Internal Revenue Code Section 41
What is the R&D Tax Credit?
The federal Research and Development Tax Credit (“R&D tax credit”) is a business tax credit for qualified research expenses that can be deducted from overall corporate income taxes. The R&D tax credit is designed to encourage companies to make new discoveries and advancements and to partner with entities, such as universities, and other organizations to conduct research and development activities. Because the tax credit can only be taken for R&D activities performed in the U.S., it helps fuel our nation’s competitiveness and economic and national security by encouraging greater R&D investment and fostering the creation and retention of domestic high-skilled jobs.
How it works
Under the law, qualified research expenses include: certain labor and wage costs for performing research activities “in-house;” certain supplies used in conducting research; and a percentage of costs associated with “contract research expenses.” The credit only applies to research performed in the United States.
The traditional R&D tax credit provides a 20 percent credit for qualified research expenses that exceed the taxpayer’s base amount (determined by reference to the taxpayer’s research expenses during the mid-1980s and the taxpayer’s recent gross receipts). In lieu of the traditional credit, taxpayers may elect to claim the Alternative Simplified Credit (ASC). The ASC provides a 14 percent credit for qualified research in excess of 50 percent of a company’s prior three-year average qualified research expenses.
Under certain circumstances, businesses can also claim a credit if they fund qualified research at another organization such as a university or other research organizations. In such instances, a business can claim only 65 percent or 75 percent (as compared to 100 percent for in-house R&D expenditures) of qualifying expenditures toward the tax credit. The 75 percent rate applies only to qualified research organizations (such as universities or research consortiums), which are tax-exempt entities organized primarily to conduct scientific research and which are not private foundations.
In 2019, $656 billion was spent on R&D in the United States.
Source: NSF Science & Engineering Indicators 2022
The R&D Tax Credit and Universities
Universities benefit indirectly from the R&D tax credit. The tax credit encourages industry to take on new research and development challenges that are important to industry but also well-suited to academic research. The law allows companies to claim the R&D tax credit for research and development activities conducted at universities or other qualifying organizations, including research consortiums which may include universities.
When companies contract with universities to conduct R&D, faculty and students benefit from receiving complex and practical research problems and the financial support to study them. The R&D tax credit, in turn, promotes greater collaboration between industry and universities. This in turn leads to R&D-based employment opportunities for students and graduates that bolsters the American workforce.
The R&D tax credit also fosters start-up companies, many of which are a result of new technologies developed at universities as a result of industry-funded research.
Improving the R&D Tax Credit
The current R&D tax credit could be improved by providing greater incentives for companies to partner with universities for R&D. This would include increasing the tax credit for R&D activities conducted at universities and other research entities so that it equals the benefit provided for “in-house” research. In addition, making the R&D tax credit permanent would significantly improve its effectiveness, since industry could reliably plan for R&D expenditures and their tax implications. This is particularly important for research that takes several years.
Background
Originally enacted in 1981, the R&D tax credit was not a permanent part of the Internal Revenue Code, and it was allowed to expire on a number of occasions. However, it was extended each time, sometimes retroactively. As part of the Protecting Americans from Tax Hikes Act of 2015, it was permanently extended.
The Tax Cuts and Jobs Act of 2017 changed how companies can expense R&D under IRC Section 174. Beginning in 2022, companies will be required to amortize their R&D expenses over five years for domestic expenses and 15 years for expenses incurred outside the United States. As a consequence, instead of deducting R&D expenses in the year in which they are incurred, companies will have to spread out their deductions over a five- or 15-year period, depending on the where the spending took place. This policy to require the amortization of expensing lowers the near-term value of R&D investments and subsequently the benefit of the R&D tax credit.
Additional Information