Frequently Asked Questions
R&D Tax Credits can be claimed by businesses in a number of industries, including software development, manufacturing, life sciences, engineering, architecture, food & beverage, aerospace & defense, and agriculture. Any company can claim R&D Tax Credits as long as they are undertaking activities that meet the requirements of the 4-part test:
- Permitted Purpose: In simple terms, the purpose of the activity or project must be to create something new, or improve upon a product, process, software, invention, patent, or formula (referred to as a business component). The permitted purpose falls under a broad umbrella that includes improving functionality, performance, reliability, or quality of the business component.
- Elimination of Uncertainty: The activities and project in question must attempt to eliminate uncertainty related to the optimal design, development methodology, or component’s capability to achieve the permitted purpose.
- Process of Experimentation: Substantially all of the activities constitute elements of a process of experimentation. The activities must include a systematic evaluation of alternative solutions to eliminate the technical uncertainty through, for example, trial and error or a Product Development Lifecycle (“PDLC”).
- Technological in Nature: The activities and process of experimentation must rely on the fundamental principles of the hard sciences, including biology, computer science, engineering, physics, or chemistry.
STRIKE Tax uses a four-step process:
- Preliminary Analysis (includes discovery and credit estimation)
- Credit Calculation
a. Qualitative Analysis: an activities-based analysis to gather and review supporting project documentation; and
b. Quantitative Analysis: analysis of financial documents to aggregate qualified research expenses (“QREs”) using various methods, including interviews, surveys, questionnaires, and proprietary tools.
3. Documentation and Substantiation of the Credits (includes delivery of an audit-ready package containing details of our methods, calculation, and applicable forms)
4.Audit Support (if the credits are ever challenged by the IRS or state, we stand by your side).
Depending on whether a company has previously claimed the R&D Tax Credit, our methods could vary. Also, since every R&D engagement is unique and has different levels of complexity, some steps can be eliminated or adjusted as necessary.
The R&D Tax Credit is a comparative credit, which means that it will depend on the difference between current year qualified research expenses (QREs) and the base amount (calculated using prior year gross receipts and/or expenses). The more research expenses a company incurs year over year, the greater the tax credit will be. Typically, a company can expect a benefit of 7-10% of the federal QREs and another 2-12% in state credits (depending on the state).
To get a better idea of your company's potential R&D Tax Credit, use our Tax Calculator, or better yet, contact one of our R&D Tax Credit experts.
The R&D Tax Credit is a dollar-for-dollar reduction of federal income or payroll tax liabilities. R&D credits can be claimed on amended tax returns (going back three years), which can generate cash refunds due to overpayments in those years. Additionally, federal R&D Tax Credits roll forward for up to 20 years.
For qualified small businesses (i.e. startups), these credits can be used to offset payroll tax owed to the IRS. Therefore, startups no longer need to be profitable to take advantage of the R&D Tax Credit.
In addition, most states also have an R&D Tax Credit available to offset various income, franchise, or sales and use tax liabilities.
There are three main categories of expenses that can be claimed for the R&D Tax Credit:
- Wages – Wages paid to employees who conduct qualified R&D activities, and the wages of the employees who directly supervise and support the research.
- Supplies – Supplies and raw materials used or consumed in the R&D process, including prototyping and testing of a new or improved product, process, formulation, or patentable business component. This also includes expenses related to rental of cloud computing assets used in software development.
- Contract Research – Payments made to third-party contractors, 1099 employees, or universities for technical activities conducted on the company’s behalf. These can include technical analysis or testing, design services, and other development activities for a qualified business component.
The more research expenses a company incurs year over year, the greater the tax credit will be. For all research costs in a given year, a company can expect anywhere from 7-10% in federal credits in addition to state credits (percentage varies), where applicable.
The following activities are excluded from R&D Tax Credits:
- Research related to arts, social sciences, or humanities are not considered qualified research activities.
- Research conducted outside the U.S. or its territories is not eligible.
- Projects solely aimed at adapting or duplicating existing business components and reverse engineering existing products, processes or software.
- Surveys, studies, activity relating to management function/technique, market research, routine data collection, or routine testing/quality control
- Some software developed for internal use, but there are exceptions for this exclusion
- Research funded by any grant, contract, or another person, conglomerate, or government entity
The definition of qualifying research activities in each state is based on the federal tax credit regulations; however, the calculation methodology varies significantly from state to state. For example:
- Some states provide a refund or exchange of unused R&D Tax Credits, so that even if a taxpayer has no tax liability it can still derive a cash benefit.
- The R&D Tax Credits in some states have not been permanently adopted, and may expire in the future.
- Most states require that the research activities must be conducted within their borders to qualify.
- Some states do not offer the alternative simplified credit calculation.
