The Research and Experimentation tax credit (AKA Research & Development tax credit) was established under the Economic Recovery Tax Act in 1981 to encourage innovation, drive technological advancements, stimulate economic growth and improve global competitiveness in the United States. The Research and Development (R&D) tax credit was designed to encourage businesses to increase their investment in research by rewarding an increase in research spending compared to prior levels. The credit was initially established as a temporary tax incentive that originally expired in 1985 and was temporarily extended 16 times since inception until it was finally made a permanent tax regulation in December 2015. This stopped almost 35 years of temporary status of R&D tax credit and removed the renewal uncertainty.
When the credit was initiated, the rules and documentation were very stringent. In 2004, changes in the regulations relaxed the requirements, especially regarding the Discovery Test. The result was that more types and sizes of companies could claim the credit. The definition of R&D activity is quite broad and includes multiple industries and types of activities. However, there are certain activities that are excluded from the qualification, such as R&D done outside the United States.
The tax credit can be calculated using two different formulas. The Regular Research Credit (RRC) method provides a 20% credit rate of research spending over a certain base amount relative to a firm’s historical R&D spending, which may date back as far as the mid-1980s. To help overcome the complexity of the RRC, the Alternative Simplified Credit (ASC) method was introduced in 2007. The ASC is equal to 14% of total qualified research expenses that exceed 50% of the average qualified research expenses for the three preceding taxable years. This method is less complex and does not rely on antiquated data.
Why would a taxpayer want to receive an R&D tax credit? There are two reasons: 1) The credit can provide current year tax savings, and 2) The credit can generate a refund of taxes previously paid for open tax years (generally the prior three years). The credit provides a dollar for dollar reduction in a company’s tax liability. For example, if $800K of tax is owed and the R&D tax credit is $300K, then the taxpayer now owes $500K. The credit can be used as a carry-back for one year and a carry-forward for 20 years.
To demonstrate the financial impact of the R&D tax credit, almost $9 billion dollars of tax credits were claimed in tax year 2008. Corporations in the manufacturing sector accounted for about 43% of all companies claiming the credit and their benefits were almost 69% of the total dollar amount of the credits. Now, who would think that manufacturing could qualify for R&D tax credits? There is a misconception that R&D only occurs in laboratories of high-tech research facilities.
There have been several, recent changes in the Regulations which make the R&D tax credit a better and more accessible tax incentive. These changes help to enhance one of the most generous tax incentives available to U.S. taxpayers:
- The ASC method can now be elected on amended returns instead of just originally filed returns.
- The definition of prototypes has been more clearly defined.
- There are proposed Regulations to clarify the definition of Internal Use Software
In addition to the federal R&D tax credit, over 40 states have an R&D incentive program. These state credits typically follow the federal Regulations, but have different tax rates and utilization methods. Taxpayers can benefit from the federal and state tax benefits to continue investing in R&D activities and growing the U.S. economy.
Two Methods of Calculation
1) Regular Research Credit (RRC) 1.1) 1984 to 1989 Base Period
1.2.1) Start-up Companies (First Five Years with QREs)
1.2.2) Start-up Companies (After the 6th Taxable Year with QREs)
2) Alternative Simplified Credit (ASC)