In today’s world, emerging technology companies are facing a barrage of challenges, including, finding funding, navigating supply chain issues, defending against increased security threats, and accelerating the pace of technological advancement.
While the threats to innovation are numerous, there is an often-overlooked incentive for U.S. companies which can provide a key funding opportunity.
The R&D Tax Credit, formally known as the Credit for Increasing Research Activities, was first enacted in 1981 as part of the Economic Recovery and Tax Act with the goal of incentivizing innovation and retaining top talent in the U.S. This was a temporary measure, re-enacted for decades until it was finally made permanent with the passing of the Protecting Americans from Tax Hikes Act in 2015. Although the name of the credit sounds like something that should be reserved for scientists wearing white lab coats and goggles, taxpayers from all industries may be eligible if they meet the following requirements:
- Permitted Purpose: The activity must be related to the development or improvement of the function, performance, reliability, or quality of a qualified business component – product, process, technique, formula, invention, or computer software.
- Technical in Nature: The activity must fundamentally rely upon principles of “hard sciences” to qualify. Examples include computer science, engineering, physics, materials science, or biology.
- Elimination of Uncertainty: The activity must be intended to eliminate technical uncertainty related to the capability or method to develop or improve a business component, or to determine the final design of a business component.
- Process of Experimentation: Substantial activity must contain elements of a process of experimentation in which one or more alternatives are evaluated to eliminate the technical uncertainty.
If a taxpayer is conducting activities that meet the criteria, then certain expenses for those activities can be used to calculate an R&D tax credit. The primary expenses that can be qualified for the R&D credit are wages, supplies, contract research expenses, and rental or lease of computer costs.
Due to the rapid evolution of the technology industry, businesses are constantly working to push the boundaries of innovation. At every stage of the innovation process, companies encounter technical challenges related to developing new or improved products, software, and production processes. In recent years, areas such as software development, cloud technology, intelligent operations, and automation have seen vast growth in development efforts. Examples of development efforts that may meet the threshold for R&D include, but are not limited to, developing or improving algorithms for enhancing computer processes, artificial intelligence advancements, integration of simulation and cloud-based solutions, custom enterprise platform integration, and increased use of robotics and motion control technologies.
Along with innovative emerging technology projects with an external focus, taxpayers may also be investing capital in internal use software (“IUS”) efforts. In October 2016, Treasury Decision 9786 clarified the definition of IUS. IUS can be software that enables a company to interact with third parties, software for financial management functions, software for human resource management functions, and software for support service functions. The R&D credit for IUS can apply to taxpayers developing software from the ground up; however, the credit can also apply to taxpayers that are improving purchased software through the addition of new features or functionality. IUS projects must meet a heightened test for qualification that proves that the software is: (1) Innovative, (2) Involves Significant Economic Risk, and (3) Not Commercially Available.
New businesses and start-up companies may be hesitant to claim an R&D benefit because they do not have tax liability to offset with a non-refundable credit. However, with the passage of the PATH Act in 2015, qualified small businesses – with fewer than 5 years of gross receipts and less than $5M in gross receipts annually – may elect to apply up to $250,000 of their R&D tax credit to offset the employer portion of Social Security tax liability on an originally filed return. This option has become even more lucrative with the passage of the Inflation Reduction Act. For tax years beginning after December 31, 2022, eligible businesses will be able to apply an additional $250,000 to offset Medicare tax liability. This brings the total maximum credit potential for eligible small business to $500,000 annually.
In addition to Federal R&D credits, many states offer their own unique R&D credit benefits, which range in credit rate, eligibility requirements, and application / filing processes. Ohio’s R&D benefit is a non-refundable credit which equals 7% of eligible Ohio based expenses in excess of a taxpayer’s base amount and is utilized against the Commercial Activity Tax (“CAT”). Pennsylvania has an application process for filing a tentative R&D credit claim. The Pennsylvania tentative R&D benefit equals 10% (large business) or 20% (small business) of Pennsylvania based research expenses in excess of a taxpayer’s base amount. Pennsylvania also provides for an R&D tax credit assignment program where taxpayers are able to apply for approval to sell their previously awarded R&D tax credits, which provides a great option for taxpayers with low or no tax liability.
Although claiming the credit requires time, resources, and expertise, the R&D tax credit provides both monetary and operational benefits to eligible companies. If you have any questions with respect to the R&D tax credit and qualification, contact a member of our Credits & Incentives team for further information.
Related Articles
This article is part of a series exploring the complex business challenges startup and early-stage companies may encounter as they grow. Additional articles include:
- Top Accounting Advisory Needs for Emerging Technology Companies
- Best Practices After an Equity Raise for Start-Up Companies
- Five Tax Considerations for Start-up Companies
- Understanding Leases In Technology Arrangements
- Pros and Cons of IPO for Early-stage Companies
- Compilation, Review or Audit? What Early-Stage Companies Should Know
About Schneider Downs Emerging Technology Services
Schneider Downs understands the ever-changing landscape and business challenges facing companies focused on emerging technologies and software. Our clients represent a wide range of organizations, from emerging growth companies to large mature companies, and we are well versed in the unique challenges they face. Our team of seasoned professionals has experience working with emerging technology companies in all phases of their evolution.
To learn more, visit our Emerging Technology page
