How Your Small Business Can Take Advantage of Federal and State R&D Tax Credits

Every year millions of dollars go unclaimed by businesses that think they can’t take advantage of R&D tax benefits.

So if you think research and development (R&D) tax credits are only for large corporations or big scientific breakthroughs, you could be missing out on some huge tax breaks for your own business.

Qualifying for an R&D tax credit may be easier than you think. Even making small improvements to a product or a process could qualify you for the credit.

What’s Going On Here…

The R&D Tax Credit was enacted in 1981 as an incentive to promote American innovation. These tax credits were originally considered a temporary addition to the tax code, although Congress routinely extended them for one or two-year periods.

In 2015, Congress passed the Protecting Americans from Tax Hikes Act of 2015 (“PATH Act”) which made the R&D tax credit a permanent part of the federal tax code.

The definition of R&D was also clarified. Any company that designs, develops or improves products, processes, techniques, formulas or software may be eligible.

R&D relates to development before commercial production for related U.S. activities — so the credit is especially popular with startup companies.

Why This is So Important

A tax credit differs from a deduction in that it is a dollar-for-dollar offset against taxes owed or paid. So a tax credit of $1,000 saves you $1,000 in total tax, while a $1,000 deduction might only save you $390 or less (depending on your highest tax bracket).

Calculating the R&D credit can be complex, which is why many small business owners rely on specialized firms to find and apply for their credits.

Most companies that qualify receive an R&D credit equal to 5%-14% of total qualifying expenditures.

Wages paid to employees who participate in R&D activities account for a majority of the expenditures.

The activities can include product development, product modification, or process improvements, as well as other research and development activities.

And since wages tend to be one of the largest expenses for small businesses, the R&D tax credit can be quite substantial.

BONUS TIP: If you or your business has been involved in qualifying R&D activities for the last several years, you may be able to retroactively claim R&D tax credits from the past 3 years. (See how you can get a 3-year review of your taxes here).

Double the credit: How to claim your R&D credits on Federal and State returns

The good news is that you may be able to claim an R&D tax credit at the state level, too, in addition to the federal R&D tax credit.

Many states provide R&D tax credits or similar incentives, although the rules are different from state to state.

Here are 15 examples of State R&D tax credits we researched to give you an idea of what you might get:

  • Arizona (AZ) offers a non-refundable R&D tax credit equal to 24% of the first $2.5 million in qualifying expenses plus 15% of the qualifying expenses in excess of $2.5 million.
  • Arkansas (AR) offers a variety of R&D tax credits, including a credit for R&D with universities, in-house research credit, and credit for research programs carried out under the Arkansas Science and Technology Authority.
  • California (CA) offers an R&D credit equal to the sum of the following: 15% of qualified expenses that exceed a base amount and 24% of basic research payments.
  • Delaware (DE) gives an R&D tax credit based on 50% of the taxpayer’s federal R&D tax credit. They also offer a small business-specific R&D tax credit.
  • Florida (FL) has a list of qualified target-industry businesses that can apply for the Florida R&D tax credit for expenses incurred in each calendar year.
  • Georgia (GA) gives a tax credit earned as a portion of the increase in R&D spending. The credit can be used to offset up to 50% of net Georgia income tax liability after all other credits have been applied.
  • Kentucky (KY) offers a non-refundable income tax credit equal to 5% of the qualified cost for “construction of research facilities” for qualifying research.
  • Louisiana (LA) businesses may receive up to a 40% tax credit on qualified research expenditures incurred in Louisiana.
  • Maryland (MD) businesses may qualify for two separate state income tax credits: the Basic R&D tax credit and the Growth R&D tax credit.
  • Mississippi (MS) offers an R&D Skills Credit. A tax credit of $1,000 is available for the first five years for each net full-time employee in any job requiring R&D skills.
  • New York (NY) has separate R&D tax incentives for companies who increase their R&D spending from year to year. Companies can also buy tangible personal property used or consumed directly in R&D without paying state sales tax. New York also has a new Life Sciences R&D credit for up to 20% of qualified R&D.
  • Virginia (VA) gives an R&D tax credit of 15% of the first $300,000 on qualified R&D expenses incurred in Virginia or 20% of the first $300,000 if research is conducted with a private or public university. There is also a major R&D tax credit.
  • South Carolina (SC) offers a State R&D tax credit equal to 5% of the taxpayer’s qualified research expenses incurred in South Carolina.
  • Texas (TX) business owners can claim the R&D tax credit to offset a portion of their franchise tax or to use towards a sales and use tax exemption on the purchase or lease of depreciable tangible personal property used in qualified research in Texas.
  • Utah (UT) offers a non-refundable tax credit that only applies to gross receipts attributable to sources within Utah. The Utah R&D tax credit is the sum of 5% of a taxpayer’s qualified spending that exceeds the base amount; 5% of payments made to qualified organizations for basic research in Utah that exceed the base amount; and 7.5% of qualified research expenses for the taxable year.

This is just a sampling. Many other states offer similar tax incentives that allow you to “double-up” on your Federal R&D tax credit.

Several states do not offer (or have eliminated) an R&D tax credit or incentives, but you can still qualify for the Federal R&D credit.

