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Calculating the R&D tax credit can be tricky, but choosing the right method could save you thousands in tax dollars.
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Unless you have previous experience with tax credits, understanding the research and development tax credit can seem impossible.
In this post, we’ll discuss everything you need to know about calculating the R&D tax credit, from the two methods available and when to use each, to what to do if you need extra help calculating and claiming the tax credit. Keep reading to learn how to calculate the R&D tax credit.
Table of Contents
The research and development tax credit (R&D credit) is a general business credit available to businesses that created or improved a product or process. Businesses that are eligible to receive the R&D credit must have participated in qualified R&D activities as outlined under Section 41 of the IRS Tax Code.
Qualified R&D expenses are used to calculate the credit, which is applied to federal income tax liability. In some cases, businesses may be able to apply the R&D credit to payroll taxes or Alternative Minimum Tax owed. Credits can also be carried forward for up to 20 years.
To be eligible for the R&D credit, businesses must have expenses that were incurred while performing qualified research and development. Qualified research must meet the four-part test of the IRS, which includes:
If all four conditions are met, the research is qualified and certain expenses associated with the project can be used to calculate the tax credit. These expenses include:
There are two different methods for calculating the R&D tax credit: the Regular Research Credit method (RRC) and the Alternative Simplified Credit method (ASC).
The RRC method (also known as the traditional method) allows businesses to claim 20% of qualified research expenses (QREs) over a base amount as a tax credit. This method may yield a higher tax credit, but it is more complex to calculate. This is because businesses will need to use the average annual gross R&D receipts for the past four years in order to calculate their tax credits. It becomes even more complex for businesses that were in operation prior to the 1990s, as additional information for these early years may also be required.
The ASC method is — as the name suggests — a simplified way to calculate the R&D tax credit. It doesn’t require annual gross receipts but instead uses qualified research expenses from the previous three years to determine eligibility and calculate the amount of the R&D credit.
The IRS recommends that taxpayers use both methods to calculate the R&D credit in order to see which yields the best tax benefits.
Don’t have time to calculate the R&D credit yourself? Work with a trusted R&D tax credit software company to make sure you get the most out of your tax credit.
The RRC method requires more information and involves more in-depth calculations. However, many businesses may find that the extra work is worth the effort when claiming the R&D tax credit. Here’s how to calculate the R&D credit using the RRC method.
To calculate the R&D credit using the RRC method, you’ll need to know your current year QREs. Gathering documentation that verifies these expenses is critical for accuracy. Some documentation that you may need includes:
You’ll also need to determine your average gross QRE receipts for the previous four years, so make sure you have documentation that helps you calculate this average.
As mentioned in step one, you will need the average of your QREs from the previous four years. Make sure to keep this number handy because you’ll need it later.
Let’s look at an example.
You’ve calculated your QREs and you have the following amounts:
To get the average, simply add together the totals from 2018 and 2021, then divide the total by 4.
($50,000 + $100,000 + $30,000 + $20,0000) / 4 = Average QREs
$200,000 / 4 = $50,000
In this example, the average QRE for the previous four years is $50,000.
The fixed base percentage is determined by whether you have an existing business or startup. According to the IRS, a startup company for the purposes of claiming the R&D tax credit either:
More details about the fixed base percentage can be found in the IRS Instructions for Form 6765. The fixed base percentage can never exceed 16%.
For the first five years beginning after 1993 for which a business has QREs, the fixed base percentage is 3%. We will be using that percentage for our example.
To calculate your base amount, multiply the fixed base percentage determined in step two by the average gross QREs from the previous four years. This is the amount that we calculated in the first step.
$50,000 X 0.03 = $1,500
The base amount is $1,500.
Put your other calculations aside for a moment, and let’s look at current QREs. In this step, you’ll multiply your current tax year’s QREs by 50%. In step one, our example shows that the current year’s QREs are $80,000.
$80,000 X 0.50 = $40,000
This calculation gives you a total of $40,000.
