How to Calculate the Federal R&D Tax Credit

July 10, 2023

The Federal Research and Development (R&D) Tax Credit is an activities-based tax credit for companies that that incur R&D expenses in the United States.  

Eligible taxpayers may claim qualifying expenses – wages, supplies, contract research, cloud hosting – for a dollar-for-dollar reduction in tax liability.  

The Credit may be calculated using the Regular Research Credit (RRC) Method, or the Alternative Simplified Credit (ASC) Method.  

The choice of Method shouldn’t be taken lightly, and taxpayers are encouraged to consult an R&D provider to advise based on specific facts and circumstances. 

Regular Research Credit Method (RRC) [Section A, Form 6765]

Under the RRC Method, the Federal Credit is 20% of a Company’s Current Year QREs that exceed a Base Amount.

The calculation is quite complex:

Step 1: Determine the time period from which you will be gathering data — the “Base Period.” 

In a base analysis all companies start as “80s Base Companies.” 

1984 is your starting point. Ask these two questions:

  • Did the Company have QREs and GRs before 1984?
  • Did the Company have QREs and GRs in at least 3 years between 1984-1988?

If the answer to BOTH questions is “yes,” then you’re dealing with an “80s Base Company,” and you’ll be gathering data from the 1980s.

If the answer to EITHER question is “no,” then you’re dealing with a “Start-Up Company,” and you’ll be gathering data from later years.

It might seem strange to call a Company that that’s been around for decades a “start-up,” but don’t let the language confuse you. For our purposes, if the first time a Company had both QREs and GRs in a tax year was after 1984, it’s a “Start-Up Company.”

Step 2. Determine the Fixed Base Percentage (FB%)

The Fixed Base Percentage is the ratio of dollars spent on R&D versus Gross Receipts, determined from a fixed period in time.

Step 3. Determine the “Base Amount” (BA) using the FB% and the Average Annual GRs

Step 4. Calculate the Credit

Digging up QREs and GRs from the mid-80s or 90s can be cumbersome, and in some cases impossible. Additionally, in some scenarios – including a significant decline in R&D spending – a firm may no longer qualify for the Credit using the RRC Method. Fortunately, there is an alternative.  

Alternative Simplified Credit Method (ASC) [Section B of Form 6765] 

In 2007, the IRS introduced the Alternative Simplified Credit Method (ASC). The Credit calculation is much simpler, and doesn’t require data that may be decades old. As such, this is a good option for newer firms or firms with less meticulous recordkeeping.  However, the Credit rate is significantly smaller – 14% if a Company has at least 3 years of QREs, and a flat 6% of the Current Year QREs if it does not.

280C Election [In Both Sections A and B of Form 6765]

Form 6765 poses an important question to all taxpayers, regardless of calculation method:

Are you electing the reduced credit under section 280c? 

Section 280c(c)(1) requires the taxpayer to reduce their deductible expenses by the amount of the Credit in a given year. The taxpayer must disallow the expenses in the amount of the Gross Credit.

However, by making an election under Section 280c(c)3, you can take a reduced version of the Credit and avoid having to adjust your taxable income.

The 280c election may only be taken on timely, original returns.

RRC or ASC?  How to Decide

Obviously, the ASC Method is the simpler choice, and it’s often selected for that reason alone. But it shouldn’t be an automatic decision, as the ASC Method doesn’t always produce the maximum benefit.

In general, the RRC method may work well for taxpayers with low “base amounts” or for new startups. These taxpayers are likely to see a larger Credit with the RRC Method.

The ASC Method is often better suited for companies with higher “base amounts,” firms that have incomplete records, or firms that have undergone mergers or acquisitions that might complicate matters.

If there has been a significant decline in R&D spending and companies no longer qualify for the Credit using the RRC Method, the ASC Method may be a welcome alternative.

Ultimately, the preferred method will ultimately depend on individual facts and circumstances. In fact, the IRS recommends that practitioners perform both calculations, and then select the one that provides the most benefit.

An additional note – just because the RRC Method was best for you last year, doesn’t mean that it will confer the most benefit again this year. As circumstances change, it’s important to reevaluate the method selected. The right R&D provider will be of immeasurable help with this decision.

 

Online Credit Calculators: Caveat Emptor

There are a number of online calculators that offer to calculate your Credit in moments. These might be useful for a very quick ballpark, but the results should be taken with a grain of salt, or perhaps the entire shaker:

  • Online calculators use flat percentages and are unable to perform the data analysis required for an accurate estimate.
  • The results generated by these calculators are entirely dependent on the accuracy of the information provided by the user. Determining the actual value of QREs is a nuanced endeavor that must be done by a professional. If a taxpayer guesstimates QRE values to input into these calculators, they must realize that the result is, at best, also a “guesstimate.”
  • Many calculators aren’t asking the right questions.
    • One popular online calculator simply asks for the number of “R&D employees,” and for their average salary.
    • It does not ask about:
      • The proportion of time each employee spends performing qualified research activity
      • Employees providing supervisory or supportive activities
      • Costs related to the other types of QREs — supplies/materials, cloud hosting, and third-party contractors

The results of such a “calculation” would be completely without merit.

Conclusion

To ensure that the R&D Tax Credit is calculated accurately and leveraged fully, an R&D specialist is highly recommended. Every situation is unique, and one size does not fit all.  

The right specialist will identify and verify every possible QRE, help select the appropriate calculation method, and thoroughly document the Credit.  

 

Eligible taxpayers may claim qualifying expenses – wages, supplies, contract research, cloud hosting – for a dollar-for-dollar reduction in tax liability.  

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