Hidden Money: Demystifying the R&D Tax Credit

Welcome to SMB Matters.

I’m Monika Diehl, divisional vice president of tax for Claris R&D. This podcast series takes a close look at the latest news and trends on a variety of topics related to running a successful small and medium-size business. Today, I’ll be talking about how small and medium size businesses can save significant money through the research and development tax credit.

The research and development tax credit is a program that’s intended to reward businesses for innovation. Unfortunately, many businesses that qualify for the credit don’t know it exists, so they don’t realize that it actually applies to them and the work that their company is doing. Missing out on these credits for the work that a company has done is basically leaving money on the table that a business could otherwise use to grow their business and reinvest.

The research and development tax credit was designed to encourage innovation in the U.S. They really were aiming to encourage businesses to develop new products and new technology. So where a business is doing work that’s related to creating new products or improving existing products or technologies, we really want to think about whether there might be some eligibility for the R&D credit.

This is generally the type of work that the credit was designed to encourage. But we also want to take a step back and think about the fact that R&D credits can apply to different types of businesses as well that you may not immediately think of as those scientific types of industries. So we want to think about things like software development, consumer product development. We’ve worked with a business that develops a skincare line, so each time they’re developing a new formula for a product where they’re developing a new product that can be qualifying activity for the R&D credit. Even craft breweries, as they create those new recipes and formulas.

And what I think is important to think about is things that are—it’s not just the first time that you create a new product. When you’re creating something for the first time, maybe you’re developing a software platform that that work qualifies. Looking forward in subsequent years, you’re probably going to be improving that technology. You’re going to be enhancing. You’re going to be developing maybe new functionality or capabilities. That is also qualifying activity for the credit.

While we’re thinking about costs that are eligible for the R&D credit, there’s generally going to be three categories. Employee wages: we can pick up a percentage of wages related, the percentage of time that is spent on R&D work. Outside contractors: if we’re working with outside contractors, 65% of that work as it relates to our R&D process can be included for the credit. And then finally, supplies that are consumed or used up in the development process would be eligible. All work does need to be done in the U.S. in order for those costs to be included for the credit. And generally that credit is going to come up to be about 7 to 10% of that total qualifying spend when you pool those costs together.

Now, when we’re thinking about how companies can actually use those dollars, we’ve calculated the credit; now, how can you actually use those dollars? The R&D credits have been around for a long time, for about 20 years, and has always been available as an income tax credit. Now, the issue was that a lot of early-stage companies, namely startup companies, were kind of left out of receiving any benefit for the credit. And this is because in the early years, startup companies are not profitable typically and they’re not paying any income tax.

And so what happened is the PATH Act in 2015 created an avenue where those early stage companies can actually monetize the credit. They can claim in income tax credit, but they wouldn’t have any income tax to use it against, which just creates a benefit that they can use at some point in the future. But the PATH Act gave them an avenue for using the credit against their payroll taxes.

And so where we’re looking at an early stage company, that’s going to be a company that is within their first five years of having any gross receipts and they have less than $5 million in gross receipts in the credit year, they’re eligible to use that credit against their payroll taxes. And so this gives them the ability to actually monetize the credit and use it against the tax that they’re actually paying. So this was a very big deal for those early-stage companies.

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This podcast is for educational purposes only. With decades of experience supporting small and medium-size businesses, TriNet has unique insight into HR best practices for businesses. TriNet does not provide legal, tax or accounting advice. The materials in this podcast and the options and opinions expressed herein may not apply to your company or scenario, so you should consult with your own advisors on how best to proceed. Reproduction in part or in whole is not permitted without express written authorization from TriNet.