Why Hasn’t My CPA told Me About This?

Even though the R&D tax credit has been around since 1981, the tax code around it has gradually evolved over the years. Most CPAs have never studied it because the credit has historically only been used by large corporations.

With the 2015 PATH Act, many more companies gained eligibility. So because of this gradual evolution over the years, many CPAs are not aware or up-to-date on the most recent policies and regulations regarding the R&D credit.

Third-party services that specialize in the R&D tax credit can help fill the gap. They do all the research for you and work with your existing CPA. They will even send your CPA all the completed forms they need so you can get the tax credits you deserve. (See the Action Steps section at the bottom of this article for more information.)

The 3 Main Reasons Why Most Small Businesses Miss Out on the R&D Credit

1: Small business owners (or their CPA) don’t realize they qualify or assume they don’t

Many businesses perform activities that qualify for the R&D tax credit without realizing it.

The 2015 PATH Act opened the door to many activities that go beyond the lab-coat-style R&D used by giant corporations.

The R&D tax credit can be used by businesses of any size in industries ranging from software development to micro-breweries. If you create or design products or do anything technology-based, improve it, and sell it to customers, you probably qualify.

Industries that commonly qualify include:

  • Agriculture
  • Brewing, Distilling, and Winemaking
  • Architecture
  • Construction
  • Engineering
  • Fintech
  • Food and beverage
  • Green Initiatives
  • Healthcare IT
  • Job Shops
  • Life sciences
  • Manufacturing
  • MEP contractors (Mechanical, Electrical, Plumbing)
  • Software
  • Tool and die
  • Waste Management
  • And many more

Qualifying Activities for R&D tax credit purposes is fairly broad. If your company engages in any of the activities below, it’s definitely worth looking into the R&D tax credit:

  • Engineering a new or improved product, process, formula, or software
  • Developing a new product, process, formula or software
  • Delivering a new product, process, formula, or software to the market
  • Determining whether a product, process, formula, or software is feasible to create
  • Checking marketability, market size, and product uniqueness
  • Developing engineering architecture
  • Creating experimental models & prototypes
  • Testing an experimental product, process, formula, or software
  • Beta testing
  • Increasing the usefulness of a product or the quality of its output
  • Improving processes or the manufacturability of a product
  • Technical design reviews
  • Attending technical meetings
  • Tracking the techniques, time, and costs related to your research activities
  • Documenting the results of research
  • Maintenance and upkeep on research equipment
  • Collecting, organizing, and presenting research data
  • Building prototypes
  • Building and fabricating experimental models
  • Experimenting with new technologies
  • Designing greener and more efficient products
  • Developing or creating more environmentally friendly designs
  • CAD or 3D Modeling
  • 3D Printing or CNC prototyping
  • Supervising technical personnel engaged in any of the above activities
  • Managing R&D teams or development cycles

Qualifying Expenditures include expenses you can use to determine your R&D credit, such as:

  • Wages — for those directly working on the R&D activities, for those supervising, or for anyone who is supporting the development process
  • Supplies — you can include any items used or consumed during the development process
  • Contract Research — you can include fees paid to outside vendors or contract workers brought in to assist in the development process or perform any of the qualifying activities

2: They think the R&D Credit can only be applied to income tax

While applying the R&D credit to income tax is the most common way to use it, the R&D tax credit can also be taken as a payroll tax offset, up to $250K per year, by qualified small businesses.

This can be a huge boon, especially for small businesses in a start-up phase.

You are considered a qualified small business if you have less than $5 million in revenue and are within five years of your first gross receipt.

If you don’t have any payroll, the credit can be carried forward to the next quarterly return. The credit doesn’t expire and continues to be available until it can be fully used against payroll tax.

Unused credits can even be saved up and applied upon exit.

3. They think it’s too much work and the potential savings aren’t worth it.

We know of companies saving tens of thousands — and even hundreds of thousands of dollars with the R&D tax credit.

Remember, this is a dollar-for-dollar credit, not a deduction. It’s applied directly against taxes owed.

Even using a third-party service to find and apply your R&D tax credit can be cost-effective.

Most of these firms use technology-driven solutions to simplify the process of finding and claiming the R&D tax credit you qualify for. And best of all, they don’t charge you anything unless they find you money.

So regardless of what your company does, it’s worth looking into the R&D tax credit.

The PATH Act guarantees the R&D credit is here to stay — and can likely become an ongoing part of a small businesses’ annual tax strategies.

Action Steps:

  1. Talk to your CPA or tax professional to see if your business may qualify for an R&D credit.
  2. Even if your CPA says you don’t qualify, consider applying with a third-party service that specializes in R&D tax credits. In most cases, it costs you nothing if they determine you don’t qualify. Otherwise, they take a percentage of whatever money they recover for you. Please email [email protected] for our most recent recommendations on R&D tax credit firms.
  3. If you find out you qualify, be sure to get a 3-year review of your past taxes by a third party. That way you can apply the R&D credit going back up to 3 years and possibly get a substantial retroactive refund (in some cases).
  4. Even if you don’t qualify now, talk to a tax professional to see if you can change some facts about your business so that you can incorporate the R&D credit into your yearly tax-reduction strategy.

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The Builders at Wealth Factory

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