- Organizations performing R&D under government contracts can qualify for federal and state R&D tax credits.
- The credit can offset income tax as well as federal payroll tax.
- Organizations should carefully assess their government contracts for economic risk and intellectual property rights.
Need clarity on R&D credits and qualifications?
The government established a federal research and development (R&D) tax credit in 1981 to encourage technology development. The credit generally equals 7% to 10% of a taxpayer’s qualified R&D costs and applies against income taxes or, in the case of certain early stage companies, against payroll taxes.
Companies with federal government contracts often assume incorrectly that only their independent R&D activities qualify for the credit. Actually, work performed under government contracts not only can qualify for the credit, but frequently constitutes a large source of the credit for a company.
When contract R&D can qualify
Two major factors determine whether a contractor performing R&D can utilize the credit: the economic risk involved and the retention of intellectual property rights.
The tax code wants the taxpayer claiming the R&D credit to have economic skin in the game. While this may seem like an easy issue to judge, in practice that hasn’t been the case. The basic proposition amounts to this: a contractor has economic risk when payment is contingent on the success of its R&D work. Courts generally have interpreted the rule to mean that work performed under firm, fixed-price contracts can qualify. The logic is that fixed-price contracts are inherently risky for contractors, thus giving them sufficient economic risk to claim the R&D credit.
Intellectual property rights
To qualify for the credit, taxpayers must also have “substantial rights” in the results of their research. That generally refers to intellectual property rights. Organizations may have substantial rights in research performed under government contracts, despite the research being subject to export control laws, security clearance classifications, and recoupment provisions. Substantial rights also may include shared rights with another party. Essentially, you must retain the ability to exploit the results of the R&D in a future endeavor.
How to claim R&D credits
If you qualify, there are several ways you can claim federal or state R&D credits.
The federal credit
Federal R&D credits are claimed on the company’s annual income tax return. For those with taxable income, the credit can offset the corresponding income tax. Any unused credit can be carried forward twenty years.
For decades, the R&D credit provided little benefit for startups generating net operating losses. This was somewhat ironic since early-stage organizations are oftentimes focused exclusively on R&D and building out their technology. This all changed in 2016, however, when Congress amended the rules to allow “qualified small businesses” to apply their R&D credits against payroll taxes, up to a maximum of $250,000 per year.
A qualified small business is one that:
- Has less than $5 million of revenue in the year for which the credit is claimed.
- Has not earned revenue for more than five years.
The ability to claim R&D credits against payroll taxes gives early stage organizations an immediate tax benefit for their R&D efforts.
Numerous states also offer valuable R&D credits, with rules generally similar to those for the federal credit. In addition to the income-tax credit, some states offer a refundable credit, which allows organizations with no tax liability to obtain cash refunds. State credit programs change frequently, so check with your tax advisor when considering state R&D incentives.
How we can help
If your organization performs R&D under a government contract, you can qualify for valuable credits at the federal and state levels. CLA professionals can help you run a comprehensive analysis to make sure your federal and state R&D credits are properly computed.Contact Us