By Ginny Veit, Tax principal, CLA
The federal research and development (R&D) tax credit was originally designed to be applied against income taxes. Under subsequent tax legislation, qualifying companies were permitted to make an annual election to apply up to $250,000 of their R&D credit against the employer portion of Social Security tax. The Inflation Reduction Act of 2022 further enhanced this benefit, beginning in 2023, by increasing the maximum election amount to $500,000, per year, and allowing Medicare tax to be offset in addition to Social Security tax. Companies in many industries may qualify, although R&D-focused startups in the life sciences and technology industries may benefit the most. Learn how the latest R&D developments may impact your organization and help you take advantage of potential tax savings.
Qualifying for the R&D tax credit
To understand whether your business qualifies for an R&D credit, it’s important to review the government’s definition of research activities. These activities need to meet the following requirements to qualify for an R&D credit:
- Permitted purpose
The activities must be undertaken to develop a new or improved product, process, technique or formula and generally be something that will deliver value to customers. Examples would include a new drug, medical device, or software developed for sale, lease or license to customers.
- Technological in nature
The activities must be based on principles of science such as biology, chemistry, physics, bioengineering and computer science.
- Intended to eliminate technical uncertainty
The activities must be intended to eliminate technical uncertainty regarding the development of the product, process, etc.
- Process of experimentation
The activities must involve an iterative process of experimentation where hypotheses are tested or alternatives evaluated.
- Qualified small business
For a company to qualify for the application of its R&D tax credit against Social Security and Medicare taxes, it must be a “qualified small business.” To be considered a qualified small business, (1) the company, including predecessors, must be within its first five years of revenue, and (2) its credit-year gross receipts must be less than $5 million.
Claiming research expenses
There are four categories of expenses a company may claim as qualified research expenses (QREs) to calculate its R&D credit.
- Wages for the time employees spend on qualified research activities including the direct supervision, and direct support, of those performing the research
- Supplies used in the performance of the qualified research activities
- Contract labor used in qualified research activities
- Certain cloud computing costs
An early-stage company can anticipate a federal R&D tax credit equaling up to 10% of its total QREs for the year. Also important to note, excess credits (for example, credits exceeding the maximum $500,000 eligible against payroll taxes) can be carried forward as income tax credits, for up to 20 years.
Many nuances and exceptions exist under the R&D credit rules; companies should be careful to educate themselves about these nuances and exceptions to be sure they qualify for the credits. It is especially important to consult an R&D tax advisor, when evaluating the extent to which they qualify.
Claiming the R&D payroll tax credit
Taxpayers applying their R&D credit against payroll taxes must make the necessary election on a Form 6765 Credit for Increasing Research Activities, which must be included with their timely, filed income tax returns.
Thereafter, the elected credit amount can start being applied to employer Social Security and Medicare taxes on a Form 941, beginning with the quarter following the quarter in which the taxpayer’s income tax return was filed. For example, a calendar year corporation filing its 2023 income tax return on April 15, 2024, would start claiming its payroll credits on Form 941 in Q3 of 2024.
Form 8974, Qualified Small Business Payroll Tax Credit for Increasing Research Activities, must also be filed along with Form 941, for each eligible quarter.
Any credit amounts exceeding the Social Security and Medicare taxes due in each quarter will carry forward to successive quarters, until exhausted.
Since the R&D payroll credit is claimed on a Form 941, it is important taxpayers coordinate with their payroll providers to properly apply and track the credits.
How we can help
Many companies are surprised to find more than a few of their activities qualify for the R&D credit and often fail to realize these day-to-day actions could translate to a dollar-for-dollar reduction of tax liability. CLA’s tax strategies team works with clients to identify, develop and implement tax savings opportunities.
For more information on R&D tax credits, contact Ginny Veit, a tax principal in CLA’s Tampa office, at [email protected] or 813-384-2744.
The information contained herein is general in nature and is not intended, and should not be construed, as legal, accounting, investment, or tax advice or opinion provided by CliftonLarsonAllen LLP (CLA) to the reader. For more information, visit CLAconnect.com.
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