The Research and Development Tax Credit, formally known as the Credit for Increasing Research Activities under Section 41 of the Internal Revenue Code, has been in existence for many years to encourage companies to conduct research and development for further development of innovation. Recent updates under the Inflation Reduction Act have created additional value to further support startups and small businesses. Furthermore, several states, including Ohio, have enacted similar tax credits that provide a tax credit for research and development.
What is the R&D Credit?
The Research & Development Tax Credit (R&D Credit) is a tax credit available to certain taxpayers for certain types of expenses including wages, supplies and certain contract services incurred in conducting qualifying research activities. To be a qualifying research activity, the Internal Revenue Service (IRS) has set forth a four-part test:
The research expenditure must be intended to discover a new or improved business component that will be sold, leased, licensed or otherwise used in the company’s trade or business. A business component can be a product, process, computer software, technique, formula or invention.
The research expenditure must be undertaken to identify uncertainty regarding a business component, find one or more alternatives and conduct a process to evaluate the alternatives through various methods including modeling, simulation and other methods.
Technological in Nature
The research expenditure must be undertaken for the purpose of discovery by relying on principles of the physical, biological and computer sciences or the general principles of engineering.
The research expenditure must be designed to eliminate uncertainty concerning the development or improvement of a product.
Under applicable Treasury Regulations, substantially all the activities related to the research expenditures should be related to the experimentation process test. Generally, the R&D Credit is not allowable for research that is conducted outside of the United States or its territories, research after commercial production, a pure adaptation or duplication research situation, social science-related research, or for research solely related to surveys, studies or managerial functions.
Eligible Research and Development Tax Credit Expenses
As discussed, a qualified taxpayer can receive a tax credit for certain expenses that were incurred in conducting the qualifying research activity. Under the applicable rules, the eligible expenses include:
- Wages: Compensation paid to an employee who is (1) performing qualifying services related to the qualifying research activity or (2) engaged in the direct supervision or support of research activities that are qualified research activities.
- Supplies: Supplies obtained and used in qualifying research activity.
- Computers: Costs incurred from a third-party for renting, leasing or maintaining computers in the qualifying research activity.
- Contract Research Expenses: Costs paid or incurred by hiring a non-employee to conduct the qualifying research activity. Generally, only 65% of the costs of contract research expenses are eligible unless certain criteria are met.
Research and Development Tax Credit Value
The R&D Tax Credit allows qualifying taxpayers to obtain a tax credit equal to 20% of their qualifying research activities. Applicable rules provide two methods for calculating the tax credit: the Regular Credit Formula method or the Alternative Simplified Credit method.
The Regular Credit Formula Method
Under the Regular Credit Formula method, a qualified taxpayer receives a credit equal to the lesser of the current-year qualified research activity that exceeds a base amount (between 3%-16%) or 50% of the current-year qualified research activity multiplied by 20%.
The Alternative Simplified Credit Method
In the Alternative Simplified Credit method, a qualified taxpayer receives a credit equal to 14% of the current-year qualified research activity that exceeds 50% of the average qualified research activity during the prior three taxable years. If there is no qualifying research activity during the prior three years, then the credit is equal to 6% of the current-year qualifying research activity.
For certain small businesses and startups, the R&D Credit can be used to offset employment (payroll) tax obligations. Prior to the Inflation Reduction Act, a qualifying small business could offset a maximum of $250,000 against their old age, survivors and disability insurance tax, commonly knowns as the Social Security tax (6.2%) obligation. However, under the Inflation Reduction Act (IRA), the R&D Credit was increased from $250,000 to a maximum of $500,000. Under the IRA, a qualified small business can now offset both its Social Security tax liability of up to $250,000 and its hospital insurance tax, commonly known as the Medicare (1.45%) tax liability of up to $250,000 (total of $500,000).
In order to qualify for the offset of payroll tax using the R&D Credit, a company must qualify as a small business. Under IRS guidelines, small businesses are defined as either a corporation, partnership, or individuals who have:
- Less than $5 million in gross receipts
- Five years or less of gross receipts
- Have qualified research activities
- The research is associated with the trade or business of the company
A qualified taxpayer can make the payroll tax credit election for up to five years, resulting in a total payroll tax credit of up to $2.5 million ($1.25 million for Social Security and $1.25 million for Medicare).
Ohio Research and Development Tax Credit
In addition to the federal R&D tax credit, the State of Ohio has a tax credit for research and development. Under Section 5751.51 of the Ohio Revised Code, taxpayers can take a nonrefundable credit for qualified research activities incurred within the state against their commercial activity tax obligations (CAT). Qualified research activities under Ohio law have the same meaning as provided under Section 41 of the Internal Revenue Code. The nonrefundable credit is equal to 7% of the excess of the qualified research activity during the current year over the average of qualified research activities over the prior three years. If a taxpayer met the necessary criteria, then they could receive both a federal tax credit and a state tax for qualified research activities.
Businesses Must Document Their Qualifying Research Activities
The R&D Credit can be a valuable tax credit for activities that a company may already be performing but not yet appropriately documenting. A recent federal Tax Court case, Moore v. Commissioner (T.C. Memo. 2023-20) illustrates the importance of ensuring that companies are documenting their qualifying research activities, including documenting what research activity is being conducted, the wages for personnel associated with that research activity and expenditures undertaken. For startups and small businesses, who may not have significant tax obligations during the first couple of years, the expansion of the tax credit to include payroll expenses can be invaluable during those formative years.
For support with understanding how your organization could benefit from the Research and Development Tax Credit or other tax matters, please contact a member of KJK’s Tax Practice Group, including our Co-Chair, Partner Demetrius Robinson (DJR@kjk.com; 614.427.5749).