U.S. businesses are big innovators, spending billions of dollars annually to create new technologies, medications and other developments. They are rewarded for their efforts by a federal tax credit. The research tax credit is designed to encourage businesses to increase their R&D activities year after year.
You don’t have to be a big drug manufacturer or a high-tech business to claim the credit, however. You can take it for research engaged in certain internal activities. For example, an appliance repair business in Georgia needed a more efficient way to manage paper invoices, work orders and parts inventory across three locations. The firm hired a local custom software developer to design and build the system. The result was a better way to track key business data, with some of the costs of development eligible for the R&D credit.
The basic research credit is 20 percent of research expenses over a base amount. In the government’s 2009 fiscal year, the credit amounted to an estimated $5.6 billion federal subsidy for research by private companies.
Here's what you need to know about the research credit.
1. No research credit. Technically, the credit expired at the end of 2011. However, it is likely that the credit will be extended for 2012, even retroactive to the start of this year. The credit was originally created by a 1981 tax act. Since then, it has been allowed to expire eight times and has been extended 13 times.
At the end of April, the House Subcommittee on Select Revenue Measures held hearings on “extender” legislation. A proposal was made at the hearings to make the research credit permanent. Both parties and the Administration support the continuation of the research credit.
2. Alternative simplified credit. The regular credit applies to increased expenditures over a base amount covering expenses going as far back as 1984 through 1988, or another period for companies that started more recently.
Some businesses, however, may benefit from another research credit option, called the alternative simplified credit. This is limited to 14 percent of qualified expenditures exceeding 50 percent of the average qualified expenditures during the three preceding taxable years. (Or, 6 percent if there were no qualified research expenses in any of the three preceding taxable years.)
This option helps companies that are just starting up and that engage in research activities. It’s also helpful for companies that don’t have the records for all the prior years that are needed to claim the regular research credit.
3. Credit not limited to products for market. Internal-use software development costs, such as those mentioned with the Georgia company, qualify as research expenses if the following three conditions are met:
- The software is innovative. It reduces cost, improves speed or makes other improvement that is substantial and economically significant.
- The software development involves significant economic risk. There are substantial resources devoted to development.
- The software is for internal use. This means it cannot be commercially available.
4. Part of general business credit. Even though you may be eligible for a research credit, the amount you can claim is limited by the general business credit. This is not a separate credit. It is an annual limitation on the total amount of the research credit along with many other business-related credits.
If the amount of the general business credit (including the research credit) exceeds the annual limit, the unused amount can be carried back one year and forward for up to 20 years to offset tax liability in these years. Thus, a current year’s credit could produce a tax refund for last year.
5. State research credits. The federal income tax credit may not be the only innovation incentive for your business. Check with your state for any research credits that may apply.
Work with your tax advisor to determine whether you have the type of innovation expenditures that may qualify you for a research credit. Find out what records you should keep to figure the credit. Also, monitor the progress in Congress to extend the credit or make it permanent.
To learn more about the credit, its background and how it compares with tax incentives from other countries, see Tax Incentives for Research, Experimentation and Innovation from the Joint Committee on Taxation.
Barbara Weltman is an attorney and a prolific author with such titles as J.K. Lasser’s Small Business Taxes and The Complete Idiot’s Guide to Starting a Home-Based Business. She is a professional advocate for small businesses and entrepreneurs and she publishes Idea of the Day and the monthly e-newsletter Big Ideas for Small Business. She is the host of Build Your Business radio. Follow her on Twitter @BarbaraWeltman.