Key insights
- There are many major changes to know about the research and development (R&D) tax credit and deduction for 2024.
- Congress is considering a potential change to how research expenses are treated for tax purposes. While the Senate has yet to vote on the bill, the pending Tax Relief for American Families and Workers Act of 2024 would retroactively eliminate the capitalization requirement for domestic R&D expenses.
- The IRS has proposed a change to the Form 6765 — the form used to claim the credit — that will introduce a new layer of complexity and require detailed project information to substantiate claims.
Are you up on the latest R&D tax credit & deduction changes?
While the lucrative research and development (R&D) tax credit isn’t a new tax incentive, there are many new rules and benefits to be aware about.
Congress is considering a potential change to how research expenses are treated for tax purposes. Additionally, the IRS has proposed a change to the Form 6765 — which is used to claim the tax credit — that will introduce a new layer of complexity and require detailed project information to substantiate claims.
Claiming the R&D tax credit isn’t an easy process, but it can be a worthwhile one, as the credit directly reduce tax liability dollar-for-dollar, unlike deductions which only reduce taxable income.
Learn what you should know about the R&D tax credits and deductions for 2024 and how you should prepare for potential legislative and procedural changes.
Decoding R&D tax credit rules: A comprehensive overview
The R&D tax credit — a significant incentive for businesses engaged in research and development — has specific rules that must be adhered to for activities and expenses to qualify. It’s essential to know these to accurately determine eligibility. Central to these rules is the four-part test that includes:
- Permitted purpose,
- Technological in nature,
- Elimination of technical uncertainty, and
- Process of experimentation.
Activities not only should aim at developing new or improved business components but also must rely on hard sciences, such as chemistry or computer science. They also should address technical uncertainties regarding capability, methodology, and/or design and should involve an iterative process of testing hypotheses.
Considerations outside the four-part test
In addition to the four-part test, businesses must consider economic risk — who bear the research costs regardless of research success or failure. Additionally, having substantial rights in the developed product and restricting qualified activities to within the United States are crucial. Excluded activities — such as those in the social sciences, research after commercial production, and several others — do not qualify for the tax credit.
It's important to understand the breadth of costs that can be claimed under the R&D credit. These include wages, supplies, contract research, and cloud computing costs, among others. Notably, certain costs are specifically excluded from the credit.
The financial implications of the R&D tax credit are significant, with the average credit ranging from six to ten percent of the qualified costs. These credits directly reduce tax liability dollar-for-dollar, unlike deductions which only reduce taxable income.
A benefit for startup companies
Since 2016, qualified small businesses may apply up to $250,000 of their R&D credits against employer Social Security payroll taxes — a major benefit for cash flow-focused startups generating tax losses.
Beginning for the 2023 tax year, small businesses can now apply up to $500,000 of their R&D credits, and the credit can offset both employer Social Security and Medicare taxes, providing even more cash flow benefits to early-stage organizations investing in R&D.
R&D tax credits directly reduce tax liability dollar-for-dollar, unlike deductions which only reduce taxable income.
Proposed changes to Form 6765 and R&D tax credit claims
Recent procedural updates include significant changes proposed for the Form 6765, which is used to claim the federal R&D tax credit. The new form requires detailed information about business components and/or projects eligible for the R&D tax credit. Taxpayers will need to provide:
- A list of qualified R&D business components and projects;
- The amount of qualified research expenses claimed for each business component and project;
- Whether any acquisitions or dispositions occurred during the year; and
- Descriptions of the information sought to be discovered and alternatives evaluated in the process of experimentation for each business component and project.
This level of detail historically has not been required for the Form 6765, as it previously only called for quantitative data, such as costs and election choices. The IRS’s intention behind this change is to verify taxpayers fully understand and can substantiate their R&D credit claims. However, the increased reporting requirements may present a significant burden, particularly for companies with numerous R&D projects.
The increased reporting requirements may present a significant burden, particularly for companies with numerous R&D projects.