- In some states, basic research payments made to universities and certain non-profit organizations can be included in the calculations.
There are 38 states that currently allow taxpayers to claim the R&D Tax Credit. Below is the list of states that DO NOT offer the R&D Tax Credit:
- District of Columbia
- South Dakota
- West Virginia
Refer to our state pages for state-specific information.
Previously, CPAs and taxpayers never had to determine whether or not the businesses expenses were Section 162 or Section 174 because all expenses were fully deductible on a tax return. However, many taxpayers businesses do fall under the Section 174 requirements and will need to amortize their research expenses on their tax returns accordingly.
Taxpayers that have already claimed the R&D tax credit and are electing to forgo the 2022 R&D tax credit to instead fully deduct research expenses as Section 162 expenses (general business expense), should speak to a CPA and closely review your options. We anticipate the IRS will have a way to identify qualified Section 174 industries and taxpayers that are not amortizing their research expenditures. If you have previously claimed the R&D tax credit, suddenly claiming expenses under Section 162 (general business expense) will raise a red flag with the IRS. Research and development companies don’t generally stop doing R&D. R&D expenses should be claimed under Section 174.
This is a common misconception among small and medium businesses. Taking the R&D Tax Credit on a timely-filed return, including extension, does not increase your company’s audit risk. According to the IRS, only 0.9% of corporate tax returns and 0.2% of small businesses (S corps and partnerships) are randomly selected for audit.
According to IRS guidelines, a return can be selected for audit based on a myriad of reasons. There is no directive that specifically targets companies who claimed R&D Tax Credits.
In addition, prior-year federal R&D Tax Credits can be carried back one year and forward up to 20 years. Once the company reaches profitability, those credits will be available for use. Each state is different when it comes to carryforward and carryback rules, but most follow the general federal guidelines.
To be considered a QSB, a company must meet these requirements:
- Less than $5 million in current-year gross receipts;
- Five or fewer years of gross receipts; and,
- Have qualified research expenses.
Yes, the R&D Tax Credit can be claimed if the federal and state statute of limitations have not lapsed. For the federal credit, an amended return can be filed up to three years from the original filing date. Most states follow the same three-year statute of limitations; however, there could be state-specific regulations for the state in which your business operates.
In order to understand the impact of this legislation, it’s crucial to understand the relationship between Section 174 Expenses and Section 41 Expenses. Section 174 Expenses are known as Research and Experimentation, or R&E Expenses. The expenses that fall under Sec. 174 can be divided into two categories, based on how essential each is to the activity being performed. Section 174 expenses encompass both direct and indirect research expenses (onshore and offshore) but are not necessarily eligible for the tax credit.
Section 41 Expenses are known as Research and Development, or R&D Expenses. These are known as “Direct Research Expenses,” and are what usually come to mind when you imagine research and development. Section 41 expenses is a subset of Section 174 expenses, focusing only on direct research expenses that qualify for the R&D Tax Credit.
While the R&D tax credit calculations, including the definition of QREs, are not changing, Section 41 expenses will no longer be deductible on businesses tax returns in the year they are incurred. By default, Section 41 expenses are classified as a Section 174 expense. The new Section 174 rules require companies claiming R&D credits to capitalize and amortize their expenses on their tax return—potentially increasing their tax bill and reducing their anticipated cash flow. As a result, the calculation of Section 41 should be the starting point in determining the potentially qualifying Section 174 expenditures and should be done concurrently.
Companies should work with their CPA to determine what the best estimated quarterly tax payment amount will be. If there’s no urgency to file this spring, a company should consider extending if possible—in the hopes that these changes are repealed in full or part. As CPAs wait for more guidance from the Treasury, taxpayers can still amend their 2020 and 2021 tax returns to generate unclaimed credits and potential cash refunds from prior years. And companies should look to see when they filed their 2019 tax return as the statute to amend and claim prior year refunds is three years from the filing date (2019 tax return filed in 2020).
The R&D tax credits do expire if they’re unclaimed before statutes expire. It may be beneficial to roll the federal and state credits forward to be used to offset future income tax liabilities that may arise from the changes to Section 174 amortization.
Contrary to general belief, businesses do not have to have employees in white coats working in a laboratory to claim R&D Tax Credits. Many activities across a wide range of industries are considered qualified research expenses (QREs). Investments your company makes in developing innovative solutions, creating novel products and formulations, or even making process improvements are claimable expenses as long as the project satisfies the 4-part test.
Tax Credit 4-part test requirements are as follows:
Permitted Purpose: In simple terms, the purpose of the activity or project must be to create a new or improved product, process, software, invention, patent, or formula (referred to as a business component). The permitted purpose falls under a broad umbrella that includes improving functionality, performance, reliability, or quality of the business component.
