The federal R&D Tax Credit is utilized by businesses to offset federal income tax liability, and in some circumstances, a reduction of the employer portion of payroll taxes. The activities must be performed in the U.S. to advance U.S. technologies. Many states also offer these credits.

The federal and state combined benefit of the credit averages between 10% to 20% of eligible spending. This could increase cash flow and decrease federal and state tax liability. It is estimated that over $15 billion of R&D Tax Credits were reported last year. If applicable, R&D Tax credits can be carried back and can also be carried forward, if not utilized within the year of the tax credit.

First, a common misconception. You do not have to achieve a major scientific breakthrough or do pioneering research to qualify. Your activity does not even have to be successful. Generally, a taxpayer must only make an attempt to discover a lack of technological information to develop or improve the functionality, performance, reliability, or quality of a business component by systematic evaluation. Generally, activities qualify if they meet each element of the following four-part test Qualified purpose: The purpose of the research must be to create a new or improved product or process, resulting in increased performance, function, reliability, or quality. The intention is that this to be used in the taxpayer’s business, or held for sale, lease or license. Elimination of uncertainty: A company must demonstrate it has attempted to eliminate uncertainty about the development or improvement of a product or process. Process of experimentation: A company must demonstrate, through modeling, simulation, systematic trial and error, or other methods, that is has evaluated alternatives for achieving the desired result. Technological in nature: The process of experimentation must rely on the principles of engineering, physics, chemistry, biology, computer science, or similar natural or hard sciences.

In general, any company can benefit from the credit. Historically, the top five industries have been in manufacturing (making up 60-70% of the total credits claimed), information technologies (15-20%), professional, scientific, and technical services (10-15%) wholesale and retail (5-10%), and financial and insurances (5%). There are millions of dollars of credits claimed by other industries such as health, entertainment, natural resources, hospitality, construction, and transportation.

Startups can apply for federal R&D credits against up to $250,000 of their payroll taxes in five separate taxable years. To qualify, they must have gross receipts of less than $5 million for the tax year AND have no gross receipts for any tax year of the four preceding taxable years.

The federal credit is reported on an IRS form 6765 with your timely-filed federal income tax return for the year in which the qualified expenses occurred. The share of credits can be reported as a pass-through for entities who are taxed as such.

There are two different types of eligible spending, qualified research expenses (QREs) and basic research payments (BRPs). Since 99% of expenses used for R&D credits are QREs, these become our focus. The QREs must be used directly in these qualified activities. They consist of taxable wages, costs of supplies, rental or lease of computers (including payments to cloud service providers), and 65% to 100% of contracted research expenses.