About the R&E Credit
Enacted in 1981 by the Economic Recovery Tax Act, the Credit for Increasing Research Activities [also known as the Research & Experimentation (R&E) or Research & Development (R&D) tax credit] rewards companies for the development or improvement of products, processes, techniques, formulas, inventions, or software applications.
The R&E tax credit is a dollar-for-dollar credit against the taxpayer’s federal income tax liability. Taxpayers may benefit from both the deduction in the year the expenditure is paid or incurred, and by claiming the research tax credit.
Following passage of the Protecting Americans from Tax Hikes Act of 2015 (“PATH Act”), which made the R&E tax credit permanent, companies can utilize their credits faster. The PATH Act allows eligible small businesses, defined as companies with average gross receipts of less than $50 million, to offset both regular and alternative minimum tax (AMT) liabilities in tax years beginning in 2016 and thereafter. Further, certain start-up companies, defined as qualified small businesses, are now able to offset the employer’s portion of FICA payroll tax liabilities with research credits generated in tax years beginning in 2016 and thereafter. These two provisions have significantly expanded the number of companies able to monetize R&E tax credits.
Approximately 36 states have incentives for research and development, typically based upon the federal definition of research. The various state R&E tax incentives range from 1 to 24% of the eligible research expenditures, with some states requiring taxable income as a prerequisite for utilizing the credit, and others refunding any unused credit to the taxpayer- irrespective of the existence of taxable income. Each state has its own requirements, and state credits are only eligible for research conducted within each respective state.
We have found that manufacturing, technology and software companies consistently perform qualified research and development activities to further their business. This may include the development of new technologies or research of materials for new and improved restorations or appliances.
How can the credit benefit your company?
This credit is activity-based, and there are four basic requirements for an activity to qualify for the research tax credit. The four main requirements include:
- Development or improvement of a business component. For an activity to qualify, taxpayers must be developing a new business component or improving an existing business component that is held for sale, lease, or license, or used by the taxpayer in its trade or business. Business components are defined as products, processes, techniques, formulas, inventions, or software applications.
- Eliminating uncertainty which is technological in nature. For an activity to qualify, the research must be undertaken for the purpose of eliminating technological uncertainty concerning the development or improvement of a business component. This uncertainty exists if the taxpayer is unsure about the capability, method or design of the business component.
- Qualified purpose of research. For a research activity to qualify, the research must relate to new or improved functionality, performance, reliability, or quality.
- Process of experimentation. For an activity to qualify, a taxpayer must eliminate technological uncertainty by engaging in a process of experimentation. A process of experimentation is an evaluative process and should be capable of evaluating more than one alternative. Treasury regulations define a process of experimentation as modeling, simulation, or systematic trial and error. This includes computer modeling, building prototypes, testing sample cases and experimenting with different tools and equipment. Activities that may qualify include, but are not limited to:
- Developing new processing methods,
- Experimenting with process improvements as a result of lean initiatives,
- Experimenting with new materials,
- Making a product safer,
- Developing new or improved testing procedures,
- Developing tooling for new products or process improvements,
- Using chemistry to reformulate a product,
- Developing new and alternative designs,
- Developing prototypes and models including computer generated models,
- Decreasing environmental emissions and effluents or performing related testing, or
- Improving package design.
While there are numerous expenditures that meet the definition of research, only three types of expenditures are allowed in calculating the R&E tax credit. These include wages paid for qualified services, supplies used in the conduct of research, and contract research (payments to third parties).
The R&E tax credit is one of the most beneficial tax incentives that companies may utilize to reduce their income tax liabilities. Both quantitative and qualitative documentation is necessary to support these research credit claims, so companies are best served by creating and maintaining the proper documentation to support such claims.