Research and development (“R&D”) expenses are generally capitalized; however, taxpayers may elect to currently deduct these expenses under §174 in the tax year in which paid or incurred, or amortize them over a period of not less than 60 months. Taxpayers may also elect to claim a nonrefundable tax credit under §41 for certain qualified research expenses paid incurred for qualified research. Taxpayers may claim either the deduction or the credit for a particular expense but not both, where unused credits can be carried back one tax year, and then forward 20 years under §39.
Section 41 generally defines qualified research expenses as:
- Supplies
- Contract research (payments to third party businesses)
- Basic research payments[(payments non-profits and institutions)
- Wages for in-house R&D activities (usually the majority of expenses eligible for the credit). This expense only qualifies if paid to an employees:
- engaging in qualified research
- directly supervising qualified research
- supporting qualified research
Subject to certain exclusions, §41 generally defines qualified research broadly:
- The activity must be to create new (or improve existing) functionality, performance, reliability, or quality of any taxpayer product, process, technique, invention, formula, etc. (a “Business Component”) used in the taxpayer’s trade or business.
- The intent must be to discover information eliminating uncertainty concerning the development or improvement of the Business Component.
- The process must be systematic process, generally using any method from the conventional scientific method to something as informal as trial and error process.
- The process must fundamentally rely on principles of the physical or biological sciences, engineering, or computer science.
The tax credit amount is calculated by using one of three methods:
- Traditional Credit Calculation – 20% of qualified research expenses exceeding a base amount
- Start-Up Credit Calculation – 20% of qualified research expenses exceeding a base amount
- Alternative Simplified Credit – 14% of qualified research expenses exceeding a base amount
Where, the base amount is the product of a fixed-base percentage and the taxpayer’s average annual gross receipts for the prior four tax years, provided that the base amount can never be below 50% of the current year’s qualified research expenses.
Note that effective for tax year 2016, qualified small businesses may use up to $250,000 of their research tax credits to offset a portion of their payroll taxes.