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How to Claim R&D Tax Credits for Small Businesses

R&D Tax Credits for Small Businesses
Lauren Ward
Lauren WardUpdated July 6, 2023
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Editor’s note: Lantern by SoFi seeks to provide content that is objective, independent and accurate. Writers are separate from our business operation and do not receive direct compensation from advertisers or partners. Read more about our Editorial Guidelines and How We Make Money.
The U.S. government recognizes that, if the American economy is going to continue to grow and evolve, small business owners need to invest in research and development (R&D). That’s why, to encourage small business owners, the IRS offers R&D tax credits. A tax credit directly lowers a company’s tax bill, which means it can offer significant cash savings for eligible companies. There are a few things to know about the small business research and development tax credit. If you’re thinking about pursuing it for tax season, here’s what you need to know.  

What Is the Research and Development Tax Credit Program?

R&D, which stands for research and development, takes place whenever a company puts money into developing new products. When a new product is developed, a significant amount of testing and experimentation needs to take place to ensure it’s safe, effective, and user friendly. Ensuring all of these often costs a lot of money, which is where the tax credit for research and development comes in. The R&D tax credit is meant to further motivate American businesses (both large and small) to invest in their own R&D. With a lower tax liability because of the tax credit, the hope is that companies will continue to innovate and push the envelope. If they were to stop being creative, outside economies could potentially swoop in and steal the limelight. To put it in perspective, it’s estimated that Apple worked on fine-tuning the Airpods for at least five years, if not longer, which is a lot of time and money to devote to a product not actively bringing in income. While we don’t know what amount Apple spent solely to develop the Airpods, we do know that from 2011 to 2016, Apple spent $34.45 billion on R&D. Clearly all of those resources were used wisely because in 2021, Apple made $12.1 billion from the sales of Airpods alone. Recommended: Is a Business Loan Tax Deductible?

Main Benefits of R&D Credits

The biggest advantage to R&D credits is that they save taxpayers money by directly lowering their tax bill. Companies taking advantage of these tax savings can use that money to further fund their R&D department. Other indirect benefits include job creation and economic growth. With more people working and spending money, the American economy is itself strengthened through R&D investments.  Keep in mind that there are many ways to lower your tax liability outside of the R&D tax credit. In fact, there are a total of 19 small business tax deductions you may be eligible for. Recommended: Alternative Small Business Loan Options

What Documentation Is Needed for R&D Tax Credits

Wondering how to claim R&D tax credit? To claim the research and development tax credit, taxpayers should keep detailed records of all expenses related to their R&D costs. While every expense may not be fully covered, it’s important to keep the appropriate documentation just in case you happen to be audited.Once you have nailed down which expenses can be included with the R&D tax credit, you need to list them on Form 6765. After this form is completed, it must be submitted with the company’s tax return and filed by the appropriate date.    Recommended: Here’s How Long You Should Keep Your Business Tax Returns

How to Increase Your Research Tax Credits

To increase your R&D tax credit, you can claim tax credits for R&D expenses that increase year to year. In order to this, you must be able to adequately prove those costs have, in fact, risen. Make sure you keep adequate receipts and documentation that proves your case should the IRS question anything.Another thing to consider is that you can claim R&D tax credits for up to three years from the current tax year. Plus, if you don’t have a tax liability, the tax credit can be put towards payroll taxesNext, look at eligible expenses covered by the R&D tax credit. There may be expenses you could take advantage of that you’re not currently using.Lastly, consider that the R&D tax credit is also often available at the state level. Each state has different rules and regulations, but you may be able to save even more.Recommended: Comparing Amortization and Depreciation

What Types of Expenses Are Covered

The R&D tax credit covers a few expenses, the biggest of which are the salaries and wages of any employees you hire to conduct the research, as well as any third party companies you pay on a contract-to-contract basis. Plus, if your company is successful in developing a new product, the R&D tax credit will even help cover the costs of developing a new patent. The tax credit will also pay for any supplies needed to conduct the research. Whether it’s new machinery, equipment, computers, or raw goods. It will even pay the rent and utilities for additional spaces needed to conduct the research.Recommended: Equipment Financing: What It Is and Tips for Applying

What is Excluded from R&D Tax Credits

The aim of the R&D tax credit is to increase innovation within U.S. companies. Therefore, the tax credit will not pay for the following: 
  • Duplication of a product that is already on the market
  • R&D costs incurred after the product has gone into mass production 
  • Any research already funded (either by an individual, organization, or grant) 
  • Any research revolving around social sciences, arts, or humanities
  • Fixed assets/ capital assets
  • Any process or product that would be for internal use only
  • Market research
  • Research conducted outside of the U.S. or a U.S. territory
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How to Calculate Research and Development Credits

To calculate the R&D tax credit, your first step is to identify which expenses are eligible. The IRS refers to these expenses as qualified research expenses (aka QREs), and goes into great detail about what qualifies and what doesn’t online.Next, calculate your base amount, which is done by averaging your expenses from the previous three years and dividing by two. Doing this will give you your credit base. If this is your first year, you can use a reduced base amount while you are funding R&D for a particular product. Once you have your base amount, subtract your credit base from your R&D expenses for this year. Lastly, multiply the previous number by 14%. The final product is what you can write off via the R&D tax credit.Recommended: Small Business Loans for Sole Proprietors 

Industry Examples of Research and Development Credits

In 2019, Inuit Inc. utilized the R&D tax credit to receive a credit of $48 million (its total R&D expenses were $1.2 billion). It also received R&D tax credits from the state of California that carried forward from previous years in the amount of $129 million.  In that same year, Apple spent approximately $16.2 billion on research and development, but received a tax credit of $548 million.  As can be seen, the R&D tax credit is not something that should be ignored. When utilized correctly, it can provide significant savings. Recommended: Guide to Small Business Grants and Where to Find Them

The Takeaway

The R&D tax credit can offer significant savings for eligible companies and expenses. Keep adequate notes and documentation about all research and development expenses so you can fully take advantage of the tax credit. Also, don’t forget that you can amend previous tax returns for up to three years should you not have learned about the R&D tax credit until recently.  Need some additional financing to fund upcoming R&D? Explore loan offers through Lantern Credit for funding that could come as soon as next day.

Frequently Asked Questions

When do you claim R&D tax credits?
Can you claim from previous years?
Is there a cut off for companies larger than a small business?
Photo credit: iStock/Khanchit Khirisutchalual

About the Author

Lauren Ward

Lauren Ward

Lauren Ward is a personal finance expert with nearly a decade of experience writing online content. Her work has appeared on websites such as MSN, Time, and Bankrate. Lauren writes on a variety of personal finance topics for SoFi, including credit and banking.
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