Everything You Need To Know About Healthcare R&D Tax Credits

Taxes are an inconvenient but necessary part of everyday operations. A better understanding of taxes can save you money by taking advantage of various credits, like the R&D tax credit. How does the R&D tax credit work? Get an in-depth look into everything you need to know, including what it is, how to claim it, and how it’s calculated.

The Research and Development tax credit is a federal tax liability reduction companies can take for approved domestic expenses. The rate of reduction is dollar for dollar. You also get back approximately 13 cents for every dollar spent on research that meets the eligibility requirements. Qualifying research and development expenses include the development, improvement, or design of a product, technique, process, or software.


This credit can lead to significant savings that free up cash for further R&D, hiring new employees, and more. For companies that meet the criteria of a Qualified Small Business, the R&D credit can be used to offset quarterly payroll taxes. For tax years 2016 through 2022, the maximum R&D tax credit for payroll tax was $250,000. The credit doubled to $500,000 beginning January 1, 2023. Many states have also enacted an R&D credit.

ERC for Tech

Who Qualifies for the R&D Tax Credit?

This lucrative credit is available for more than established researchers and scientists. The Research and Development tax credit is also known as the Research and Experimentation (R&E) tax credit. These two terms refer to the federal benefit outlined in Section 41 of the Internal Revenue CodeAny company working within the United States to develop or improve a process or a product can claim the credit, no matter what industry it is in. 

There are nearly endless ways for a business to qualify for the credit.

Here are a few examples:

  • Designing cloud-based software solutions
  • Developing new products
  • Improving or enhancing an existing product
  • Developing or improving an existing process
  • Testing a product or process
  • Beta testing
  • Conducting research and documenting the results


The Four-Part Test for R&D Tax Credits

Qualifying for R&D tax credits involves a stringent four-part test set by the IRS. This test ensures that your activities align with the IRS definition of research and development. Here’s a brief overview.

Permitted Purpose

This part verifies if the activity is intended to create new or improve existing business components (products, processes, software, techniques, inventions, or formulas). The goal should be to increase performance, functionality, reliability, or quality.

Elimination of Uncertainty

The activity must aim to eliminate uncertainty concerning the capability or method for developing or improving a product or process, or its appropriate design.

Process of Experimentation

The activity should involve a systematic process of testing various alternatives to achieve results. This can include simulations, modeling, or trial and error.

Technological in Nature

The process of experimentation must rely on the principles of hard sciences like physics, chemistry, biology, computer science, or engineering.

Which expenses qualify for R&D tax credits?

If your company is engaged in research and development (R&D), you may be eligible for substantial tax credits to offset your expenses. Here are four categories of expenses that generally qualify for R&D tax credits:

Wages

The R&D tax credit often covers salaries, wages, or other compensation for employees who are directly engaged in research activities. This may include their time spent on developing new products, improving existing products, or even supervising these activities.

Supplies

Any supplies used in the R&D process that are not subject to depreciation may qualify for the credit. These could be raw materials used for building prototypes or other consumable items needed for testing and development.

Contract Research Expenses

If you contract outside parties to perform research and development on your company’s behalf, up to 65% of those expenses may qualify for the credit. Be aware that the work must still meet the IRS’s four-part test to qualify for the credit.

Rental or Lease Costs of Computers

If you are paying to use cloud-based platforms or leasing servers for direct use in R&D, these costs might be eligible. Similarly, the cost of renting or leasing other equipment necessary for your research may also qualify.

Documentation Required for R&D Tax Credits

Proper documentation is essential for claiming Research and Development (R&D) tax credits. Here are four vital sources:

Project Records

Maintain documents describing the uncertainties and solutions of your project. Meeting minutes, project plans, and trial iterations serve as good examples.

Time-Tracking Records

Keep track of the time employees spend on R&D work. Timesheets and work logs are key in establishing wage claims for the credit.

Financial Records

Financial documents should detail your R&D costs. Include general ledger expense details, project expense reports, and payroll records.

Technical Documents

Preserve technical files like chart notes, design drawings, treatment diagrams, flow charts, and prototype results. They provide evidence of technological advancements.

How Are R&D Credits Calculated?

The IRS provides several formulas for businesses to calculate the correct R&D tax credit. One method called the Alternative Simplified Credit method, involves the following five steps:

  1. Calculate your business’s qualified research expenses going back three years.
  2. Calculate the average of the three totals.
  3. Multiply the average by 50% to get your credit base.
  4. Subtract your calculated credit base from the year’s total R&D expenses.
  5. Multiply this number by 14% to calculate your R&D credit.

New businesses that don’t have three years of expenses to calculate a credit base can multiply the year’s R&D expenses by 6%. The process is simple but requires you to understand which expenses qualify and to have documentation to submit as proof.

It’s a good idea to consult a tax specialist to ensure you take full advantage of the credit and calculate it correctly.

Is R&D Tax Offset Taxable Income?

The R&D tax credit reduces your federal taxable income by giving you a dollar-for-dollar credit on qualified expenses. You can also still deduct certain R&D expenses on your tax return.

What Happens to Unused R&D Credits?

If your business lacks tax liability, you first must carry the credits back one year (if there was tax liability). Then any remaining credits can carry forward for a maximum of 20 years. The extended time frame was put into effect by 2015’s Protecting Americans from Tax Hikes (PATH) Act.

How Far Back Can You Claim R&D Tax Credits?

One of the great things about R&D credit is that you can claim it for any open tax years by filing an amended return. Typically, this is about three years, although it may be longer if you sustain losses.

If Our Company Has Had Losses but Incurred Qualified Research Expenses, Can We Utilize the R&D Credit Benefit?

One of the most common questions is, “Can you take R&D credit if you have a loss?” The simple answer is yes, you can. Your company mustn’t be profitable to take advantage of the R&D tax credit. Companies that have a loss also benefit. As a loss-making company, you could potentially claim back a more significant percentage of your R&D expenditure than those that make a profit. Also, you could receive a cash credit instead of reducing your tax bill.

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