Financial Glossary
Research and development (R&D) tax credit
The Research and Development (R and D) tax credit is a federal and often state-level incentive allowing companies to offset a portion of qualified research expenses (QREs) against their tax liability. QREs generally include wages for employees conducting qualifying research, supplies consumed in that research, and a percentage of contract research costs paid to third parties. The credit calculation uses either a regular method based on historical QRE percentages or an alternative simplified credit method. The credit can be carried forward when it exceeds current-year tax liability and, for qualifying small businesses, may be applied against payroll taxes.
Problem & Application
A SaaS startup spends $400,000 annually on engineer salaries, of which 60 percent is attributable to developing new software features that qualify under the four-part test (technological uncertainty, process of experimentation, technological in nature, and new or improved business component). QREs total $240,000. Under the alternative simplified credit method, the credit is roughly 14 percent of QREs exceeding 50 percent of the average of the prior three years' QREs -- a calculation that commonly yields tens of thousands of dollars in real tax savings. Proper substantiation requires contemporaneous records: project logs, time-tracking data, and payroll allocations by qualifying project. Businesses without documentation risk losing the credit on audit.
In Short
The R&D tax credit is a valuable incentive for businesses to invest in innovation and development, potentially reducing their overall tax liability.