The government offers R&D tax credits that offset federal income taxes, and in certain circumstances, payroll taxes. A lot of states offer similar credits, so check with your specific state or your local accountant as well. The program is outlined in IRC Section 41 where it is officially called “Credit for Increasing Research Activity.” However, this is a more helpful read from the IRS with instructions and the Form 6765 you’ll need to attach with your taxes here.
The program gives credit for Basic Research Payments and Qualified Research Expenses. Basic Research Payments are original investigations for the advancement of scientific knowledge that do not have a specific commercial objective. Qualified Research Expenses on the other hand, must be for commercial objectives and can include product and process development or improvement, or software development. More than 99% of the credits claimed are Qualified Research Expenses. You can qualify for these credits whether your R&D activities succeed or not.
Activities may qualify for the deduction if they meet the following four-part test:
- Qualified purpose. The purpose of the activity is to improve the functionality, performance, reliability, or quality of a product, process, software, technique, invention or formula that is intended to be used in the taxpayer’s business or held for sale, lease or license (component).
- Technological uncertainty. The taxpayer encounters uncertainty regarding whether it can or how it should develop the component, or regarding the component’s appropriate design.
- Process of experimentation. To eliminate the uncertainty, the taxpayer evaluates alternatives through modeling, simulation, systematic trial and error, or other methods.
- Technological in nature. The success or failure of the evaluative process is determined by the principles of engineering, physics, chemistry, biology, computer science, or similar natural or “hard” science, as opposed to principles of, e.g., economics, social sciences generally.
Some activities are excluded because they weren’t judged to incentivize the type of R&D in the US that the credit was designed to stimulate.
Excluded activities include:
- Research conducted outside the U.S.
- Routine data collection or ordinary testing for quality control of existing components
- Market research
- Consumer preference testing
- Research “funded” by an unrelated third party, i.e., for which the taxpayer either doesn’t retain rights to the results of the activity or necessarily have to pay for the activity because an unrelated third party is contractually obligated to pay for it, even if the activity fails to produce the desired result.
Other activities that don’t qualify because, generally, they don’t meet the four-part test:
- Repairs and maintenance
- Preproduction planning for a finished component
- Tooling-up for production
- Trial production runs
- Accumulating data relating to production processes
- Activities relying on the social sciences, arts, or humanities
- Research after commercialization
- Adapting existing components to a particular customer’s need
- Duplicating an existing component via reverse engineering
Note that in October 2021, the IRS made additional filing requirements to claim this credit. You can find more information on the IRS website here.
Even if your business doesn’t have income, you can benefit from the R&D payroll tax credit! As a qualified small business (gross receipts less than $5m), you can deduct up to $250k of research credits against the employer portion of your social security tax liability. For more information on the payroll offset, you can look here on the IRS website which also has a link to Form 8974 that you’ll need to attach.