Expected effective date to changes to Form 6765
The proposed changes are expected to take effect for the 2024 tax year, providing taxpayers with some time to prepare. Taxpayers are advised to begin building comprehensive lists of R&D business components and projects and tracking time allocated to such, to be compliant with the form changes. Proactive steps taken now will ease the transition and readiness for the new reporting standards.
Understanding legal precedents in R&D tax credit claims
Recent court cases have emphasized the importance of proper documentation when claiming R&D tax credits. The cases of Little Sandy Coal vs. Commissioner, Moore vs. Commissioner, and Betz vs. Commissioner serve as critical reminders for businesses to maintain detailed records of their R&D activities and projects.
Key documentation practices should include:
- Recording technical uncertainties,
- Documenting specific experimentation processes, and
- Associating employee time and costs with specific projects (i.e., building nexus between costs and activities).
These practices are not only crucial for meeting legal requirements but also for defending R&D credit claims in the event of an IRS or state audit.
State credit updates: Encouraging innovation across the U.S.
Recently, there have been important developments in state-level R&D tax credits. These changes reflect the states’ commitment to fostering innovation and supporting businesses engaged in R&D activities.
- Missouri has introduced a new R&D credit, initiating an application process and creating a fund pool specifically allocated for minority-owned, women-led, and startup companies. This strategic move aims to bolster the growth of diverse and emerging businesses within the state.
- Kansas increased its R&D credit from 6.5% to 10%, providing a more substantial incentive for companies engaged in R&D. Kansas also made the credit transferable, allowing taxpayers who cannot use the credit to transfer it, enhancing its utility and flexibility.
- Arizona has adopted an alternative simplified credit methodology, which will allow more businesses in the state to take advantage of the R&D credit. This taxpayer-friendly change coupled with the state’s highly favorable credit rate and refundability option makes Arizona’s R&D tax credit one of the most valuable in the U.S.
Navigating the complex landscape of IRC Section 174
Businesses continue to struggle with the Section 174 capitalization tax law change, requiring R&D expenses to be capitalized and amortized for tax years beginning after December 31, 2021. This change dictates that research expenses incurred domestically are to be amortized over a span of five years, while those for foreign R&D must be spread across fifteen years.
This legislative change to the tax code has resulted in heightened financial pressure for many companies engaged in R&D activities.
The pending Tax Relief for American Families and Workers Act of 2024, currently awaiting Senate vote, includes a retroactive elimination of the capitalization requirement for domestic R&D expenses (foreign R&D would continue to be amortized over fifteen years). The significance of this pending legislation cannot be overstated, as it aims to lift the financial burden imposed by the costly capitalization requirement.
Although a legislative change to the Section 174 capitalization requirement has broad bipartisan support in Congress, other provisions in the pending legislation are proving contentious in the Senate making the bill’s fate uncertain.
The significance of the pending Tax Relief for American Families and Workers Act of 2024 cannot be overstated, as it aims to lift the financial burden imposed by the requirement for R&D capitalization.
New IRC Section 174 guidance
Furthermore, the IRS released Notice 2023-63, providing substantive guidance on implementing the Section 174 capitalization requirements. This notice elaborates on the broad range of costs falling under the purview of Section 174 and sheds light on potential issues related to double capitalization.
The guidance indicates if a research provider has no financial risk but retains the right to use the resulting research without requiring approval in their business, they must capitalize the costs. This interpretation could lead to situations where both parties in a contractual agreement might be obliged to capitalize, thereby raising concerns about double capitalization.
The impact of these developments is important, as they not only influence current tax filings but also pose significant implications for future tax strategies. Companies are now faced with the challenge of navigating these complex changes while awaiting further clarification and potential legislative relief.
How we can help
Our dedicated R&D team has helped small, medium, and large businesses in a variety of industries identify and document their qualifying research activities to enhance their R&D credit potential. We understand the complex qualification rules, have deep knowledge in the most credit-intensive industries, and have years of experience developing supportable tax credit claims.
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