If your business conducts research and development (R&D), you may be eligible for certain tax breaks. This is so whether you’re creating a new product or merely working on new internal-use software to run things better within your company. These tax breaks are significant and greatly reduce the financial cost of your R&D activities.
Expensing of R&D costs
From a tax perspective, research and development (R&D) costs can be treated in one of 3 ways:
- Deduct all costs currently
- Elect to treat the costs as deferred expenses, amortizing them over a period of at least 60 months
- Elect to amortize them over 10 years beginning in the year the costs are paid or incurred
You’d think that taking deductions upfront would be the best alternative. However, a company may prefer to spread them out to better offset future income resulting from R&D efforts. And there are alternative minimum tax considerations for owners of businesses that are not C corporations.
What are R&D costs?
R&D costs are those in the experimental or laboratory sense (i.e., they are for activities intended to discover information that would eliminate uncertainty concerning the development or improvement of a product). Uncertainty exists if the information available to the taxpayer does not establish the capability or method for developing or improving the product or the appropriate design of the product. The amount of qualified research expenses that can be taken into account for the deduction is reduced by the amount of any research credit (discussed next).
R&D costs don’t include:
- The ordinary testing or inspection of materials or products for quality control;
- Efficiency surveys;
- Management studies;
- Consumer surveys;
- Advertising or promotions;
- The acquisition of another’s patent, model, production or process; or
- Research in connection with literary, historical, or similar projects.
Note: Starting in 2022, the option of taking an immediate write-off for R&D costs no longer applies. Instead, these costs will have to be amortized (deducted ratably) over 5 years (15 years for foreign research expenditures).
Tax credit for R&D costs
In addition to deductions for R&D, businesses may also qualify for a federal tax credit. In 2013 (the most recent year for statistics), this credit totaled $11.3 billion in tax savings for businesses. And use of the credit isn’t limited to large drug companies or multinational corporations; small businesses are at the heart of innovation.
According to the SBA , 4% of small businesses are in the field of scientific and research and development (NAICS 5417), compared with 0.8% of large firms. Moreover, as mentioned earlier, the credit can be used for developing internal-use software, regardless of the industry you’re in.
The research credit (technically referred to as the “credit for increasing research activities” because of the formula used to calculate it) can be as much as 20% of qualified costs. There’s an alternative simplified method of calculating the credit; the rate for this option is 14%. The credit is nonrefundable, so any credit amount in excess of current tax liability is not used immediately. It is part of the general business credit, which is carried back one year and forward for up to 20 years.
Small businesses can use up to $250,000 of the credit to offset the employer’s share of Social Security taxes (part of FICA). Small businesses are those with less than $5 million in gross receipts and no gross receipts in the preceding 5 years.
Note: In addition to the federal tax credit, you may be eligible for state income tax credits for R&D activities.
Albert von Szent-Gyorgy, a Hungarian scientist who won the Nobel prize for isolating vitamin C, said:
“Discovery consists of seeing what everybody has seen and thinking what nobody has thought.”
Fortunately, the government helps to underwrite the cost of this thinking through tax breaks for R&D. But the rules that coordinate the deduction of research costs with the tax credit are complicated, so work with a knowledgeable tax advisor to see how these rules impact your company.