The Essential Guide to Research and Development Tax Credit: State vs Federal Benefits

Did you know that 36 states across the United States offer their own research and development tax credit programs? These state incentives work along with the federal R&D tax credit that has been driving new ideas since 1981.

Companies making profits can reduce their federal income tax liability dollar-for-dollar through R&D tax credits. The Inflation Reduction Act now lets qualifying small businesses use up to $500,000 of their credits against payroll taxes. State R&D tax incentives share similar principles with the federal program, but they often use different qualification criteria and calculation methods.

The federal research and development tax credit applies nationwide when companies spend money on qualified research to improve products. State programs want businesses to conduct research within their own borders. Minnesota led this movement and became the first state to launch an R&D credit in 1981.

In this piece, we’ll show you what counts as research and development tax credit at both federal and state levels. You’ll learn about the main differences and ways to get the most from these benefits. We’ll also give you practical tips to help your business claim these valuable tax incentives successfully.

Understanding R&D Tax Credits

The R&D tax credit stands as one of America’s most valuable tax incentives for companies that welcome new breakthroughs. Let me walk you through what this credit means, how it has developed, and the differences between federal and state versions.

What is the R&D tax credit?

This tax incentive helps businesses reduce their federal income tax when they develop or improve products, processes, or software. The credit exists under Section 41 of the Internal Revenue Code and offers a dollar-for-dollar reduction in federal income tax liability for companies that conduct qualified research. Businesses get back 5-10 cents for each dollar they spend on qualifying research. The credit’s benefits remain available to companies even during less profitable times since unused credits last for 20 years.

Purpose and history of the credit

The Economic Recovery Tax Act of 1981 brought this credit to life to boost American research spending and drive innovation. The credit’s original version lasted until December 31, 1985, and then went through 15 extensions and 8 expirations over time. The credit took a major step forward in 2006 with the introduction of the Alternative Simplified Credit (ASC), which made credit calculations more flexible. The story ended up with a happy ending when the Protecting Americans from Tax Hikes (PATH) Act of 2015 made the credit permanent.

Federal vs. state R&D tax incentives

The federal program now has company – 38 states offer their own R&D tax credits. These state programs often follow the federal model but come with their own rules and calculations. Connecticut makes it easier for expenses to qualify by setting a lower threshold. California takes a different approach by counting only the property sales within the state in its gross receipts definition. Minnesota led the way with state credits in 1981, while Virginia joined the group much later in 2011. Some states have stepped back from their programs – North Carolina in 2015 and Washington in 2014.

Federal R&D Tax Credit Explained

Businesses must meet strict IRS criteria to qualify for the federal research and development tax credit. The IRS uses a four-part test to determine qualified research activities. Your expenses must qualify under Section 174. The activities need to be technological. You must develop or improve a business component through your research. The process should resolve technical uncertainty through experimentation.

Eligibility criteria and qualified research activities

Qualified research activities cover developing or improving products, processes, software, formulas, or techniques. A patent issuance proves that you’ve met the technological nature requirement. Notwithstanding that, some activities don’t qualify. These include research after commercial production starts, customizing existing products, copying existing products, surveys, studies, research outside the US, social sciences research, and funded research.

Types of qualifying expenses

Qualified Research Expenses (QREs) fall into two main categories. The first category includes in-house research expenses. These are wages paid for qualified services like conducting, supervising, or supporting research, supplies used directly in research, and computer rental costs. Contract research expenses make up the second category, which is 65% of the amount paid to third parties for qualified research. You can only claim expenses directly tied to qualified services. General administrative costs don’t count.

Calculation methods: Regular vs. Simplified

You can pick between two calculation methods each year. The Regular Research Credit (RRC) gives you 20% of current-year QREs that exceed a base amount based on historical percentages. The Alternative Simplified Credit (ASC) offers 14% of QREs exceeding 50% of your average QREs from the previous three years. The ASC rate drops to 6% if you had no QREs in any of those three years.

How to claim using IRS Form 6765

IRS Form 6765 has sections that match different claiming methods. Section A calculates the Regular method, while Section B handles the Alternative Simplified Credit approach. Small businesses with less than $50 million in average gross receipts can offset Alternative Minimum Tax with these credits. More importantly, qualified small businesses earning less than $5 million can use up to $500,000 of their R&D credits against payroll taxes.