For this step, you will compare the base amount calculated in step three with the current year QRE calculation from step four. In our example, the base amount was $1,500. The current QREs as calculated in step four total $40,000. In this step, you’ll choose the greater of the two numbers. Still using our example, the greater of the two figures is $40,000. This is your minimum base amount.
Now, we will subtract the minimum base amount found in step five from the current year’s QREs. The minimum base amount from the previous step was $40,000, while the current QREs are $80,000.
$80,000 – $40,000 = $40,000
After performing this calculation, your total is $40,000.
Take the figure from the previous step and multiply it by 20%. This will give you the total amount of your R&D credit.
$40,000 X 0.20 = $8,000
In this example, your R&D credit would be $8,000.
The ASC method is slightly easier and requires less information than the RRC method. Here’s what you need to know about calculating the R&D credit using the ASC method.
To calculate the R&D credit using the ASC method, you’ll need to know your qualifying research expenses for the current year, as well as the previous three years. To ensure accuracy, you’ll need to gather your documentation. Now is a great time to do this, as you’ll be required to submit documentation to the IRS when you claim the credit on your income tax return. Your documentation may include things like:
Once you’ve gathered your documentation, calculate the QREs for each year.
If you didn’t have QREs during any of the three previous years, the calculations look a little different. Your credit will be equal to 6% of your current tax year’s QREs.
The next step is to calculate the average QREs for the previous three years. Let’s look at an example.
In the first step, you gathered your documentation and determined that your QREs for each year are as follows:
For this step, we’re going to focus on 2019 through 2021. To calculate the average, add together the QREs for each year, then divide the total by three.
($50,000 + $100,000 + $30,000) / 3 = Average QREs
$180,000 / 3 = $60,000
In this example, the three-year average is $60,000.
The next step is simple. Take the average from Step 2 and multiply it by 50%.
$60,000 X 0.50 = $30,000
In this example, our total is now $30,000. Remember this number as you move into the next step.
The next step is to subtract the Step 3 total from the current year’s QREs. As a reminder, the current year QREs as noted for this example in the first step is $50,000.
$50,000 – $30,000 = $20,000
Remember $20,000, as you’ll need it for the final step to calculate your R&D credit.
Finally, you’ll multiply the $20,000 you calculated in the previous step by 14%.
$20,000 X 0.014 = $2,800
Based on this example, your R&D tax credit is $2,800 using the ASC method.
As you can see from the examples provided above, using the RRC method was far more complex, but resulted in a higher tax credit. This isn’t the case for every business, but this is why it’s recommended to try both methods before filing your tax return.
Typically, startup businesses and businesses with recent R&D expenses will benefit the most from using the RRC method. However, one thing to note is that this method is more complicated and does require more information that may be difficult for your business to gather. However, if you have your records in order, it’s worth taking the time to do the math to determine if the RRC method yields better tax benefits.
The process of determining eligibility, calculating, and filing for the R&D credit is extremely complex. Business owners with no prior tax prep experience often find the process to be time-consuming and frustrating, but using the best R&D tax credit software can help.
There are some situations where calculating and claiming the credit can become even more confusing. This includes filing an amended return for claiming prior years’ credits, carrying forward credits from previous years, or applying a portion of the credit to payroll or AMT taxes. Add in potential penalties and interest from the IRS for errors on a tax return, and it’s easy to see why many business owners hire a professional to tackle this task.
If you have any questions about your eligibility, how to claim your credit, or how to calculate the amount of your credit, it’s best to at least consult with an expert who can offer guidance. CPAs, tax preparers, and businesses that specialize in business tax credits can all offer assistance with calculating and claiming your R&D credit. An added bonus is that these experts may offer additional benefits, such as helping your business identify other tax credits or providing support if you’re audited by the IRS.
Calculating the research and development tax credit isn’t necessarily a quick or easy process. However, businesses that engaged in qualified research will find it’s worth taking the time to gather necessary data and perform calculations for potentially huge tax-saving benefits. And if you don’t have the time or know-how to crunch the numbers yourselves, working with a reputable financial expert can help you get the tax credits you deserve.
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