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The R&D Tax Credit Explained for Small Business

Research and development tax credits are often overlooked by entrepreneurs, who assume they must have on-site laboratories or breakthrough research to claim the credits. Others fear they’ll face complex tax calculations or trigger an IRS audit. But small and midsize businesses that employ engineers or outsource product testing can claim R&D credits, says Sean Haggard, a CPA with Florida accounting firm Kaufman Rossin. The credits have become more attractive for small companies in recent years because they’ve been simplified, can be transferred in an acquisition, and can be taken retroactively, he says. And they are particularly good for startups, since R&D costs incurred in years when a company has no income can be carried forward to offset taxes on future profits. Haggard spoke recently to Smart Answers columnist Karen E. Klein; edited excerpts of their conversation follow.

Q: What is the research and development tax credit?

A: The rules were promulgated in 1981 to incentivize technological advances and the hiring of workers to perform R&D. The companies that receive the greatest dollar benefit of the R&D credit—80 percent—have $250 million or more in gross receipts, according to IRS statistics.

The cost of this credit in 2008 was substantial: $8 billion. That has grown from $5 billion in 2004, and those numbers just count C corporations. In 2006, the IRS broke out numbers to show that $388 million in R&D credit was claimed on individual tax returns, including pass-through income from smaller companies organized as S corps or partnerships.

Do you feel that the R&D credit is underutilized by small and midsize companies?

Small and midsize companies don’t know how to capture qualified research expenses and quantify them. Also, in most small companies, the R&D is heaviest up front, when they are developing products and services. Because their research costs decrease over time, it’s tougher for them to utilize the credit.

About 5,600 C corporations with less than $5 million in gross receipts claimed the R&D credit in 2008. These small companies received less than 7 percent of the $8 billion credit. Startups benefited on average of $151,000 per claim.

How would a small company claim an R&D tax credit?

We recommend that our clients use the alternative simplified credit process, known as ASC. The regular credit calculation is complicated and involves floating numbers and multiple worksheets. On Jan. 1, 2007, the ASC went into effect, which simplified matters a great deal and allows companies to calculate the credit based on their prior three years of R&D expenses incurred.

How does it work?

If you’re a startup and you don’t have research expenses for the previous three years, you can use 6 percent of your qualified research expenses to offset your tax liability, if you have any. If you don’t have tax liability, perhaps because you have no income as a startup, you can claim the credit prospectively and carry it forward into a year when you do owe taxes. The great thing is that there’s a 20-year carry-forward provision for this credit.

How would it work for a small company that is not a startup?

An existing company has to have qualified research expenses that exceed 50 percent of the average they’ve spent for the three preceding tax years. So if you spent an average of $10,000 annually over three years, you multiply that by 50 percent, and you’d get $5,000. Anything you spend above $5,000 this year, you can use as your credit base and take 14 percent of that as your tax credit. The 14 percent is for tax year 2011 and 2012.

Say your company spends $15,000 this tax year, and the average has been $10,000 annually. You’d have a $10,000 credit base amount and you’d multiply that by 14 percent to get $1,400 off your tax liability for 2011. It may be just a few thousand, but for small companies, that might be a lot of money.

What kinds of companies should investigate the R&D credit?

Tech companies, software developers, software-as-a-service companies, biotechnology companies, and anyone providing cloud-based technology or services. The rule of thumb is if you have an engineer on staff, you probably have research and development expenses you should be capturing. If you’re undertaking research that’s technological in nature, with a process of experimentation to eliminate uncertainty, you have qualified R&D expenses. Doing the research and filing for and obtaining a patent is a qualified R&D expense.

Does filing an R&D credit trigger an audit?

There are instances when the IRS comes in and scrutinizes returns over this credit. Under this Administration, we’ve seen increased scrutiny, but it’s not on the small corporations—it’s on that 80 percent that get the biggest benefit.

How does a company go about properly documenting its research and development expenses?

[Documentation] should be gathered while you’re actually doing [the research], even if you’re building something in a garage without a formal R&D plan. You want to keep all the diagrams you make and all the schematics, whether they are on paper or written on a napkin. Keep time sheets for anyone doing research, even if they are salaried, and note what they are working on and when. If you can document that 80 percent of a person’s activity is qualified research and development, you can utilize 100 percent of their wages for the credit.

How do these credits make mergers and acquisitions more attractive?

Because the credits can be claimed in one year and taken in another year, they can be transferred to new ownership. The credits also legitimize a company’s technology. A lot of small companies claim the credit every year because they are looking to be acquired by a larger corporation, and if they have R&D credits on their books it proves they have technology someone else is likely to want.

Klein is a Los Angeles-based writer who covers entrepreneurship and small-business issues.

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