If you’re a business owner, there’s no doubt you’ve spent time and money creating better processes, materials, or solutions for your customers. Those activities can lead to big tax breaks, but the IRS won’t go out of its way to spell that out for you.
For whatever reason, research and development (R&D) tax breaks are an elusive secret that few business owners understand. Perhaps it’s because many business owners don’t consider themselves scientists or inventors. You’re just doing whatever it takes to make your customers happy and improve your bottom line.
But when it comes down to it, many business owners create (either by choice or by necessity) and, therefore, may be leaving related tax breaks on the table. The main opportunity here is the research tax credit, which can be achieved by fulfilling a four-part qualified research activity test:
- The purpose of the activity must be to develop a new or improved product or process in the U.S. That “product” could be a new technique or method.
- The activity must involve a hard science like engineering, physics, chemistry, or computer science. Be open-minded here: It’s likely your R&D fits into one of these categories.
- Some technical uncertainty is necessary (called the Section 174 test). In other words, the activity needs to be true trial and error, for which you’re unsure what the result will be.
- An evaluation of different alternatives must be completed either through systematic trial and error (trying alternatives and documenting results) or through modeling and simulation.
How can a business owner fulfill these requirements? Let’s look at building contractors as an example. You may be faced with building on less-than-optimal land or within unique city or county requirements. Maybe you’ve been challenged to build stronger, lighter, faster, or more environmentally friendly, energy-efficiently, or automation-enabled. Perhaps the architectural design is unique, or maybe you’re building near an Interstate and have a new idea for soundproofing. Or maybe it’s a back-office management method or a new way of ensuring perimeter security during construction.
These challenges often require innovation on your part to overcome. Local organizations like the Southwest Research Institute exist for this purpose: They have resources like scientists and engineers available to help both large corporations and small businesses wanting to invest in research activities. The tax break could cover the cost of contracting with an organization like this to perform research activities.
Industry-specific tax breaks may also be available. Builders, for example, should consider whether their innovative new builds meet the requirements for the New Energy Efficient Home Tax Credit or, for commercial builds, the expanded Energy Efficient Commercial Buildings Deduction.
Finally, innovation can change how the IRS views your business activities and, thus, can improve your tax bill. When we were first introduced to a company in the self-service car wash industry, the owners had been operating and paying taxes as a distributor of car-cleaning solutions. But they made their own chemicals, which made them a manufacturer. Recategorizing saved them a substantial amount in taxes.
The moral of the story: If you’re thinking outside the box with your business, consider whether you should also be thinking outside the usual box on your taxes. Feel free to contact us with questions.