal Revenue Code (the federal US tax code), the research and development activity must:
- Be intended to resolve technological uncertainty that exists at the outset of a project or initiative, be related to the capability or methodology for developing or improving the business component or the appropriate design of the business component;
- Rely on hard science, such as engineering, computer science, biological science, or physical science;
- Relate to the development of a new or improved business component, defined as new or improved products, processes, internal-use computer software, techniques, formulas, or inventions to be sold or used in the taxpayer’s trade or business; AND
- Substantially all constitute a process of experimentation involving testing and evaluation of alternatives to eliminate technological uncertainty.
One of the activities specifically listed in the section, “internal-use software,” has some additional criteria that have to be met for it to qualify as an R&D credit activity. Those are:
- It has to be innovative, which means a reduction in cost or an improvement in speed that’s substantial and economically significant;
- Developing the software involves significant economic risk, requiring substantial resources and subject to uncertainty of cost recovery in a reasonable time period, AND;
- The software is not commercially available (i.e. sold to consumers), and could not be sold, leased, or licensed without having to make significant modifications to it.
Unfortunately, there are also a number of research activities that the Code specifically excludes from qualified research, including research that takes place after a product is commercially released, the adaptation of existing business components for a specific customer, duplicating business components, surveys, or research into social sciences.
Should companies care about R&D credits if they are not profitable yet?
Yes! In 2015, the US Congress passed the “Protecting Americans from Tax Hikes” (PATH) Act, which created two new, big benefits for small businesses and startups:
First, eligible small businesses can use the tax credit to offset their “alternative minimum tax” or AMT. “Eligible” for purposes of this benefit means that the business is a corporation that’s not publicly traded (including LLCs), a partnership, or a sole proprietorship with annual gross receipts for the past three years totaling under $50 million, with adjustments made if the business hasn’t existed for three years. Both the owner and the business must meet this test.
Second, qualified startups can use the tax credit to offset the FICA employer portion of their payroll taxes. To qualify, the startup cannot have existed for more than five years, and it cannot have $5 million or more in annual gross receipts. Pass that test, make an election on its tax return, and a growing startup can save a lot of money.
