Industry Voice: Leveraging state and federal R&D tax credits

By Adam Farnsworth | Dec 04, 2020

As business owners, you invest your time, energy, and money into making a business grow, only to see 20, 30, or 40-plus percent of your profits taken by taxes: federal income tax, state income tax, payroll tax, sales tax, real estate taxes, franchise tax, etc. With so much to pay in taxes, it's time to get some of those tax dollars back in your own pocket for the work you are doing to improve your business. This is where research and development (R&D) tax credits enter the picture.

As a credit that is able to be utilized by a multitude of industries. Companies are able to claim tax credits for work you are most likely already doing. For example, take a start up that is making a new app, their focus is on development and ensuring the software interacts with other systems. Upon launching and bringing in the fruits of their labors, they are shocked when they need to use their funding to pay 20 percent in federal income tax and 5 percent state income tax. R&D tax credits can help to offset those liabilities.

Since 1981, Congress has used the federal tax R&D credit to incentivize companies to make their businesses bigger, better, faster, and stronger while performing the work within the United States. As such, Congress created the tax credit to reduce companies' tax liability. Companies are able to use the credit right away or institute a carry-forward of up to 20 years if the company is unable to take the credit in the current year. In addition, startup companies in their first five years may be able to utilize their credit against their payroll tax returns.

At the federal level, the credits are worth between 6 and 8 percent of qualified costs. States vary from having refundable credits (such as in Arizona), credits that can be applied to payroll (such as in Georgia), or multiple credits (such as in Utah). There are also some states that do not have a credit. At the federal level, there is no limit to the number of dollars available for the federal R&D tax credits, but some states limit the funding available and require various applications in order to claim state R&D credits.

There are two methods to compute the R&D tax credit at the federal level: the regular and alternative simplified methods. Each methodology seeks to determine if you are increasing your research efforts year over year. As such, in order to prepare for either methodology, it's necessary to gather the following documents to assist in the computation of your credit:

  • Prior four years of tax returns
  • Prior three years of W-2 Wages
  • Prior three years of trial balances

Note that if you are a startup and do not have three to four prior years of information, information is only required for years since inception.

The most advantageous part about R&D tax credits is the fact that they're incredibly broad in terms of what type of work qualifies. Your business does not need to be on the verge of inventing a car that flies or have a lab full of scientists working on a cure for cancer to receive funds (although those would certainly qualify). The R&D tax credit encompasses any company that is engaging in product or process development that is technological in nature, and includes the process of experimenting with overcoming capability or methodology uncertainty.

The best way to determine whether or not your business would qualify is to connect with an expert. If you are wondering whether you may have some qualifying activities, consult the four-part tax credit test and see if any of your projects check all four boxes:

Four part test

The R&D incentive is a way to lower your taxes, boost your profits and improve cash flow using a tax credit. The federal and state R&D tax credits are some of the most lucrative and usable credits available for companies.

Adam Farnsworth, founder of LEAF Specialty Tax Consultants, helps companies save big on R&D tax credits by lowering your taxes, boosting your profits, and improving cash flow.