State R&D Tax Credits: What You Need to Know

38 states in America have their own research and development tax credit programs. Each state has created its own rules. This makes it challenging for businesses to understand and use these programs.

Which states offer R&D tax credits?

Minnesota led the way with state R&D credits in 1981. Virginia became one of the latest states to join in 2011. Eight states have ended their programs. North Carolina stopped in 2015, Washington in 2014, and Michigan in 2012. Businesses need to keep track of these changes in their areas.

Key differences from federal credit

State programs usually follow federal rules but with notable changes. Utah gives a volume-based credit at 7.5% instead of using an incremental approach. Some states have extra rules. Colorado only allows credits in enterprise zones. Kentucky focuses on building costs, while Mississippi needs university partnerships. Connecticut makes it easier by setting a lower threshold for qualifying expenses.

Refundable and transferable credits

Some states offer valuable refundable credits. This means businesses can get cash back even without owing taxes. Arizona, Delaware, Iowa, and Connecticut give this benefit. Seven out of twelve refundable or transferable credit programs help small businesses. Louisiana, New York, and Virginia give better rates to smaller companies.

State-specific application processes

Each state has its own way of handling applications. Maryland sets November 1 as its yearly deadline. Florida has a short window from March 20-26. Virginia needed applications by September 1, 2024. Most states need special forms beyond regular tax paperwork.

Carryforward and caps by state

States often limit their programs. Virginia caps its program at $7.77 million each year. Companies can get up to $45,000, or $60,000 if they work with universities. New York offers up to $250 million, and Pennsylvania gives $55 million. The time to use leftover credits varies by state. Texas lets companies keep their credits for up to 20 years.

Maximizing Your R&D Tax Benefits

Businesses that adopt innovation can reduce their tax burden. They can make use of information about R&D tax credits at both government levels.

Can you claim both federal and state credits?

Yes! Your business can claim both state and federal R&D tax credits when it meets each program’s requirements. This creates a powerful tax advantage. Most states provide their own R&D credit to reduce state tax liability. These combined benefits can give you up to 10% in benefits for every qualifying dollar identified in a performed study.

Common mistakes to avoid

Companies often make four critical errors that hurt their R&D claims. Poor documentation leads to “leaving money on the table.” They claim costs that don’t qualify. Many underestimate what counts as true research. Some try complex claims without expert help. Other issues include bad time tracking, mismatched records, and wrong expense classifications. Companies often list equipment purchases as supplies. Testing equipment and other depreciable items usually don’t qualify.

Best practices for documentation

Good records are the foundations of successful claims. Create records as work happens, not after. Link them directly to expenses. Keep them organized digitally. Make sure they fit your business needs. Store them for 5-7 years. Sort information by project and employee. Focus on quality rather than quantity. Keep detailed project plans, reports, communications, time sheets, and expense records.

Working with tax professionals

Expert specialists help you get the most from your claim. They find all eligible expenses, ensure compliance, and reduce errors. The right expert will help your R&D tax credits match your tax planning and business goals. They use AI tools that make data clearer and analyze documents better, which reduces your paperwork.

Conclusion

R&D tax credits are powerful financial tools that help innovative American businesses grow. Companies that participate in qualified research activities can benefit substantially from federal and state programs. The federal R&D tax credit gives 5-10 cents back for each qualifying dollar spent. State programs provide extra ways to reduce tax burdens.

You need to know the differences between these programs to get the most benefits. Federal credits support nationwide innovation. State incentives want to promote research within their borders. While qualification criteria may differ between programs, they share basic principles of technological advancement and experimentation.

Documentation is the life-blood of successful claims. Your research expenditures need strong, current records to validate claims during IRS reviews. A solid position comes from avoiding typical mistakes like claiming ineligible costs or missing qualifying activities.

Your business can claim both federal and state credits at the same time. This combined approach could yield up to 10% in benefits for each qualifying research dollar. Companies should learn about all options instead of focusing on just one program.

Tax professionals without doubt bring immense value to this process. Their expertise helps spot all eligible expenses and ensures compliance with complex regulations. On top of that, they can blend R&D tax planning into your overall business strategy.

The R&D tax credit remains one of America’s most valuable tools to promote innovation. Companies that understand these programs well, keep detailed records, and partner with knowledgeable professionals can maximize their benefits from these powerful tax incentives. These credits could give your business a real advantage—check your eligibility today.