The R&D Tax Credit, established in 1981, allows businesses to reduce income tax liability or claim refunds for taxes paid over the past three years. Many states offer similar credits. The credit’s eligibility was expanded in 2015 through the PATH Act, making more businesses, especially small ones, eligible for benefits like the Payroll Tax Credit to offset payroll tax liabilities. We’re here to help address your frequently asked questions!
Can you stack the Puerto Rico Benefit and the US Benefit?
While it is rare for Puerto Rico-based companies to be paying significant Federal income tax, claiming both the Federal and Puerto Rico R&D Credits is possible. For the Federal credit under section 41, work conducted in Puerto Rico and other U.S. territories is deemed as U.S.-located. The Puerto Rico credit is currently based on PR Act 52 and has several other requirements, including that a company must apply for a Certificate of Compliance from the DEDC. Ultimately, the PR tax credit may be worth up to 50% for all qualifying R&D expenses in PR.
What are the documentation requirements for claiming R&D on amended returns?
When claiming the R&D Tax Credit on an amended return filing, the IRS requires the taxpayer to attach a statement within the filing that describes each business component and the information that the taxpayer sought to uncover within each business component.
What happens if you have been claiming the R&D credit but not capitalizing it?
For tax years 2022 and onward, we would recommend that returns were amended as soon as possible to properly categorize (i.e. capitalize and amortize) research costs, to correspond with the credit that was claimed. If not, the level of risk upon an audit would be extremely high, as R&D costs should have been capitalized. Roughly, for whatever credit amount was claimed, the expenses capitalized should have been about 10 times that amount; the underpayment of tax accordingly would likely be assessed, including penalties and compounded daily interest levied.
I am told many believe the 5 year amortization will be reversed. Any info on this?
There is some suggestion that the administration’s goal is to eventually repeal the requirement to capitalize research costs, but we would caution against assuming it will happen in the current tax year. Last year’s proposal to do so only passed the House of Representatives, and never came to fruition.
The next step in the budget reconciliation process is for the House and Senate to reconcile their respective budget resolutions, which can be accomplished by: conference committee, an exchange of amendments or one chamber adopting the budget resolution passed by the other without any changes. Once the House and Senate committees agree on a common budget resolution, a resolution will be sent to their respective floors for a vote.
We do research on coverage of telecom companies in rural areas. Does this in cover in this tax?
If we are assuming correctly that by “research on coverage of telecom companies” you mean that data analysis and root cause analysis are performed to evaluate telecom coverage in rural areas, then this would not be a qualified research activity for the purpose of the R&D Tax Credit. This activity would likely fail scrutiny as there is no design-related uncertainty associated with pure data and root cause analysis. To benefit from the R&D Tax Credit, the taxpayer must be creating or improving a process, product, technique, formula, software, or invention.
If the funds come from SBIR or other federal grants can you claim it?
No, SBIR or other grant funding wherein the exact research activities performed are described in the SOW and the grant funding is contingent upon these activities being conducted cannot be included in the R&D Tax Credit calculation. This is considered “funded research” and is explicitly disallowed by the IRS in determining the R&D Tax Credit.
What about research funds from private entities and Venture Capital?
Generally, funds from private entities and Venture Capital groups do not disqualify a company from claiming the R&D Tax Credit in the same way as grant funding. This is because these two sources of funding are going towards the business operations in general, and there are typically not stringent requirements as to how these funds are used. Grants fund very specific activities that are contractually obligated to be completed, whereas general business funding does not to the same extent fund specific research activities.
Can a SaaS company be registered in the US and Canada have R&D work done by an individual in Can while all product revenue in booked in the USA?
Because the R&D Tax Credit is an activity-based credit, the most important qualifying factor is where the physical research is taking place. If R&D is being done on Canadian soil, then those activities cannot be included in the R&D Tax Credit calculation. Please note, however, that foreign-based research costs incurred by U.S. entities must be capitalized and amortized over a 15-year period under Section 174.
We allocate other items such as travel, dues and subscription and shipping/postage to our R&D department. Are these expenses considered a section 174 expense?
Generally, Section 174 expenses are those that represent research and development costs in the experimental or laboratory sense, and include those incident to the development or improvement of a product (including pilot models, processes, formulas, inventions, techniques, patents, or similar property). Additionally, they include costs incurred ‘if they are for activities intended to discover information that would eliminate uncertainty’ concerning the development or improvement of a product. Notice 2023-63 includes travel costs as those that should be capitalized under Section 174 if necessary for the performance or direct support of research activities. Dues and subscriptions may also fit into this category if necessary for discovering information to eliminate uncertainty. Costs not treated as SRE (qualified under Section 174) expenditures include those ‘paid or incurred by general and administrative service departments or functions;’ shipping and postage would likely fall under this category, unless the R&D project itself involved new or improved packaging, for example.
Do patent costs and related legal costs need to be capitalized?
Yes, patent-related expenses and their associated legal costs are considered research costs under IRC § 174, and therefore must be capitalized and amortized over a 5-year period.
Can we claim credit on custom made to order prototype costs?
If your business is developing a prototype and orders that prototype from a manufacturer, these expenses may be included in the R&D Tax Credit calculation. Development of a prototype is a highly qualifying technical activity, and therefore any wages, third-party expenses, and materials used to develop the prototype may certainly be included in the R&D Tax Credit calculation.
How can Leyton Help?
Navigating the R&D Tax Credit can be time-intensive, complex, and difficult. Leyton’s engineers, tax professionals, and tax attorneys have extensive experience reviewing contracts, understanding research activities performed, and navigating the question of who may claim the R&D Tax Credit for qualified research activities. Working with a company like Leyton to evaluate your potential to claim the R&D Tax Credit can alleviate the heavy burden of contract review and ensure that you are following all relevant IRS regulations. Allow Leyton to be your one-stop-shop for specialty tax credits and incentives; contact Leyton’s experts to evaluate your potential tax savings today!
