The incentive every accountant needs to know about: the R&D Tax Credit
Matt Donaldson & Ari Salafia — Jul 6, 2021
The best accountants are the proactive ones. While some may be content to service clients as needed, the proactive accountant finds opportunities to save money their clients didn’t even know they were missing.
The R&D Tax Credit is a great and often overlooked way of saving money for innovative businesses. By claiming the credit, your clients can generate non-dilutive funding—and lots. In 2019, over $13 billion was claimed. The IRS expects to distribute $148 billion to corporations between now and 2026.
So why do 90% of eligible businesses miss out? For one, they might not know about the credit. Others know it exists, without understanding that they qualify. As an accountant, it’s up to you to understand the R&D Tax Credit and, when possible, to help your clients qualify as a way of saving money. Here’s everything you need to know.
What is the R&D Tax Credit?
Simply put, the R&D Tax Credit rewards U.S. companies that invest in innovation. As a tax credit, it offsets past, present, and future tax liabilities dollar-for-dollar. In most cases, you can amend tax returns for prior years in which clients did not claim the credit and carry forward unused credits for up to twenty years.
First created in 1981, the R&D Tax Credit was made a permanent fixture of the federal tax code by 2015’s PATH Act. And with strong bipartisan support, this incentive is something your clients can plan around.
Companies of any size and revenue can take advantage. Startups with less than five years and $5 million in gross receipts are eligible for the payroll tax offset, even if operating in losses. The payroll tax offset is a specific provision, which we’ll cover in greater detail at the end of this blog post.
One last thing before moving into the nitty gritty: While the R&D Tax Credit is a part of the federal tax code, there are often state-level R&D tax credits. Be sure to investigate those as well.
Any company that is developing, designing, or improving technology might be eligible for the R&D Tax Credit. The criteria is purposefully broad, so even if your client isn’t building a Martian habitat, it’s worth investigating whether they’re eligible.
The industries that qualify most often are the usual suspects: technology, manufacturing, life sciences, and engineering. You might be surprised by some of the businesses that fall into these categories. For instance, architecture firms often meet the criteria.
However, you shouldn’t count a client out just because they sit in an industry other than these ones. Plenty of companies qualify for the R&D Tax Credit in unexpected industries like agriculture, cosmetics, printing, and more.
For example, a brewery developing a zero-calorie beverage is innovating. That process takes technology and knowledge of food science. So, as you’re trying to determine which clients might qualify, it pays to think outside the box.
Once you’ve gone through your book of business—with an open mind!—it’s time to qualify which companies truly have qualified research.
The quickest test is to ask whether your client, in providing goods or services, is going through a process that emulates the scientific method. To know for sure, you can ask the team these questions when raising the credit as a possibility:
- “Is your business developing a new or improved product?”
- “Is there uncertainty or risk regarding the outcome of the project or ultimate design of the product?”
- “Is there an iterative process of experimentation/testing with the project to resolve the technical uncertainty”
If the team answers yes to any of those questions, their company has a strong case for the R&D Tax Credit.
Qualified Research Expenses
After you’ve identified a good candidate for the credit, you’ll have to identify which expenses count as a Qualified Research Expense (QRE) under the IRS’s definition. There are four types of QREs:
1. Internal W-2 Payroll
Some or all of employees’ wages might qualify as QREs if those employees are linked to qualified research. Employees whose wages qualify could be the ones directly performing research, but they might also be personnel supervising the research or supporting the research in administrative ways. Note that only certain smaller businesses can take advantage of the payroll tax offset.
2. U.S. based contractors
Many businesses bring contractors on to help with research efforts. If the contractor is tied to the qualified research, their wages may also be considered QREs. Remember, though, that qualified research must take place inside the U.S. Even if you hired a contractor through a U.S. agency, they will only be eligible if they are working in the country’s borders.
Any materials used or consumed during the qualified research process are considered QREs. That includes raw materials and prototypes.
4. Cloud computing services
If you’re using costly cloud services to support your qualified research, as in the case of software development, those subscriptions count as QREs, too.
As you can see, the tax code defines QREs broadly. And now that you know which expenses qualify, you can begin to preview for clients what their cost savings could be.
