How to determine your R&D Tax Credit eligibility?

If your company is in one of the qualifying industries listed above, then you likely conduct activity that will qualify in order to claim a state or federal research and development tax credit. However, qualifying R&D activity is just the beginning of the equation.

Once qualifying activity is identified and quantified, there are three ways to calculate the ideal credit amount. A company is eligible for the first method, the “regular base,” if it has been in business for many years and has business records to show for it. Otherwise, a “start up base” is used to calculate a taxpayer’s R&D credit. In newer companies, or companies with limited historical records, the Alternative Simplified Credit (ASC) can be used, which considers only the prior three years of operations to calculate credits. Eligibility for each of the calculation methods depends on several factors, and each taxpayer is responsible for choosing the method that best suits their operational record keeping and tax needs. Each of the above calculation methods will produce a different credit amount.

Once credits are properly qualified and calculated, taxpayers must properly file for them. There are certain elections to consider on tax returns, such as the 280c election and Eligible Small Business election. If your company is within its first years of operation, and under $50mm in gross receipts, then it may be eligible to use R&D credits against payroll taxes. This “start-up” provision was created beginning in the 2016 tax year, and can be used to offset up to $250,000 in payroll taxes annually. Otherwise, if a claimant is generating profit and paying income tax, the R&D credits will be used to offset income tax liability.

Credit usage should also be considered when assessing eligibility to claim a research tax credit. Each business entity type uses credits differently. For example, an S-Corp’s credits flow through to each shareholder of the corporation, whereas a C-Corp’s credits are utilized at the entity level. Therefore, each entity or shareholder’s tax position should be considered relative to the amount of R&D credits claimed. If a corporation or shareholder is in losses, credits may not be used in the tax year in which they are claimed. However, federal R&D credits, and many state R&D credits, can be carried forward for up to 20 years. Therefore, credit eligibility from a utilization standpoint should be considered from a cost/benefit standpoint to determine whether, and when, credit claims will provide actual realized benefit to a taxpayer.

Some flow through entities with many shareholders can generate credits, but the logistics and mechanics of how the credits will flow through to so many shareholders are prohibitively complex, and often prevent R&D credit claims.

Therefore, when determining eligibility for federal R&D tax credits, it is critical to consider qualifying activity, calculation methodology, tax position at the entity or shareholder level, and the effect of the various tax form elections available.

Some states, such as Virginia, have a limited pool of R&D funds that require taxpayers to apply and wait for state taxing authorities to award a portion of claimed credits to taxpayers. Most states allow for R&D credits to be carried forward for between three and twenty years, whereas federal credits have a R&D tax credit carry-forward period of 20 years. It is imperative to understand the nuances of each state’s R&D tax credit code prior to claiming and filing in that state.