How to Claim the R&D Tax Credit
What is the Research and Development Tax Credit?
The Research and Development (R&D) tax credit is a valuable incentive for businesses to invest in innovation and technology that was first created in 1981.
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It was designed to encourage companies to conduct research and development activities that lead to the creation of new products or processes. Historically, this most often applied to manufacturing companies or research labs, but is also available to tech startups that spend a lot of money in wages or otherwise on new software development.
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Eligible expenses for the R&D credit include wages, supplies, and even costs associated with contractors that do R&D for your company. Determining what qualifies as a research expense is a super important part of this process and involves a process of looking at your expenses to determine what and how much qualifies. This process can be extensive, although many software companies have created methods to streamline this process by plugging into existing workflows.
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The general rule is that the qualified activities must be undertaken for the purpose of discovering information that is technological in nature and the application of which is intended to be useful in developing a new or improved business component. This generally involves a four-part test that analyzes the nature of the research activities, the technological uncertainty involved, the process of experimentation, and the aim to develop a new or improved business component.
Filing for the R&D Tax Credit - Form 6765
Once you have confirmed your eligibility for the R&D credit, the next step is to file form 6765, which is the IRS form used to claim the credit.
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Form 6765 needs to be attached to your business tax return, whether it be a corporate return (Form 1120) for C corporations, a pass-through return (Form 1065 or Form 1120-S) for S corporations and partnerships, or an individual return (Form 1040) for sole proprietors.
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When filling out form 6765, you will need to provide detailed information about your research and development activities, including the amount of qualified research expenses, the base amount for the credit calculation, and any elected alternative simplified credit. You may also need to include additional documentation to support your claim, such as project summaries, time tracking records, and payroll data.
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Compared to other IRS forms, form 6765 may seem much simpler, but there are a few things you should know about the different sections before diving. Let's walk through these 4 sections.
Section A - The Regular Credit
Section A of Form 6765 is used to calculate the regular research credit for increasing research activities. This part requires the taxpayer to provide detailed information about the qualified research expenses (QREs) incurred during the tax year, as well as the base amount and the fixed-base percentage. Qualified research expenses include wages, supplies, and contract research costs directly related to qualified research activities. The base amount and fixed-base percentage are used to calculate the credit based on the taxpayer's historical level of R&D spending.
Section B - The Alternative Simplified Credit
Because you need historical data to complete Section A of the form (the regular method) there is an alternative simplified method in Section B which is typically used by smaller, new, businesses to claim the R&D tax credit. An eligible company is generally defined as a taxpayer with average annual gross receipts of less than $50 million for the preceding three tax years, so if you started the company within the last 3 years, the years in which the company did not exist yet would be 0. You would choose between Section A or Section B, and then move on to Section C to figure out the final amount and report it properly.
Section C - Finalizing your Credit
After choosing which method you use (either Section A or Section B) Section C instructs you on where to report the calculated credit amount on your tax return. This varies depending on your business structure:
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C Corporations: Report the credit on Form 1120, Schedule K.
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S Corporations and Partnerships: Report the credit on Form 3800, General Business Credit.
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Individuals and Estates/Trusts: Report the credit on Form 1040, Schedule 3.
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For a newer tech startup specifically, this determination is not trivial and you should be sure about how you are designating your company here.
Section D - The Payroll Tax Option for Qualified Small Businesses
This election allows eligible small businesses to claim a portion of their R&D credit as a payroll tax credit, rather than reducing their income tax liability. Typically, the R&D credit is a dollar for dollar reduction in income tax liability, but there are many companies that are investing resources in research and development, but are new and/or not yet profitable, so this doesn’t help very much.
What this addition to the R&D credit does is enable smaller companies to still claim the credit, but reduce their payroll taxes instead, which can make a big difference, especially for a small software company that may need to pay competitive salaries to top engineers at an early stage. This can be claimed up to $500,000 per year.
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If you are trying to figure out whether this is right for you, it’s important to consider how much saving on payroll taxes will benefit you now, compared to saving R&D credits toward potential income tax liability in the future.
To qualify for this section, a company must have no more than 5 years of revenue and less than $5 million in the current year of revenue.
Review and Submit Form 6765
Once all the required information has been accurately completed on Form 6765, it's important to review the form thoroughly to ensure that all the information is accurate and complete.
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Any discrepancies or inaccuracies could lead to delays or potential issues with the IRS. After reviewing the form, the taxpayer can submit Form 6765 along with their tax return, typically Form 1120 for corporations or Form 1065 for partnerships. It's important to keep a copy of the completed form and any supporting documentation for record-keeping purposes.
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It is important to fill out form 6765 accurately and completely to avoid any potential consequences. The IRS may require documentation to support the claimed credits, and failure to provide this documentation can result in the disallowance of the credit and potential penalties.
Frequently Asked Questions
How far back can you claim R&D tax credits?
Businesses can generally claim R&D tax credits for up to three years prior to the year of filing the claim.
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Is R&D tax credit taxable income?
The R&D tax credit is treated as a general business credit and, as such, does not count as taxable income.
Do R&D tax credits expire?
R&D tax credits do not expire and can be carried forward for up to 20 years to offset future tax liability.
Is claiming the credit different for startups?
Startups may be eligible to claim the R&D tax credit even if they have not yet generated income or paid taxes. The credit can be used to offset payroll taxes for qualified small businesses.
Who should I hire to claim my R&D credit for me?
It is recommended to work with a tax professional or accounting firm with experience in claiming the R&D tax credit. They can help navigate the complex rules and calculations involved in claiming the credit, and ensure that all requirements are met for a successful claim. To find the right tax professional to help claim your R&D credit, contact Open Advisor. We compare rates of companies across the industry to find the company that works best for you and gets you the best rate.