Does your business qualify for the Research & Development Tax Credit?

Many businesses are still unaware that R&D credit eligibility extends beyond product development to include activities such as the latest manufacturing methods, software development, and quality improvements. Even start-ups may be able to utilize the R&D credit against their payroll tax for up to 5 years.

So, if your company does any of the following, your business likely qualifies for the research and development credit:

• Develops or designs new products or processes
• Enhances existing products or processes
• Improves upon existing prototypes and software

Wage, supply, contractor, and computer costs coupled with credible employee testimony can form the basis of an R&D credit claim.

The IRS permits businesses to deduct all R&D expenses in a single year instead of amortizing as a capital expense. It's up to you which deduction method you use. It's generally a good idea to deduct R&D expenses the first year you start. In this case, if you spend $100,000 on R&D in a particular year, you can deduct it all at once. For small businesses with limited operating funds, this is a break.

A company's net income and operating income go down when R&D is expensed. As an expense, R&D expenditures won't create assets, so they're treated as expenses.

Examples of activities typically considered to fall within the research and development functional area include the following:

• Research to discover new knowledge
• Applying new research findings
• Formulating product and process designs
• Testing products and processes
• Modifying formulas, products, or processes
• Designing and testing prototypes
• Designing tools that involve new technology
• Designing and operating a pilot plant

Examples of activities that would be included as part of R&D costs include; Materials, equipment, and facilities acquired or constructed for R&D activities. 

Generally, all costs incurred during the pre-production prototype phase can be expensed as R&D costs. Once the product or project goes into normal operations, it is no longer considered R&D until future qualifying alterations and improvements are made. 

Note: As long as the items have no alternative future use, and therefore no separate economic value, they may be expensed as R&D costs as incurred.

Examples of activities that would be excluded from R&D costs:

• Quality control during commercial production, including routine testing of products.  
• Legal work on patent application is not considered as Research & Development costs

According to the forecast for 2022, the United States will be the leading country worldwide in terms of spending on research and development, with R&D expenditure exceeding 679 billion U.S. dollars. 

However, China is expected to invest about 551.1 billion U.S. dollars into research and development.  

Direct expenses like research and development and selling, general and administrative (SGA) expenses won't be included in the cost of goods sold (COGS). 

When calculating efficiency ratios such as gross profit margins, COGS is key. 

Comparisons with similar companies should always be made when evaluating a company's relative performance.

Because future economic benefit of R&D is uncertain, ASC 730 says you should expense them when they're incurred. Before January 1, 2022, under IRC section 174, taxpayers can choose whether R&D expenses should be deducted as current expenses, deferred expenses and amortized when a benefit is realized, or capitalized. 

R&D costs have to be capitalized and amortized over five years starting after December 31, 2021.

​​There's still a lot of business owners who don't know that R&D credits extend beyond product development and include things like software development, manufacturing methods, and quality improvements. Almost any company can take advantage of the R&D credit, even start-ups.

Your company can likely claim R&D credit if it does the following:

• Creates new products or processes
• Improves existing products or processes
• Enhances existing prototypes and software

The R&D tax credits are available as a dollar-for-dollar reduction of business taxes owed. 

If a company owes 50,000 in taxes and a current year R&D tax credit is realized of $30,000, the company will now owe $20,000.  

The federal tax credit can be realized up to 3 years prior. This would require amending prior returns and will result in refund checks for prior years if found successful.  

36 of the states allow for additional state credits, so the rules and limits vary per state. 

Current year R&D tax credits can only be taken as a credit to offset taxes owed.  If the full amount is not needed or used it can be carried back 1 year and forward up to 20.