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Research & Development Tax Credit
The Research & Development (R&D) tax credit rewards companies that dedicate resources to creating or improving products, processes or software. It’s also known as the Research Credit or the Research & Experimentation credit, and if your company develops new products, processes or software at any level, you may be eligible.
Unlike R&D deductions, R&D credits offer a dollar-for-dollar offset to corporate and individual federal and state income taxes. In fact, new opportunities for R&D credits on qualified research expenses (QREs) are always evolving as state and federal entities expand their programs to encourage advancements in a wide range of fields. You may even be able to claim credits for your company’s past research & development.
Moreover, due to recent legislation expanding the scope of the credit, for eligible taxpayers the R&D credit may be used to offset:
- → Regular tax
- → Payroll tax (employers portion) up to $250,000 for qualified small business for tax years beginning after December
- → Alternative minimum tax for eligible small businesses for tax years beginning after December 31, 2015
You may be surprised to learn how far-reaching the R&D tax credit is. Many eligible organizations don’t participate in the program because of these common misconceptions:
“Our company doesn’t conduct R&D activities”
- → I.R.C. § 41 rules are more inclusive than you may realize.
- → R&D tax credits are intended for research in the commercial environment (not the lab environment).
- → The credit includes product & process development activities if those activities satisfy the tax definition of R&D.
- → Credits are not limited to work done by your internal R&D group. Engineering, product development, product
management and R&D support groups may also qualify.
- → The R&D credit includes most new product, process, or software development if the activities undertaken on those
projects satisfy the tax definition of R&D.
“Our research is not new to the industry, let alone the world”
- → Any advancement has the potential to earn credits.
- → The R&D test is activity based. The level of technological advancement achieved is irrelevant so long as the
activities satisfy the tax definition of R&D. The work doesn’t have to be new to the market or industry, just to your
- → Substantial improvements of existing products, processes or software is not necessarily required.
“We don’t have documentation to support R&D tax credit"
- → There’s no requirement to document every project.
- → Recent case law regarding level of substantiation has been favorable to businesses.
- → Tax service provider methodology is critical in determining the level of substantiation required.
“Claiming credits will disrupt business operations”
- → It is not necessary to speak with every employee for whom R&D wage expenses are claimed.
- → 95% of employees will spend 45 or less minutes preparing for an R&D credit.
- → The methodology employed by the service provider must appropriately balance the need to substantiate the
credits claimed with any potential impact to business operations.
“Our research won’t qualify because of the way its funded”
- → Funding is just one aspect of determining eligibility.
- → Government contracts or research reimbursed by customers can qualify, depending on the rights and risks
detailed in your contract.
- → Contract terms should be vetted by qualified attorneys with specific experience in tax and contract law.
Qualifying for the R&D Credit
To qualify for an R&D credit, research has to fulfill four important requirements:
1. Permitted Purpose
- → Was your research related to a new or improved product, process, technique, invention, formula, or software?
- → Was the goal of your project to create or improve new functionality, reliability, quality or performance?
2. Technological in Nature
- → Does your research rely on principles of the physical sciences, biology, engineering or computer science?
3. Technical Uncertainty
- → Were there technical issues that the project team did not know how to resolve at the outset of the project?
- → Was the uncertainty or technical issue related to your capability to develop the product or process, the
methodology employed to achieve the desired result, or the appropriate design of the new product or process?
4. Process of Experimentation
- → Did you engage in activities that constitute elements of a process of experimentation or an evaluation of
alternatives to resolve the technical uncertainty?
- → Research credit made permanent
-      -The PATH Act of 2015 modifies and makes permanent the research credit
- → Payroll tax credit for research expenses
-      -For tax years beginning after December 2015, "qualified small businesses" may elect to apply a portion of its
research credit (capped at $250,000 against 6.2% payroll tax imposed on the employer's wage payments to
- → Research Credit may reduce Alternative Minimum Tax Liability (AMT)
-      -For tax years beginning after December 2015, "eligible small businesses" may use their R&D credits to offset AMT
For companies in the pharmaceutical industry, there is another federal tax credit designed to incentivize the development of drugs and biologics for rare diseases and disorders. Known as the "Orphan Drug Tax Credit," it provides a benefit of 50% of qualifying clinical testing expenses (QCTE).
The criteria for determining QCTE is the same 4-part test used for R&D tax credit purposes, with the additional requirement that these expenses must relate to the development of a drug or biologic product that has been granted orphan designation by the FDA. To qualify, both the drug and the disease or condition must be intended for the safe and effective treatment, diagnosis, or prevention of rare diseases and disorders that affect fewer than 200,000 people in the United States.
Generally, the same expenses may qualify under both the Orphan Drug and R&D tax credit programs, but a company cannot claim both credits for the same expense. Depending on the circumstances, taking one of the credits for an expense is more valuable than taking the other. Understanding how to maximize the benefit from both of them is critical to optimizing your reduction in taxes. Unlike R&D deductions, these credits offer a dollar-for-dollar offset to corporate federal and state income taxes.
Think you may qualify? Contact us to maximize your benefit from the R&D and Orphan Drug credits.