How to Calculate R&D Tax Credits
There are two general methods for computing the Research and Development Tax Credit, the Regular Research Credit (RRC) Method and the Alternative Simplified Credit (ASC) method.
Both methodologies are included on IRS Form 6765, Credit for Increasing Research Activities.
The taxpayer is permitted to elect either of the two methods when preparing a timely filed return, but since each method has distinct advantages and disadvantages, it is important to understand the two computation methodologies particularly because the elected method cannot be changed on an amended return.
What is the Regular Research Credit Calculation (RRC) Method for The R&D Tax Credit?
The RRC method allows for a credit of 20% of a company’s current year qualified research expenses (QREs) over a base amount. To calculate the credit, businesses need the average, annual gross R&D receipts over the prior four tax years. Companies that ran operations in the 1980s or prior need to provide additional information.
What is the Alternative Simplified Credit (ASC) Method?
Unlike the RRC method, the ASC method doesn’t require gross receipts as a component of the R&D tax credit calculation. It looks at QREs over the previous three-year period. This allows companies that lack the historical records necessary to document their base amount to determine their eligibility and file for the R&D tax credit.
How Do You Calculate The R&D Tax Credit Using the Alternative Simplified Credit Method?
As of 2009, the ASC is defined as 14% of QREs incurred in the current tax year, above 50% of the average QREs in the previous three years. If the taxpayer had no QREs during any of those three prior years, the credit is calculated as 6% of the QREs in the current tax year. Using these guidelines, the four-step simplified calculation process is as follows:
- Identify and calculate the average QREs for the prior three years
- Multiply average QREs for that three-year period by 50%
- Subtract half of the three-year average from current year QREs
- Multiply the result by 14%
The Research and Development Tax Credit (R&D) is a tax credit for businesses of all sizes that conduct R&D in the United States. The R&D tax credit can be extended to a wide range of businesses and industries that exceeds far beyond scientists and research labs.
It was created to provide a tax incentive for U.S. companies to increase spending on research and development in the U.S. Each year more and more companies take advantage of the R&D tax credit. Additionally, in 2015, the Protecting Americans from Tax Hikes (PATH) Act, made the R&D Tax Credits permanent, while also extending the benefit to startups.
The activities that qualify for the R&D Tax Credit are the same ones driving growth in your business.
- Creating improved products, processes, formulas, software, and techniques
- Automating or improving internal manufacturing processes
- Designing tools, jigs, fixtures, and molds
- Integrating new equipment
- Development of data center, big data, and data mining tools
- Integration of APIs and other technologies
- Development of financial or pricing models
- Hiring outside consultants to perform any of the listed activities
- Manufacturing new or improved products
- Developing prototypes, first articles, models
- Evaluation of alternative materials
- Development of firmware
- Network hardware and software development and optimization
- Developing simulators
- Development of risk management systems
Ensuring that you understand the rules for qualification is an essential first step in claiming the R&D Tax Credit. This is normally done during a feasibility analysis, also referred to as Phase 1. R&D activities are explored and identified at a high level along with related qualified research expenses (QREs). This information is then used to estimate your federal and state R&D Tax Credits. Education is key and provides the ability to identify qualified activities and QREs so a more accurate benefit estimate can be determined.
The expenses that qualify for research activities within your company typically include employee compensation, materials, and contracted services. Various forms of documentation are sufficient to support your qualified expenses and may include payroll records, financial records showing supply or contract research expenses, and vendor invoices.
On average, companies are typically able to claim 7-10% of their qualified expenses as a federal R&D Tax Credit. For example, a single software developer, engineer, or lab technician who receives a W2 of $100,000 a year may generate a tax savings of up to $10,000.
Here’s an example of a case study for a brewery that successfully claimed the R&D Tax Credit:
Established in 1995, this $70M brewing company produces over 260,000 barrels of beer annually and currently sells in over 40 U.S. states plus Washington D.C. A restaurant has been added along with an Inn, which was built to allow customers to explore the brewpub and production brewery.
A brewery is not what a person thinks of when they hear “R&D”. The challenge for this brewery was to be able to identify the research activities from everyday brewing production. The company thought they had R&D taking place, but wasn’t sure. For this brewery, R&D involved creating new brews. Typically, gluten-free beers are generic white lagers that lack the exotic flavor and aroma of popular microbrewery beers. The brewery performed research and development in an effort to satisfy the gluten-free beer connoisseurs, which resulted in experimentation and testing of various new formulations and brewing processes.
For this specialty brewing company to qualify for an R&D Tax Credit, they needed a team that would invest the time and resources required to understand the complexity of the brewing process to maximize their R&D Tax Credit potential. With the experience of having performed more than 2,200 R&D studies resulting in federal & state tax savings for their clients totaling over $1 billion, the Source Advisors tax credit team was a clear choice.
The Results Speak for Themselves
Source Advisors began conducting R&D Tax Credit studies for the company when the company’s revenues were $10 million. For nearly a decade, the company has benefited from R&D credits averaging $65,000 annually. This annual $65,000 offset in taxes has allowed the company to continue investing in the development of additional brews and reaching $70 million in sales. The company’s ability to grow at this pace is, in large part, driven by sales of its new products.
