The Research and Development Tax Credit was created by Congress in 1981 as a way to help companies in the United States stay competitive within the global marketplace. The PATH Act (Protecting Americans from Tax Hikes Act) officially made the R&D Tax Credit permanent on December 18, 2015. The PATH Act makes it easier for startups, small and medium sized company to take advantage of this strategic financial planning tool.
Under the PATH Act, startups, small and mid-size businesses are able to use the credit against their Alternative Minimum Tax (AMT). Companies, such as C Corporations, or shareholders of qualifying pass-through entities, like S Corporations, that have an AMT liability can take advantage of this provision.
Companies operating under $50 million in gross receipts, based on a three year average, can use the R&D Tax Credit to reduce AMT limitations. AMT was one of the biggest hindrances to the credit in the past because eligible companies and its shareholders couldn’t always utilize the credits meaningfully.
Let’s take a look at how a company can qualify for the R&D Tax Credit:
The R&D Tax Credit is available for any company that designs, develops or improves products, processes, techniques, inventions, formulations or software. Under recent IRS regulations, more industries can now qualify for the tax credit than ever before. For example, engineering, software, technology, environmental, life sciences, manufacturing and design.
The research activities conducted within these industries are called qualified research activities (QRAs). For activities to be considered QRAs they need to fulfill the IRS Four-Part Test. The IRS Four-Part Test requires a new or improved business component (product, process, technique, invention, formula or software), the business component to be technological in nature (hard sciences), some kind of elimination of uncertainty, and a process of experimentation.
The expenses incurred while conducting QRAS are called qualified research expenses (QREs). The IRS defines QREs as the sum of “in-house research expenses” and “contract research expenses”. These expenses are composed by wages, supplies and contract research. Wages are compensations that are taxable or subject to self-employment tax to individuals performing, directly supervising or supporting the qualified research. Supplies are the amount paid or incurred for materials used in the conduct of qualified research and contract research which are payments for the conduct of research completed by a third party.