A one-dollar reduction in the after-tax cost of research and development creates an additional dollar of new spending in the short term and two dollars of additional spending in the long term, according to the Council of Regional Information Technology Associations (CRITA)—but what small business can afford R&D in times like these? Those who use the federal research and development (R&D) tax credit, perhaps.

The R&D tax credit, first enacted under the Economic Recovery Tax Act of 1981, provides certain companies with a tax credit for R&D expenditures used to introduce new products and services, improve current products and services, or simply enhance processes.

The tax credit reduces the cost of capital, thereby mitigating the risks of R&D investment and allowing companies to “push the envelope” in the development of new products and services. In other words, your company might get a tax break simply by making its products or processes better.

The R&D tax credit likely applies to more companies than you think it does. Contrary to popular opinion, the tax credit is not just for scientific research done in a large laboratory setting. Thanks to recently relaxed regulations, it applies to companies of all sizes in many industries, such as manufacturing, technology, software, and engineering.

Examples of small companies that could potentially use the R&D tax credit are a 10-person company that designs and manufactures disk drives for personal computers, or a five-person company that develops software for streamlining real estate companies’ billing operations. And the list goes on. Companies involved in any of the following activities may also be eligible for the R&D tax credit:

  • Manufacturing new products, processes, or formulas
  • Developing new, improved, or more reliable products, processes, or formulas
  • Developing prototypes or models (including computer-generated models
  • Designing tools, jigs, molds, or dies
  • Applying for patents
  • Conducting certification testing
  • Testing new concepts and technology
  • Trying to use new materials
  • Acquiring new equipment
  • Conducting environmental testingDeveloping or improving manufacturing processes
  • Developing, implementing, or upgrading systems or software
  • Building or improving manufacturing facilities
  • Using outside consultants or contractors to do any of the above activities

If your company is eligible, you can generally claim a 20 percent credit against your taxes for qualified expenses above a base amount. Qualified expenses include in-house costs for wages, supplies, and a percentage of any contract costs. However, you must provide certain documentation showing that your projects are not just part of the ongoing cost of doing business.

That’s where the tax credit gets tricky. For example, unqualified expenses include (but are not limited to) internal-use items, such as the installation and customization of software used by your company internally. In one case, a company increased efficiency and reduced costs with an administrative software package. It claimed the R&D tax credit for the wages of its computer programmers and analysts working on the system during its installation and customization. The IRS denied the claim.

If you think you may be eligible for the R&D tax credit, you may want to contact your accountant now. The credit has expired and been extended many times—most recently in October 2008, when President Bush signed into law a retroactive two-year extension of the tax credit, from January 1, 2008 through December 31, 2009. In some ways this is good news. Because it is retroactive to January 1, 2008, eligible companies can take advantage of a full year’s credit in a single quarter. However, if it’s not renewed again, you only have a year left to take advantage of the credit.

Finally, note that you may also be eligible for an R&D tax credit offered by your state. Your accountant can provide you with more information.

Published with permission from TechAdvisory.org. Source.