Yes, Federal Research & Development (R&D) tax credits are the real deal. The goal of the credit is to incentivize innovation. And, in this case, innovation can really help cash flow! 

But, as the old adage goes, “cash doesn’t grow on trees”. There’s qualifying for the R&D tax credits and there’s applying for the credit itself. In this post, we’ll expand on your understanding of what the R&D tax credit is, help you identify if your business qualifies, peek behind the curtain on how to calculate your company’s potential credit and, finally, offer recommendations on how to prepare your supporting evidence & documentation throughout the year so that when tax season comes around, you’re ready to apply with confidence.

What are R&D Tax Credits & does my business qualify for them?

The R&D tax credit is a government incentive offered to all businesses, not just tech or research oriented start-ups, in an effort to reward investment in innovation. Businesses of all sizes and ages can apply. Your business is not required to have an engineering team or a research facility to participate. If you’re building something new, either with in-house or external resources, your business may be eligible to participate.

Below is the four-step criteria for eligibility to receive R&D tax credits:

• Permitted purpose: Your business is developing something new or improving upon an existing product or technology.
• Technological in nature: In order to develop something new or improved, your business is relying on technical sciences such as engineering, physics, chemistry, biology, or computer science.
• Technical uncertainty: Your desired outcome isn’t currently known or established and may be difficult to reach as you forge into unchartered ideas.
• Experimentation: Success involves continuous iteration, using simulations, enhanced modelling and vigorous trial and error.

It is important for us to call out that many tech startups are eligible for R&D tax credits and don’t realize they are. Some don’t even realize that the R&D tax credits program exists. For example, in 2019, an estimated $60 billion of the $92 billion available R&D tax credits went unclaimed.

Is applying for R&D Tax Credits worth the time?

Again. Absolutely, yes. The R&D tax credit is a dollar-for-dollar credit with no hard-cap.

The key metric used in calculating your R&D tax credit is how much spend or investment you make towards those projects that qualify. The summation of qualified expenses are called Qualified Research Expenses, or QREs. QREs are calculated from four primary expense buckets:

1. Total wages (including bonuses) that were used and allocated toward eligible projects.
2. Total costs of supplies used, inclusive of Cloud & Software related expenses.
3. Total rental or lease costs of computers dedicated to the project.
4. Total amount paid for contract research - including contractor resources - that worked on eligible projects. Note: 25% or 35% haircut is taken on all eligible contract research spend when calculating QREs

There are two ways to calculate your annual R&D tax credit: (1) the Alternative Simplified Credit (ASC) and (2) the Regular Method. As each method of calculation comes with its own nuances, book a free call with Afino today to calculate your business R&D tax credit.

1. ASC: Method commonly used by startups and businesses lacking historical QREs, but also used by established companies for simpler calculations. If you don’t have a history of QREs, this method must be used. It’s easier to calculate but, generally, less favorable when maximizing the credit.
2. Regular method: Generally used by companies with consistent or increasing QREs. Without historical QREs, this method can’t be used. While more difficult to calculate, this method generally yields higher credits and scales better with businesses increasing annual QREs

How does my business receive the R&D Tax Credits?

The credit is “paid” in three different ways:

1. Credit against year-end tax liability: Your actual tax liability could act as a “hard-cap” because your credit won’t exceed your tax liability (refer to #3 below).
2. Credit against payroll tax liability: There is a cap of up to $500,000 on how much payroll tax liability you can offset.
3. Tax credit carryforward: Unused credits can be used to offset future tax liabilities

The way R&D tax credits are applied depends on the size and maturity of your business. If your business had less than $5M in revenue in the current tax year and has generated revenue for no more than 5-years you are considered a Qualified Small Business (QSB) and may use up to $500,000 of your credit to offset payroll tax liability. Any remaining credit can then be applied to corporate tax liability or carried forward. If your business does not meet these requirements, the credit must be applied to corporate tax liability first, with any excess carried forward to future years.

