If your business has research and development expenditures, you may qualify to claim the federal income tax credit for research activities. The credit applies to research and experimental expenditures according to section 174 of the Internal Revenue Code. The research must be undertaken to discover information that is technological in nature. The application of that information must be intended to develop a new or improved business component. Substantially all the research activities must be elements of an experimentation process relating to a new or improved function, performance, reliability or quality.
As pointed out by Daniel Karnis, CPA, in the Journal of Accountancy, this IRS definition of research activities would generally include developing new or improved products, processes or formulas; developing prototypes or models; developing or applying for patents; developing new technology, including software technologies; building or improving manufacturing facilities; streamlining processes; and environmental and certification testing. Karnis points out that the definition of research and experimental expenditures has been the subject of extensive interpretation by the IRS and the courts.
The credit is based on increases in research expenditures, so it is intended to provide an incentive for continually increasing investments in research. There are two methods for calculating the credit, which is claimed on Form 6765, Credit for Increasing Research Activities: the regular credit and the alternative simplified credit.
The regular credit is calculated as a percentage of the increase in research expenditures in the current year over a base amount that is calculated for prior years that go back to 1984 or by another method for companies that started up later. The alternative simplified credit is a percentage of qualified research expenditures over 50% of the average annual qualified research expenditures in the three preceding tax years. If your business had no research expenditures in those three preceding years, you could still take a credit using the simplified method for your expenditures in the current year.
As indicated by Karen E. Klein in an article on Bloomberg Businessweek, the credit for research expenditures is not just for large companies. Small and medium-sized companies that have qualified research activities can also qualify for the credit. Research and development expenditures incurred by start-up companies in years when they have no income can be carried forward and used to offset taxes in future years when there are profits. And the research credit can be transferred in an acquisition.
Peter T. Beach and Christopher J. Hamlen, in an article in the New Hampshire Bar Journal explain that the credit for research activities reduces the amount you can claim as a deduction for research and experimental expenditures. For example, if you had qualified research costs of $10,000 and claim a credit of $2,000, your deduction would be reduced to $8,000.
Daniel Karnis, CPA, Navigating the R&D Tax Credit, Journal of Accountancy
Form 6765, Credit for Increasing Research Activities, IRS
Karen E. Klein, The R&D Tax Credit Explained for Small Business, Bloomberg Businessweek
Peter T. Beach and Christopher J. Hamlen, Federal Income Tax Treatment of the Development, Acquisition and Disposition of Intellectual Property, New Hampshire Bar Journal