- R&D tax credits help businesses lower their tax liability for taking on certain research activities and projects
- You will use IRS Form 6765 to claim the R&D credits you qualify for
- Form 6765 has four sections to complete when filing for the credit (Sections A through D)
- You have three years from when you filed the initial tax return to claim an R&D credit
- Qualifying activities must have these characteristics:
- Permitted purpose
- Technical uncertainty
- Process of experimentation
- Technical in nature
- Qualifying activities must have these characteristics:
It seems like the IRS always finds a way to complicate our lives. Their Form 6765 instructions are just as daunting as everything else the agency releases. They refer readers to the Internal Revenue Code, and unless that is something you peruse for pleasure reading, you likely aren’t familiar with it.
One area of tax law that can get confusing fast is tax credits. New credits are often released to support individuals and businesses, especially during a crisis like the COVID-19 pandemic.
It’s hard to understand how these credits work, if you’re eligible, and how long you can apply for them, however. The employee retention credit (ERC) is an excellent example of a pandemic-related credit you can still claim if you qualify.
There are other credits related to conducting research for a project. These credits don’t just apply to scientists or researchers – they can also apply to small businesses. They provide a significant opportunity to get some tax relief.
This guide helps you learn how to receive a tax credit for increasing research activities. We break down all the IRS jargon into layperson’s terms, providing you with everything necessary to understand research credits, gather appropriate documentation, apply for a research tax credit, and use the IRS 6765 form.
What Is a Research and Development Tax Credit?
Research and development (R&D) tax credits have been around since the early 1980s. The U.S. federal government implemented the first R&D tax credit in 1981, aiming to provide support for companies in their R&D efforts.
The credit was initially a temporary measure and had to be renewed regularly, but it eventually became permanent. The credit has since been amended and expanded several times, with different states also implementing their own versions of the credit.
The primary goal of R&D tax credits is to incentivize companies to invest in innovative research and development projects. These projects can involve a variety of fields, from technology and engineering to science and social sciences. R&D tax credits provide financial incentives for companies that engage in such activities, which helps promote economic growth and technological advancement.
These credits have been significant for small and medium-sized businesses that may not have the same resources as larger firms to take on complex R&D projects. Since their introduction, R&D tax credits have been a critical tool for promoting innovation and stimulating economic growth in the U.S.
What Is IRS Form 6765?
The purpose of the federal Form 6765 is to help eligible businesses calculate and claim R&D tax credits. This form provides tax credits for increasing research and experimental activities relating to developing or improving processes, software, or products. The Protecting Americans from Tax Hikes Act (PATH Act) in 2015 made the R&D credit permanent and expanded who could claim the credit.
The rules for receiving R&D credits are in Internal Revenue Code §41. The credit is available for eligible expenses relating to qualifying research activities. Some of the most significant benefits of this credit include the following:
- Reduces federal and state tax liability
- Increases the company’s cash flow and market value
- Lowers business effective tax rate
- Allows businesses to retain more profits
You will indicate where you want to apply your credit when filing Form 6765. Qualifying small businesses may use it to offset their regular and alternative minimum tax or apply it against payroll taxes.
How to Complete the Four Sections of Form 6765
Form 6765 has four sections you must complete to receive credit. Let’s walk through each of these sections in detail:
Sections A and B
You can use two calculation methods when determining your R&D tax credit. You will complete section A if you use the usual method; if you use the alternative simplified credit method, you will complete section B.
Note that you can do either section A or section B, but not both. Determine your tax credit using both methods to figure out which is best, and use the one most beneficial to your company.
The regular research credit is 20% of all current-year qualifying expenses over a specific base amount. Determining the base amount involves detailed calculations, depending on whether your business is a startup or is more established. This method is when you’ll use section A.
The alternative credit method, section B, requires you to find the difference between the qualifying expenditure amount in the current year and 50% of the average qualifying expenditure for the prior three tax years. You will then multiply the difference by 14% to arrive at your R&D credit.
You must determine whether your expenses qualify as eligible research activity before you can calculate your Section A or Section B credits. You may claim three kinds of costs:
- Salaries: Only those paid for qualified services performed by an employee.
- Supplies: Computer rentals, molds, parts, and other base materials.
- Contract work expenses: Paid for services meeting the R&D criteria if costs are only for those services.
Remember that you will need to substantiate your expenses with documentation.
The end of Form 6765 provides an opportunity to take a reduced credit. This option will reduce the amount of R&D tax credit you get but eliminate any unfavorable taxable income adjustments. It can also make the preparation of state tax returns easier.
After you quantify your R&D credit for the current year, Section C will direct you to other forms and schedules. You will need to report the amount of your R&D credit on those forms. This varies depending on your business structure.