On average, companies experience a 10% return on annual QREs. Rippling makes it fast and easy to generate reports on your clients’ internal spend, seeing the exact dollar amounts going toward W-2 payroll, contracts, and software. While you’re exploring the R&D Tax Credit, it can be really powerful to estimate how much your clients could save, using Rippling.
You’ll want to make sure your client is audit-ready, too. Companies should save any documents related to qualified research and be able to illustrate a “nexus” between QREs and activities related to that research. This is especially true when considering wages related to qualified research.
While there is no “perfect document,” you can help your clients by providing them with this checklist of relevant document types:
- Internal status reports
- Technical emails
- Meeting minutes
- Lab notebooks
- Patent applications
- Product specs
- Test result reports
- Project timelines
- Diagrams and drawings
- Engineering reports
The most common way we see companies lose the credit, or get theirs adjusted, is through a lack of documentation. As you’re recommending the R&D Tax Credit to your client, set them up for success by stressing the importance of proper documentation.
Calculating the credit
There are two methods for calculating the credit. It’s worth evaluating them both for your client to see which will maximize their benefit.
The first is the Regular Research Credit: This provides a credit of up to 20% of the current year’s QREs that exceed a base amount. The base amount is calculated based on prior years’ gross receipts and QREs.
The second is the Alternative Simplified Credit: This provides a credit of up to 14% of the current year’s QREs that exceed 50% of the average QRE amount for the past three years. It’s considered simpler because it uses less historical data.
It pays to compare the benefits of both. If you’re going through your book of business, and it feels time-intensive to do this for every eligible client, TaxTaker’s software can do it for you.
How big of a credit can your client receive?
When thinking about tax credits, most accountants think of revenue. But the R&D Tax Credit has nothing to do with revenue. It’s all about internal spend. For every qualified $100,000, companies can receive up to $10,000 in tax credits.
And if your client’s research expenses are rocketing, they might be eligible for a lot more than that. There is no limit on how much companies with QREs can claim—with one exception. The payroll tax offset has a ceiling of $250,000. Let’s quickly cover that exception in greater detail.
Startups and the payroll tax offset
Only certain small businesses and startups can take advantage of the payroll tax offset. Its rules work a little differently from the rest of the credit’s provisions. To be eligible for the payroll tax offset, your client must be less than 5 years old and have less than $5 million in gross receipts.
Unlike other QRE types, the credit these companies can receive against FICA payroll taxes has a cap: $250,000. Although that number is smaller than the credit your clients can claim for supplies or software, it can mean a ton of additional runway for startups.
One other benefit? Your clients can be eligible for the payroll tax offset even if they’re not profitable.
Preparing for the R&D Tax Credit
The R&D Tax Credit is a huge opportunity, but it does require some legwork. It helps to raise this credit as a possibility with clients long before tax time. They’ll need to be documenting expenses appropriately, just in case there’s an audit around the corner.
To keep your clients on-track, share this process checklist with them:
- Identify and document Qualified Research Activities (QRAs)
- Identify, accumulate, and document QREs
- Substantiate and document projects and build report for claim year
- Calculate the R&D Tax credit and complete forms for filing
- Deliver forms to payroll provider to receive quarterly offset benefits
Depending on which QRE types your client is claiming, they will need to file out one or two forms. Form 6765 is the standard for the R&D Tax Credit. An additional form, 8974, is for small businesses taking advantage of the payroll tax offset.
Building relationships with the R&D Tax Credit
The R&D Tax Credit can create a huge competitive advantage for your clients, but it also creates a huge competitive advantage for your firm. It can help you win clients, score referrals, and keep in touch with your clients in the off-season.
With this overlooked incentive, you can show prospects and clients that you’re more than a bookkeeper—you’re a strategic advisor. And if you need help identifying opportunities for the incentive or preparing your pitch, Rippling and TaxTaker can help with the number-crunching so you can focus on the relationship.
Matt Donaldson is the Head of Channel Sales here at Rippling, overseeing our Accounting partnership team. Ari Salafia is the co-founder and CEO of TaxTaker. Tax Taker helps startups and small businesses fund their growth by maximizing their R&D tax credits.