Qualified small businesses may be eligible to apply up to $1.25 million—or $250,000 each year for up to five years—of the federal R&D credit to offset the Federal Insurance Contributions Act (FICA) portion of their payroll taxes each year, but far too many miss the opportunity.
Today, more companies than ever are qualified to take advantage of the Research & Development (R&D) tax credit, yet when we review potential clients’ past returns, we find nearly half of them haven’t claimed or maximized the benefit.
Introduced in 1981 as a temporary incentive and made permanent by the Protecting Americans from Tax Hikes (PATH) Act of 2015, the R&D credit rewards companies for investing in research and development activities in the current tax year. The credit was preserved with the passage of the Tax Cuts and Job Act and is intentionally broad and intended to be inclusive in order to benefit the largest number of taxpayers, but too many business owners and tax preparers fail to capture it.
In order to qualify for the credit, a business generally needs to have less than $5 million of gross receipts over a five-year, or less, period, as well as qualified research and development costs. Technology, health, and manufacturing do make up a majority of R&D credit claims, but any industry can qualify if it’s actively developing new products or processes.
Our experience tells us that business owners fail to realize the maximum benefit of the R&D credit because of two common misconceptions:
- “We don’t have research labs or scientists, so we don’t do R&D work.”
- “We’re not inventing anything new or groundbreaking.”
In reality, if you are attempting to develop a new product or process, or enhance an existing one, you may well qualify for the R&D credit -- even if you’re not successful. The effort invested in the development activity is the qualifying factor, not the result.
As technology continues to expand into every industry, many day-to-day activities, activities companies don’t even consider, qualify for this dollar-for-dollar reduction in income tax liability. Here are the 3 we see missed most often:
- Automation tools and artificial intelligence
Newly emerging technology -- from automated shelving to labeling systems and even robotics -- improve workflows and processes. Implementing them may just qualify you for the R&D credit. The time you invest in designing those tools, how and where they’ll be used, and the trial runs used in testing them may be qualified expenses (though the upfront cost is not).
Virtual helpers (think of Siri and Alexa at home -- but more complex) are creeping into businesses, too. Computer systems are being assigned to tasks that once required human intelligence. R&D credit opportunities abound in this space.
Any product or process using AI that allows you to do something more efficiently can qualify. In addition, the time spent training AI systems to use data and guiding the system through making distinctions could also qualify you for the R&D credit.
- Replacement of obsolete parts
It’s not uncommon for a supplier to go out of business or stop making a piece of previously sold equipment that was used as part of a product or process. A commercial HVAC company, for example, might find that a filter it previously used is no longer available, and a replacement cannot be found. When that happens, that HVAC company might have to make changes to their products to accommodate whatever new filters are on the market. Design changes related to size, functionality, and more will all have to be addressed. This is particularly the case when the now-obsolete part is so old that developing totally new technology is better than attempting a retrofit.
Small businesses can recoup expenses related to the design and testing of the new product provided they can provide proof of concept, demonstrate how their innovation made the product better, and document any failure points. To recoup wages, the business must also prove each individual’s contributions to the process and that they had the required experience needed to participate in the design.
- Leasing in “the cloud”
It’s now cheaper and easier to lease cloud computing time than it is to purchase servers and outfit data centers. Cloud computing server, platform, and SaaS software application innovation costs may be considered qualified research expenses (QREs) that are eligible for R&D credits when the cloud is operated by someone other than the taxpayer and located off the taxpayer’s premises, and the taxpayer is not the primary user of the computer. Cloud-hosted development platforms and beta testing of pre-released software programs are included but operating platforms are not.
By no means is this an exhaustive list. We see missed opportunities for the R&D credit often and across all industries. Too many business owners and their CPAs miss the boat.
The chances that you’re doing something that qualifies you for the credit have always been good, and newly emerging technology makes them even greater. Don’t continue to leave money on the table that could otherwise be used to fuel growth.