How CPAs Can Maximize Clients’ Savings Through R&D Tax Credits
Businesses of all sizes can qualify for significant tax savings through research and development credits. Here are some tips for CPAs to consider.
By Michael Smith | Digital Exclusive – 2024
It's a common misconception that research and development (R&D) tax credits only apply to organizations engaged in cutting-edge scientific research. In reality, any business (of any size) investing time, effort, and resources into improving their products, processes, or solutions may be eligible for federal and state R&D tax credits—this applies across all industries, from manufacturing to software development.
Fortunately, certified public accountants (CPAs) are in a prime position to help their small- and medium-sized business (SMB) clients take advantage of the often-overlooked opportunities through R&D tax credits. As you work with your clients, here are some considerations that can significantly enhance the identification and utilization of these credits.
How the Federal R&D Tax Credit Works
The federal R&D tax credit, established in 1981 through the Economic Recovery Tax Act, aims to incentivize businesses to increase their investment in R&D. While initially a temporary measure, the credit was permanently extended through the Protecting Americans From Tax Hikes (PATH) Act of 2015.
The PATH Act allows qualified small businesses to apply the credit against alternative minimum tax and the employer's share of Social Security tax, which provides a significant cash-back benefit for businesses not paying income taxes. It offers a dollar-for-dollar reduction of a company’s tax liability based on qualified domestic expenses related to the design, development, or improvement of products, processes, techniques, formulas, or software. Typically, this equates to approximately 6% to 8% of the total qualified research expenditures. Unlike deductions, these credits directly reduce the tax bill, offering substantial financial benefits.
Activities that qualify for R&D tax credits may include:
- Development or improvement of products (tangible or intangible).
- Enhancement of processes (e.g., manufacturing and technical).
- Software development (for external or internal use).
- Creation of new formulas, techniques, or inventions.
Importantly, businesses of any size engaging in innovation to maintain competitiveness or expand their market share might qualify. Here are a couple of examples where R&D tax credits helped smaller businesses, for instance:
- A small machine shop in California with 10 employees and average annual revenue of $2 million identified $134,800 in federal and state R&D tax credits for activities between 2016-2019.
- A pest control company developed new internal-use software and secured $265,000 in R&D tax credits.
Tips for Claiming R&D Tax Credits
To claim a R&D tax credit, businesses must identify qualifying expenses and maintain appropriate documentation, per Internal Revenue Code (IRC) Section 41. This includes financial and business records, oral testimonies, and technical documents. The credit is claimed using Form 6765, which should be included with the taxpayer’s income tax return. Given a forthcoming revised Form 6765, a robust R&D plan can assist in achieving proper compliance and reporting. Additionally, conducting a comprehensive R&D study can help further determine eligibility and meet IRS substantiation and documentation requirements.
Businesses can claim credits through an original or amended return, and unutilized credits can be carried back one year or forwarded up to 20 years under general business credit carryover rules. Some businesses may also strategically elect to bank these credits for future high-tax events.
Illinois’ R&D Tax Credit Program
Illinois is one of many states that offer R&D tax credits similar to the federal R&D program. The Illinois research and development credit is a nonrefundable credit that may be claimed against Illinois corporate income tax liability for expenditures qualifying under IRC Section 41 that are attributable to research in Illinois, including wages for qualified services, cost of supplies, rental or lease costs of computers, and contract expenses. The credit equals 6.5% of qualifying expenditures. The number of qualifying expenditures is the sum of R&D expenditures incurred for the current taxable year, minus the sum of the average expenses for the three taxable years immediately preceding the taxable year for which the determination is being made.
Illinois’ R&D credit may not be claimed for:
- Surveys or studies.
- Duplication of an existing product or process.
- Research conducted after the beginning of commercial production.
- Adapting to an existing product or process to a particular customer’s need.
- Research in the social sciences, arts, or humanities.
- Research related to certain internal-use computer software.
In today’s uncertain economic climate, SMBs must innovate to stay competitive and grow revenues. If your clients are designing new products or processes, modifying their systems, or even supporting research in a partner company, they may be eligible for R&D tax credits. As CPAs, be sure your clients are aware of these tax-saving opportunities for efficiency and growth.
Michael Smith is a director of tax, strategic partnerships, and alliances at ADP.
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