As an example, assume your business qualifies as a QSB and generated $1.0M in R&D credits, had a corporate tax liability of $250,000 and paid in excess of $500,000 in employer payroll taxes, the business could use its R&D tax credit as follows: (1) apply up to $500,000 to offset payroll tax liability, (2) apply $250,000 to offset corporate tax liability, and (3) carry forward the remaining $250,000 for future tax years.

OK, I’m sold: How does my business apply for and claim the R&D Tax Credits?

While it is possible to compile and aggregate your documentation last second to support your R&D tax credit filing at year end, Afino recommends a structured and consistent approach, ideally on a monthly basis, to position your business for the highest and most defensible R&D tax credit. 

Detailed below is guidance on how to prepare and file for your annual R&D tax credit, as well as recommendations on how to gather support & documentation in the event of an audit.

(1) Make technical project documentation a part of your team culture

‍In the event of an audit, clear, concise and clean documentation is paramount. It is best proctive to make this a recurring process.‍‍

• ‍Maintain a detailed project list using available PM tools (Asana, Jira, Linear, etc.) or available internal resources (Excel, etc)
• Create a repository to manage documentation and ensure engagement with the repository is a team expectation. Bonus points for doing this at the project level.
• Channel the four qualifying criteria when documenting. Here are the types of key project documentation:
  ‍
  • Project plans & technical specifications
  • Meeting notes or email correspondence discussing R&D challenges
  • Software development logs (GitHub, Bitbucket, GitLab commits)
  • Prototype designs, CAD models, engineering drawings
  • Testing results, A/B test reports, failure logs
  • Simulation data and technical reports
  • Change logs for software, prototype versions, or engineering modifications
  • Failure analysis reports & iteration tracking‍

(2) Ensure Qualified Research Expense (QRE) calculation and gathering of supporting documentation becomes part of your monthly close process

‍Work with your project teams to implement a regular and repetitive process to identify, document and calculate QREs:‍

• Use payroll systems to extract key employee financial information, such as wages and bonus payments‍
• Create a process that allows project teams to clearly identify eligible time spent on eligible projects ‍
• Understand expense buckets that pertain to calculating QREs and delineate between development vs. production costs ‍
• Retain and manage supporting documentation for all QREs‍

(3) Run ASC or Regular Method calculations, prepare required forms, and file by the due dates:‍

If possible, use both the Regular Method and ASC calculations to determine which methodology yields the largest credit.

Then, the following IRS forms need to be completed to receive the Federal R&D tax credit:‍

• Form 6765: To calculate your annual credit using the Regular Method or ASC‍
• Form 3800: To apply tax credits to offset year-end corporate tax liability
• ‍Form 8974: To apply (up to $500,000) in credits to offset payroll tax liability (Note: Payroll tax liability offset is only available to businesses with <$5M in gross receipts in the current year and no gross receipts before the last five years)‍
• ‍Form 941: To reflect Company’s quarterly payroll tax deductions using R&D tax credits

R&D tax credit filings should accompany your annual corporate tax filings. Due date of corporate tax filings is dependent on your business tax election.‍

• March 15th:  Partnerships & S-Corps (including extension filing)‍
• April 15th:  C-Corps (including extension filing)‍
• September 15th: Extension deadline for Partnerships & S-Corps‍
• October 15th:  Extension deadline for C-Corps

Whether you’re scrambling at year-end to file for your R&D tax credits or your business is diligent about documentation throughout the year, R&D tax credit compliance takes effort. Book time with Afino today to learn how our experts can help turn this time consuming task into tangible tax credits. Plus, our fee structure is 100% success based so there’s no upfront costs.

Summing it all up

Federal R&D tax credits are a real and legitimate incentive to improve your operational cash flow. Implementing processes today can help ensure your business maximizes its year-end R&D tax credit.

And we didn’t even mention the 35+ states that offer incremental, state level R&D tax credits!

It’s time to capitalize on receiving your earned Federal R&D tax credit. Book a free call with Afino today to learn more.