Founders of product and technology-based small businesses often find themselves straddling multiple internal functions. Most entrepreneurs are heavily involved in high-level corporate strategies, including designing, improving, and manufacturing merchandise. However, the list of action items doesn't end there. These business owners also often oversee other mission-critical tasks, such as marketing and selling their product lines.
Of course, many founder-led organizations also manage other peripheral responsibilities like accounting, HR, administration, purchasing, and maintenance. After performing multiple full-time jobs, there's still one looming task waiting for most small- to mid-sized business owners: taxes.
Acena Consulting Breaks Down R&D Tax Credit Basics
Sound familiar? If you're coordinating several internal functions in your organization, it's crucial to simplify whatever you can to streamline your efforts and free up bandwidth to focus on your core competencies. You can start with the research tax credit.
At Acena Consulting, we recognize that the innovation tax credit is complex. So we break down some of the basics of this lucrative, government-backed incentive to help small business owners understand the core concepts and potentially lower their federal tax burden.
The Basics: Qualified Research Expenses and the Four-Part Test
What Are R&D Tax Credits?
R&D tax credits are a government incentive designed to encourage businesses to invest in research and development activities. These tax credits provide businesses with a dollar-for-dollar reduction in their federal income tax liability or a cash refund, depending on when the credit is applied for (an originally filed tax return for a reduction in federal tax liability or an amended tax return for a cash refund).
The R&D tax credit can be monetized using one of two methodologies:
- The regular credit: This credit is calculated based on the amount of qualified research expenses (QREs) a business incurs during the tax year in excess of a base amount of qualified expenses.
- The alternative simplified credit (ASC): This credit is a simplified method for calculating the R&D tax credit. The ASC is equal to 14% of the excess of the business's qualified research expenses for the tax year over 50% of its average qualified research expenses for the three preceding tax years.
Who Qualifies for R&D Tax Credits?
Many small business owners mistakenly believe that R&D tax credits are only available to large corporations. However, businesses of all sizes can take advantage of these credits, provided they meet certain criteria.
Small businesses must meet the following requirements to qualify:
- The business must be engaged in "qualified research activities." Qualified activities must be intended to develop new or improved business components, such as products, processes, or software.
- The activities must involve a process of experimentation. This means the business must conduct a systematic process to evaluate one or more alternatives to achieve a desired result.
- The activities must be technological in nature. This means the process of experimentation must rely on the principles of engineering, physics, computer science, or biological sciences.
What Are Qualified Research Expenditures?
Qualified Research Expenditures (QREs) are expenses directly incurred for research activities that meet the Treasury regulations for the R&D tax credit, namely, employee wages, supplies, contract research, and computer rental expenses. To better understand the types of activities that qualify for the R&D tax credit, an understanding of the four-part test, found in the R&D tax credit regulations, provides detailed information.
Critical Components of the Four-Part Test
Qualifying research and development activities must pass a battery of tests commonly referred to as the four-part test. At Acena, our team of skilled R&D tax credit professionals thoroughly examines every potentially eligible operation. However, understanding the basic requirements can help you pinpoint possible activities that require more in-depth analysis. The four-part test includes:
- Business Component Test
The business component test requires that activities are undertaken to develop a "business component" or product, process, software, technique, formula, or invention either for sale or used by a client.
- Elimination of Technical Uncertainty
At the beginning of the research and development process, uncertainty must exist relative to either the capability, method or appropriate design of the business component in order to meet the second test. To eliminate uncertainty, some common questions to ask include:
- Can we develop this? (capability)
- How can we develop this? (method)
- What is the appropriate design? (appropriate design)
- Process of Experimentation
The third test requires 80% or more of the development process to be spent on evaluating one or more alternatives designed to alleviate the technical uncertainties identified at the beginning of the development process. Acceptable methods noted in the regulations include trial and error, iterations, scientific method, or an evolution of the design.
- Scientific Principles
The final test in the 4-part test requires that the Process of Experimentation inherently rely upon the principles of hard science. This particular component of the four-part test is defined as the principles of physical, biological, engineering, or computer science.
- Supporting Documentation
It's important to note that there's no such thing as "perfect documentation" when proving eligibility for the research and development tax credit. Every small business leverages a unique strategy to document their development efforts. Larger companies often have a standardized process or system in place to help track key details, such as expenses and operations. However, smaller businesses often struggle to keep thorough records that track their qualifying activities.
Some documentation guidelines to help manage and support qualifying activities and innovation efforts include:
- Project-Based Time Tracking
Ideally, contemporaneous project tracking that documents the project goals, technical uncertainties, personnel hours, and tasks completed should be considered and implemented. While not a statutory requirement, some type of documentation system is strongly recommended.
- Development Process
Innovation often relies on repeated failures and missteps. Most successful companies recognize the value of documenting not only their projects but their overall development strategy, process, and projects. The term "roadmap" is often used to describe the long-term view for a company's development strategy. We recommend not only the documentation of a company's long-term vision for innovation but also the standardized process used and detailed steps within each phase of the process.
- Project Description and Detail
Project documentation should also document the goals of the project as well as a breakdown of the process as it relates to the four-part test. This is a specific area where Acena Consulting can provide support, direction, and guidance.
There may also be other relevant documents needed to support a research and development tax credit claim. Emails, CAD drawings, meeting minutes, and any other pertinent papers should all be compiled with other documentation to ensure an organization can demonstrate proof of all eligible expenses.
R&D Tax Credit Strategies for Qualified Small Businesses to Consider:
Due to updates in legislation from the Protecting Americans From Tax Hikes Act (PATH) and the Jobs Act in 2015, and more recently the Inflation Reduction Act of 2022 (IRA), a few helpful strategies have surfaced that can benefit small businesses.
Offset Payroll Taxes: Payroll Tax Credit vs. Income Tax Credit
Qualifying small businesses can elect up to $500,000 in payroll tax credits instead of an income tax credit. A Qualified Small Business, defined as a business with less than $5 million in annual gross receipts and having gross receipts for no more than five years, can use the R&D tax credit to offset the Federal Insurance Contributions Act (FICA) employer portion of payroll taxes. I'm not going to get into the mechanics of taking the credits here but it is easy to see how this election could benefit a startup in the early stages with payroll expenses and the associated payroll tax liability, but not much income to be taxed.
The payroll tax credits can apply only against your small business' liability for the employer portion of Social Security tax, as imposed by section 3111(a) of the Internal Revenue Code. You may not use the payroll tax credit as a credit against any other employment tax liability and the credit may not be refunded in the absence of liability for your employer Social Security tax. However, it can be used prospectively to offset future payroll taxes each quarter.
Offsetting Alternative Minimum Tax With the R&D Tax Credit
This rule limited many small- to mid-sized businesses in their ability to use the credit if they were subject to alternative minimum tax (AMT). This is especially true for many owners of pass-through entities. With the permanency of the R&D tax credit came an enhancement that specifically benefited small businesses. “Eligible small businesses” may now claim the R&D tax credit against AMT liability. An eligible small business is defined as a business with less than $50 million in average gross receipts (i.e., revenues) for three preceding years.
Contact Acena Consulting Today for More Information
We simplify the research and development tax credit process for small business owners in over 40 industries. Contact us today to learn more.
