What is the Research Tax Credit?

The United States government gives tax breaks to companies for doing research and development (R&D).

The IRS broadly defines R&D. It's doesn't just include Nobel Prize-level science experiments; it also covers common engineering tasks like developing new software and improving manufacturing processes.

Companies can cut their Federal corporate taxes

Companies that don't pay significant corporate income taxes can also carry Research Tax Credits forward for up to 20 years to use against future tax obligations.

Startups can cut their payroll taxes

Companies with less than $5 million in annual Gross Receipts (a measure similar to revenue) can use Research Tax Credits to reduce their FICA payroll taxes (the 6.2% Social Security and 1.45% Medicare taxes that employers pay on top of W-2 wages) by up to $250,000.

You can claim it retroactively for 3 years

Sometimes companies don't realize that work they've been doing qualifies for a big tax credit. A company can amend its tax returns to claim the Research Credit for up to three prior years.

Most states also have R&D credits

Most U.S. states also have R&D credits to offset state corporate taxes.

Map of U.S. states with state research tax credits

Federal credit + state credit

Federal credit only

In 1981 the U.S. introduced a temporary Research Tax Credit. It expired and was renewed by Congress several times.

December 2015: permanence and expanded usefulness

In December 2015, Congress made the Research Tax Credit permanent.

Congress also added a new provision allowing small businesses (under $5 million in Gross Receipts) to use Research Tax Credits to pay off their FICA payroll taxes up to $250,000. This made the credit more relevant to startups, because unprofitable companies don't pay corporate income tax and therefore get no short-term benefit from most tax credits.

December 2017: AMT repeal

In the December 2017 tax reform package, Congress repealed the corporate Alternative Minimum Tax primarily to protect the R&D credit.

To count as Qualified Research for the purposes of the tax credit, work must pass the IRS's Four-Part Test:

  • It's about eliminating uncertainty: when the company started the project they weren't sure it was possible to develop, or they weren't sure how to develop it
  • The work is technological in nature: it involves physical or biological sciences, engineering, or computer science
  • It has to be for developing a new or improved business component: the company is creating a new product or feature, or improving an existing product
  • There has to be a process of experimentation involving evaluating and testing one or more alternatives

For each project a company does that might qualify as research, RetroacDev lets you send the project's manager a survey asking for information related to the Four-Part test and the additional tests and exclusions below.

Internal-use software is more complicated

If a company builds custom software for their own internal use, that development counts as R&D if it passes the Four-Part Test above and also passes the Three-Part High Threshold of Innovation Test:

  • Successful software development would reduce cost, improve speed, or otherwise measurably improve the business
  • Development has significant uncertainty that creates economic risk
  • There's no commercially available alternative to developing the custom software

Whoever took the risk gets the credit

If you're performing R&D as a contractor for a client, the party that takes on the financial risk is the party that gets to claim the tax credit for the work. If a client pays you a fixed price to do R&D, and payment is contingent on a deliverable, then your company took on the risk and gets to claim the credit for that work. But if the client pays you on a time and materials basis without a fixed deliverable, then the client took on the risk, and you can't claim the credit for that work.

Some things don't count

These activities are excluded, and don't count towards your R&D expenses:

  • Market research, social science research, and research in the arts and humanities
  • Research done outside the United States
  • Implementing and configuring prepackaged, internal use software (like installing an off-the-shelf database)

For more detail on what's a Qualified Research Activity and what isn't, read the IRS guide to Qualified Research Activities.

Which expenses qualify

Once you've determined which activities count as Qualified Research, you can count expenses for:

  • Wages and salaries for employees who do Qualified Research. For many companies that do R&D, wages are the vast majority of their Qualified Research Expenses. If an employee spends 50% of her productive time doing Qualified Research, you can count 50% of her wages as an expense. If an employee spends 80% or more, you can round it up to 100% and count the entire salary. Salary expenses don't include fringe benefits (like employer-sponsored health insurance), payroll taxes, office rent, etc.
  • Supplies used directly in performance of the research, including computer rental costs. A software company can count the cost of development and testing servers it rents to perform Qualified Research, but it can't count servers it rents to run the production software app.
  • Expenses paid to contractors to perform Qualified Research. However, you have to multiply this number by 0.65 (this effectively means you assume that 35% of a contractor's bill went to non-research overhead).

If you're looking for more detail on what expenses you can claim, read the IRS guide to Qualified Research Expenses.

The credit uses a complicated formula

Once you've determined the total Qualified Research Expenses for a tax year, a complex formula on IRS Form 6765 determines the actual amount of the credit. The credit amount depends on the company's Gross Receipts and Qualified Research Expenses in prior years, and there are two different forumalas you can use (the Regular Credit and the Alternative Simplified Credit).

If it's a company's first year with Qualified Research Expenses, and those are at least 6% of Gross Receipts, the Regular Credit equals 10% of total Qualified Research Expenses.

Use our R&D Credit Calculator to estimate the size of the credit for a particular company.

The Research Tax Credit is so complicated that it has historically required a labor-intensive process to produce the documentation the IRS requires. Many CPA firms document Research Tax Credits by doing numerous in-person interviews with their clients to determine which projects qualify, and to ask for estimates of what the staffing breakdown was on each project.

RetroacDev simplifies that process by sending surveys to a company's project managers with questions tailored to the Four-Part Test, other tests, and common exclusions. For software companies, RetroacDev can also estimate employee time allocation to projects and tasks using data pulled from the company's Version Control Software.

RetroacDev also includes calculators to determine how much of each project is Qualified Research, what percentage of each employee's time was Qualified Research, and the total payroll that counts as Qualified Research Expenses. It publishes the calculations and the accountant's supporting documentation into organized PDF reports.

For more information on how RetroacDev can help, see the list of RetroacDev's Features.

Whether you're an accountant or a startup, RetroacDev can help your business