Elimination of Uncertainty: The activities and project in question must attempt to eliminate uncertainty related to the optimal design, development methodology, or component’s capability to achieve the permitted purpose.
Process of Experimentation: Substantially all of the activities constitute elements of a process of experimentation. The activities must include a systematic evaluation of alternative solutions to eliminate the technical uncertainty through, for example, trial and error or a Product Development Lifecycle (“PDLC”).
Technological in Nature: The activities and process of experimentation must rely on the fundamental principles of hard science, including biological sciences, computer science, engineering, physics, or chemistry.
Click here to read more about industry-specific qualified research expenses (QREs).
The Credit for Increasing Research Activities (the “R&D Tax Credit”) is a government-sponsored tax incentive that rewards companies who conduct research and development in the United States and its territories. The R&D Tax Credit is a federal and state (most states) tax credit that can result in dollar-for-dollar reduction of taxes owed at year end. For startups that meet qualifying criteria, the R&D Tax Credit can be used to offset payroll taxes. Originally enacted in 1981 under the Economic Recovery Tax Act, the credit expired eight times and was extended 15 times until it was made permanent in 2015 under the Protecting Americans from Tax Hikes Act (PATH Act). Primarily a labor-based incentive, the R&D Tax Credit aims to promote U.S. innovation by creating positive cash flows and reducing taxes.
Typically, “Research and Development” implies laboratories, test tubes, and white lab coats. However, the IRS’s definition of R&D is rather broad, and can be applied to many industries including manufacturing, engineering, architecture, food & beverage, and software development. Any business of any size can claim the R&D Tax Credit if their R&D activities satisfy the 4-part test and the associated expenditures qualify under IRC Section 41.
The Tax Cuts and Jobs Act (TCJA), passed in December of 2017, amended Section 174 to require capitalization and amortization of all research and experimental (R&E) costs incurred in the tax years beginning after December 31, 2021 (2022 tax year for calendar filers). Dating back to 1954, taxpayers could deduct their expenses in the same year they were incurred on their tax returns.
Despite the bipartisan support, and numerous bills and acts introduced to repeal or defer the amortization requirements to provide taxpayer relief in the short term, it is unclear whether a legislative fix will be signed into law anytime soon. The TCJA’s stated purpose was to be an economic incentive to bring jobs back to the U.S. Companies that have never had to separate their section 174 expenses from regular expenses will face a new challenge with the recent change.
Section 174 will affect any industry and company that performs research but the software industry will likely take the biggest hit. The TCJA specifically called out software development expenses incurred in the tax years starting after December 31, 2021, as no longer tax deductible under Rev. Proc. 2000-50. Instead, these costs must be classified as Section 174 expenses and amortized as such.
Therefore, any software development company that previously deducted its onshore and offshore software development related expenses will now have to capitalize and amortize these costs over five years, for domestic expenses, and fifteen years, for international expenses. Software businesses that retire, dispose, or abandon a software development related project will no longer be able to fully amortize the remaining capitalized costs.
The IRS clarified in Notice 2021-49 that business owners with a majority stake (51%) in a business cannot claim their wages when they apply for the tax credit. Attribution rules, which outline the legal principal owners of a business, must also be applied to determine if family members’ wages can be qualified wages too.
If a business owner qualifies for the ERTC in 2020 or 2021 but hasn't applied yet, the only way to apply for the ERTC right now is to file an amended Form 941-X. With up to $26,000 per employee available, filing an amended return makes financial sense.
The best way to check on your tax credit status is to call the IRS at (877) 777-4778. Staffing problems have made reaching a live person difficult but not impossible. We recommend calling the IRS hotline first thing in the morning. Strike sees an average refund time of about 3-6 months from the date the 941-X is filed.
Even though the ERTC officially ended on September 30, 2021 with the signing of the Infrastructure Bill, the Bill also allowed business owners the ability to retroactively claim the credit up to five years from when they filed their original return (extended from the previous 3-year statute of limitations).
Financial service companies may be unaware that their clients qualify for the ERTC, or they may not want to wade into what seems like a complicated new tax credit. Repeated changes to the ERTC program have added additional barriers to claim the credit. Additionally, instead of trying to adapt to the changing ERTC rules, many CPAs and payroll companies have chosen to outsource ERTC claims for their clients. As a specialty tax company, we love claiming credits like the ERTC for our clients.
The ERTC is a direct refundable payroll credit and not a loan. While the ERTC funds will not run out, taxpayers have limited time to claim the tax credit.
Because Strike operates on a success-based fee structure, our clients incur no out-of-pocket expenses related to R&D Tax Credit filing. We invoice when our clients reduce tax liabilities on a current year tax return or when they receive refunds from amended prior year returns.