R&D tax credits have been gaining in popularity in recent years. It is a great way for business owners to take advantage of this little known tax strategy.
But how do you do the calculation? Many think the calculation is complex, so we will try to break it down into a few easy steps.
Table of contents
- What is the regular research credit calculation (“RRC”) method?
- What is the alternative simplified credit calculation (“ASC”) method?
- How to calculate the R&D credit under the alternative simplified credit method?
- R&D Tax Credit Example
- How to choose between the ASC and the RRC method?
- A close comparison of the RRC and ASC R&D tax credit calculations
- Final Thoughts
Eligibility for the R&D tax credit?
First, we have some good news. The R&D tax credit is available to virtually any industry or business structure that pays certain costs while developing new or improved products or processes. Many folks believe the credit is available to just certain business types.
R&D tax credits can be used to offset the costs relating to research and experimentation for the following:
- processes
- products
- invention
- techniques
- software
- formulas
An easy, four-part test will help the company determine whether the business might qualify for the credit.
- Eliminate uncertainty. The research goal was to eliminate the uncertainty surrounding the development or significant improvement of a process or product. Changes made for aesthetic purposes alone will not qualify.
- Process of experimentation. The research activities should have some investigation that reaches technical certainty. Technical certainty would include simulation, modeling, systematic trial and error, or various other methods.
- Technological in nature. The research procedures must be based on hard science, such as computer science, engineering, chemistry, physics, or biology.
- Qualified purpose. The goal of the R&D activity was to create a new or improved process or product. The desired result is to increase the performance, quality, reliability, or function.
There are a couple of options that business owners have when calculating the R&D tax credit. The two options available are: (1) the Regular Research Credit (“RRC”) method; or (2) the Alternative Simplified Credit (“ASC”).
What is the regular research credit calculation (“RRC”) method?
The RRC method allows the company a 20% credit of the current year eligible research expenses over a base amount. This method is challenging because it requires the company to use the average annual qualified expenditures over the prior four-year period.
What is the alternative simplified credit calculation (“ASC”) method?
The ASC method can be a little easier to calculate compared to the RRC method. The ASC method does not require the company to use gross receipts as a component of the R&D tax credit calculation. Instead, it looks at qualified research expenses over the prior three-year time period.
Suppose the company did not do a good job of maintaining accounting records and supporting documentation. In that case, it might not be possible to accurately calculate the base amount needed to determine R&D tax credit eligibility.
But don’t lose hope. Certain businesses who may be unable to qualify under the RRC method may actually be eligible under the ASC method.
How to calculate the R&D credit under the alternative simplified credit method?
Let’s break down the calculation. The ASC calculation is based on 14% of qualified research expenditures incurred in the current tax year that are above 50% of the average qualified research expenditures in the prior three years.
If the company had no qualified research expenditures during any of the prior three years, the credit then uses 6% of the qualified research expenditures in the current year.
Under the approach, there is a basic four-step calculation process as follows:
How to calculate the R&D tax credit:
- Calculate the 3 year average
This is usually the most challenging part of the calculation. It can be difficult reviewing your accounting records to properly identify any transaction that would qualify. Once you have analyzed your qualified research expenditures for the prior three years then just do a simple average calculation.
- Multiply by 50%
This is the easiest part of the calculation. Multiply the average qualified research expenditures for the three years by 50%. It doesn’t take a math whiz to do this part.
- Subtract half
Make sure you have determined your qualified research expenses for the current year. Subtract half of the three-year average that was calculated in step #2 from the current year expenditures.
- Multiply by the applicable credit rate
You are almost done. Multiply the number in step #3 by the credit rate of 14%.
R&D Tax Credit Example
Let’s take a look at an example of how the calculation works. Let’s assume a company has analyzed its historical research expenditures and has determined the following:
| Year | Expenses |
|---|---|
| 2017 | $50,000 |
| 2018 | $60,500 |
| 2019 | $80,500 |
| 2020 | $99,000 |
| 2021 | $95,000 |
With the current year 2021, the average for the previous three-year period (2018-2020) would be $240,000/3=$80,000.
The next step is easy. You take 50% (or half) of this amount, which is $40,000.
The next step takes the current year expenditures of $95,000 and subtracts the $40,000 three-year average for a net of $55,000.
In the final step, the business owner will calculate the ASC by multiplying $55,000 by 14% for a final credit of $7,700.
Summary of the ASC Method Calculation:
| Calculation | Amount |
|---|---|
| Three year average expenditures | $80,000 |
| 50% of the three year average | $40,000 |
| Current expenditures minus three year average | $55,000 |
| Credit: $55,000 x 14% | $7,700 |
How to choose between the ASC and the RRC method?
Determining the best method to use can be challenging. If R&D expenditures are declining, many businesses will not qualify under the RRC method. However, the ASC approach is often still a viable solution.
Some companies might have developed improved processes that have resulted in lower overall R&D costs. This can hurt the ratio of R&D expenditures relative to gross expenditures. As such, the company might not meet the “base period” requirement and be unable to claim the credit using the RRC method.
As a general rule, each company should analyze both the ASC method and the RRC method as applicable and use the approach that yields the highest credit.
A close comparison of the RRC and ASC R&D tax credit calculations
When you take a close look at the different calculations, a few things become evident:
1) the RRC method can result in a larger credit in situations where the base amount is very low. The RRC approach is often beneficial when the business is a startup or has recently instigated an R&D expenditure program.
2) the ASC calculation is generally easy to calculate compared to the RRC approach. The RRC method requires more diligence in gathering and analyzing historical data. Many business owners can’t tackle the analysis, and the burden can be expensive and time-consuming.
Let’s compare the two methods. Consider the sample ASC calculation above and compare it to the RRC calculation using the numbers below:
Current year expenditures = $95,000
Fixed base percentage = 3%
Average annual expenditures over four years $150,000
The base amount is determined by multiplying the fixed-base percentage by the average gross expenditures over the prior four years. This resulting amount is $4,500.
Base amount = $4,500
Greater of the base amount or 50% $????
Excess of current expenditures over the base amount $????
multiplied by the 20% credit rate = $14,000
Based on the above, a comparison of the two methods results in the following:
the RRC method vs. the ASC qualified tax credit amount would be as follows:
RRC R&D Tax Credit Calculation = $18,000
ASC R&D Tax Credit Calculation = $15,000
Final Thoughts
R&D tax credits can result in substantial tax savings for many business owners. But it can be challenging to navigate the two different calculation methods and determine which one will yield the best result.
Gathering the required information can be worth the work in many situations. Just make sure you apply the calculation accurately and timely.