We talk quite a bit about the R&D tax credit, and for good reason. This provision from Section 41 of the Internal Revenue Code (IRC) offers a major benefit to companies of all sizes. Large corporations can use it to offset their income tax liability. Even pre-profit companies can benefit, tapping this credit to reduce their payroll taxes by up to $500,000.
In short, if your company does any R&D, you want to know how those expenses can help shrink your tax bill.
We’ve talked extensively about maximizing this credit, passing its four-part test, and applying it to your payroll taxes. Today, we want to get a little more granular and talk about the actual calculations laid out in IRC § 41. You can calculate your R&D credit in one of two ways.
First, know your qualified research expenses (QREs)
Whichever calculation method you use, the size of the credit you can claim depends directly on the total amount of your business’s qualified research expenses (QREs). Your accountant can help you figure out what expenses apply here.
As a general rule, though, you can count the money your company pays toward:
- Wages for an employee engaged in qualified research activities (including time spent supervising those activities)
- Supplies for qualified research
- The cost of leasing or renting computers you use in the qualified research
Contract research expenses can also count if they’re domestic and meet some other parameters. The amount you paid a qualified research consortium can add to your QRE total, for example.
Once you know your total QREs for the taxable period, you use that amount to determine how much you can slash from your tax bill.
Calculation option 1: The traditional method
Using the traditional method, your R&D credit equals 20% of the QREs that exceed your base amount.
That makes it sound somewhat simple, but the “base amount” piece adds a fair bit of complexity. To make calculating it easier, let’s break it down step by step.
Step 1: Figure out your fixed-base percentage (FBP)
If your company was founded in 1984 or later, § 41 treats you as a startup and the rules laid out in §41(c)(3)(B) apply. It lays out a phased plan for your FBP, starting with the first year you have QREs (not the year of your founding).
| Year | FBP |
| 1–5 | 3% |
| 6 | (Aggregate QREs for years 4 and 5 ÷ aggregate gross receipts for those years) × 1/6 |
| 7 | (Aggregate QREs for years 5 and 6 ÷ aggregate gross receipts for those years) × 1/3 |
| 8 | (Aggregate QREs for years 5, 6, and 7 ÷ aggregate gross receipts for those years) × 1/2 |
| 9 | (Aggregate QREs for years 5, 6, 7, and 8 ÷ aggregate gross receipts for those years) × 2/3 |
| 10 | (Aggregate QREs for years 5, 6, 7, 8, and 9 ÷ aggregate gross receipts for those years) × 5/6 |
| Year 11 on | Aggregate QREs for any five years you choose between years 5 and 10 ÷ aggregate gross receipts for those chosen five years, not to exceed 16% |
From year 11 on, you lock in with the same FBP. As a result, you want to choose whichever five years from the six-year period of years 5–10 will give you the lowest FBP. That results in a lower base amount, which helps you get a bigger credit.
Step 2: Figure out your average gross receipts
This step’s a lot easier, fortunately. You just need to total up your annual gross receipts for the past four years, then divide that by four.
Step 3: Calculate your base amount
Again, this is much easier. Your base amount = your fixed-base percentage × your average gross receipts.
Step 4: Calculate your R&D credit
Now that we know your base amount, we can circle back. Remember, your R&D credit equals 20% of the QREs over your base amount. So the calculation here is:
R&D Credit = (QREs – Base Amount) × 0.2
Obviously, this calculation method requires a fair bit of work. Fortunately, the IRS offers a different way to crunch the numbers.
Calculation option 2: Use the alternative simplified credit (ASC)
Your company can elect to take the alternative simplified credit (ASC). To crunch the numbers in this way, you:
- Calculate your average QREs for the past three years
- Multiply your average QRE result by 50%
- Subtract the result from your current year QREs
- Multiply the result by 14%
To put that all into one calculation:
ASC = (Current year QREs – [(Total QREs in the prior three years ÷ 3) × 0.5]) × 0.14
Applying the resulting credit to your taxes
Once you know how much you can claim with your company’s R&D credit, the next step is to actually apply that money to your tax bill. Some companies have two options here:
- Use it to reduce your federal income tax liability by the resulting credit amount.
- Use it to offset payroll taxes.
You can only tap option 2 if you’re a qualifying small business. That means your company is younger than five years old and has less than $5 million in annual gross receipts.
If you fit into that category, you can use the R&D credit to reduce your payroll taxes by up to $500,000. That means you can take half a million off the 6.2% you pay for your employee’s Social Security taxes and the 1.45% you pay for their Medicare taxes.
To tap into these savings for income or payroll taxes, your company needs to file Form 6765 (the R&D credit form) and Form 3800 (the general business credit form). If you’re going to use the ASC calculation, you need to elect to do that on Section B of Form 6765.
If this sounds like a lot of work, it’s because it is. Fortunately, our team specializes in helping companies calculate their R&D tax credit using the most advantageous method, then apply it in similarly strategic ways. To talk with us about the best option for your company, book some time with us today.
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