written by Jay Logal and Jennifer Cochran
This is article number three in our series of Tax Credits. The first and second articles can be found here.
Code Section – 41
Expiration Date – 12/31/11 (expected to renew)
Allowable Entities – Individuals or any private or for-profit business
Form to Claim Credit – 6765
Type of Tax Offset – Regular federal tax, non-refundable
AMT Limitation – Yes
The Research and Experimentation Tax Credit rewards companies who invest resources in innovation and product & process improvements which help to expand our economy.
The R&E tax credit has been in existence since 1981, but changes in regulations in 2001 and 2003 have allowed for additional activities to qualify as research activities. Consequently, many companies that were not eligible in the past may now claim this federal tax credit. Companies may also file amended tax returns to obtain refunds of previously paid income taxes, and in some cases, may be able to recapture taxes paid up to four years ago.
The R&E tax credit is a wage-based tax credit available for the development or improvement of products, processes, techniques, formulas, inventions or software. In addition to qualified wages, companies may capture supply costs for prototypes, as well as 65 percent of contracted labor spent performing qualified research on behalf of the company.
Companies can benefit by both deducting the research expenditures and by claiming the credit. While the research expenditures are a reduction of taxable income, the R&E tax credit is a general business credit, and a dollar-for-dollar reduction of tax. Generally, companies must first use the credit to offset tax for the year the credit is generated, and if additional credit remains, the company may carry the credit back one previous tax year or forward to the next 20 years. However, the recently enacted Small Business Jobs Act of 2010 allows research credits earned in 2010 by eligible small businesses to be carried back up to five previous tax years and forward for the next 20 tax years.
The Federal R&E tax credit expires periodically, and Congress historically renews the R&E tax credit after its expiration. The current law allows taxpayers to claim Federal R&E tax credits for expenditures paid or incurred prior to December 31, 2011. Taxpayers may amend Federal tax returns to claim R&E tax credits in prior years and establish systems to claim R&E tax credits in the future.
There are four basic requirements for research activities to qualify:
- Qualified research activities are defined as the development or improvement to a business component, which is defined as a product, process, technique, formula, invention or software (including smart phone apps).
- The research must be technological in nature. That is, the process of experimentation used to discover the information fundamentally relies upon the physical or biological sciences, engineering or computer science. Furthermore, companies may use existing technologies and may rely upon existing principles to satisfy this requirement.
- The research must be intended to eliminate uncertainty concerning the development or improvement of a business component. Uncertainty exists if the capability or method for developing the business component is unknown, or if the appropriate design of the business component is unknown.
- Elimination of the technical uncertainty must be accomplished through a process of experimentation, including systematic trial and error, modeling or simulation.
In addition to these four basic requirements, the organization must bear the economic risk for this research. Documentation is the key to substantiating the R&E tax credit claim.
Eligible Industries May Include:
- Aerospace and Defense
- Agriculture and Farming
- Architectural and Engineering
- Boat Manufacturing
- Chemical Manufacturing
- Computer and Electronic Product Manufacturing
- Custom Manufacturing
- Dental Laboratories
- Design-Build Contracting
- Electrical Equipment and Component Manufacturing
- Energy and Utilities
- Food Processing
- High Tech
- Medical Device Manufacturing
- Metal Casting and Fabrication
- Oil and Gas
- Pharmaceutical and Biotech
- Plastics and Rubber Manufacturing
- Software Development
- Smart Phone App Development
- Tool and Die
- Transportation Equipment Manufacturing
Qualifying Activities May Include:
- Designing new products
- Developing new, improved or more reliable products, processes or formulas
- Developing prototypes
- Design tools, jigs, molds or dies
- Developing or applying for patents
- Performing certification testing
- Conducting testing of new concepts and technology
- Developing or improving production or manufacturing processes
- Improving or building new manufacturing facilities
- Expending resources on outside consultants or contractors to do any of the above-stated activities
Please contact us if you have any questions about R&E tax credits.