The final section of the form is where you may indicate your desire to use some or all of your R&D credit to offset your payroll tax obligation for the current year. This is allowable up to a maximum of $250,000.
You simply transfer the amount you elect to use for payroll taxes, as noted on Form 8974. The payroll tax offset becomes available quarterly after you file your federal income tax return.
This list gives you an idea of a Form 6765 example. Make sure you complete all sections as appropriate for your business. Talk through your options with a tax professional if you’re unsure about what to do when you begin working on Form 6765.
Do You Still Have Time to File a Research Activity Credit?
You typically have several years to claim any tax credit you qualify for. Filing Form 6765 generally takes place with your company’s standard income tax return by the deadline or by the extended due date of your tax return.
There is a standard three-year look-back from the filing date of your return to amend your return and receive the R&D credit. You may still be able to obtain your credit within three years from when you first filed the applicable tax return if you believe you are eligible and have yet to claim the credit. You will have to amend those returns to claim the credit retroactively.
The IRS has a four-part test that activities must meet to qualify for the R&D credit. This section examines each of these qualification requirements for activities:
1. Permitted Purpose
The activity must have a permitted purpose. This means the intent is to make or improve a process or product that will enhance the item’s reliability, performance, function, quality, or cost efficiency.
2. Technical Uncertainty
The intent of the activity must be to eliminate technical uncertainty. This involves developing or improving a product or process relating to design, technique, methodology, inventions, or formulas.
3. Process of Experimentation
The activity includes the process of experimentation. The idea is to eliminate or resolve technical uncertainty. The process consists of evaluating alternatives and approaches through simulation, modeling, prototyping, trial and error, or other methods.
4. Technical in Nature
The process is technical in nature, meaning it must rely on the hard sciences of computer science, chemistry, biology, engineering, or physics.
Confirming your project’s eligibility will help you move forward with Form 6765. Make sure the research activities you’re taking on meet the requirements of each of these four tests.
Qualifying and Excluded Expenses
Now consider which research-related expenses can be included. The expenses you incur while performing qualifying activities can apply to your credit, including computer leasing, contractor research, supplies, and employee salaries. You may claim employees performing the activities as well as their supervisors and first-line managers who support them in those activities.
The employee expenses are usually 85% or more of the total qualifying expense. The balance is supplies and contractor expenses, and with contractor research, you may claim 65% of the cost.
Many expenses meet these qualifications, but there are some exclusions to be aware of. You may not claim the following expenses on the research and development credit form:
- Research after starting commercial production
- Research to adopt an existing product for an existing customer
- Duplicating a process or product already in existence
- Marketing research studies or surveys
- Research for internal use software
- Research outside the U.S., a U.S. territory, or Puerto Rico
- Humanities, arts, or social sciences research
- Research receiving funding from a grant, organization, government, or person
- Cost of fixed assets necessary for business operations
Be sure to work with your Form 6765 specialist to determine whether the expenses you claim meet the IRS qualifications. Remember that you may not claim the same costs for two tax credits, and be careful when determining your expenses for this credit.
Documents You Need
It’s now time to gather all the information you’ll need to complete your form correctly. When claiming the R&D credit using Form 6765, you will need the following documents:
- Form 6765, Credit for Increasing Research Activities (make sure you have the most recent version)
- List of your R&D activities that qualify for the credit
- Wage reports
- Supplies and other research expenses and receipts
- Time-tracking information or allocation of employee time for W-2 taxable wages you’re claiming for the credit
- Contracts and other documentation for any outsourced R&D activities
- Design drawings, blueprints, progress reports, test records, and marketing material showing the impact and process of research
The more proof and documentation you have, the better. Make sure you save everything for your records during the research process. Remember that regardless of your business entity’s structure, all businesses must file Form 6765 to claim the R&D tax credit.
Why Work with a Tax Credit Specialist?
There have been changes to Form 6765 every year since 2002. This makes it difficult for anyone other than those with a strict dedication to handling tax credits to ensure they’re calculating the correct credits available.
Accounting staff and CPAs may need to catch up on changing tax laws with this ever-changing credit. A professional specializing in Form 6765 will be up-to-date on what you can and cannot claim.
A Form 6765 specialist also knows what documents are necessary for proving your claim should the IRS question your deductions. Thanks to your tax credit professional’s guidance, you can rest assured that your proof will be ready to show the IRS at any time.
ERC Today specializes in helping businesses claim tax credits. We can help you maximize the amount you claim, ensuring everything you claim is eligible and that you have the documentation you need to prove your position.
Contact ERC Today for assistance in completing Form 6765 R&D tax credit or Form 941-X for the ERTC. Our experts are here to help!