Key Takeaways
- Carrying forward unused tax credits, such as the R&D credit, can offset future tax liabilities.
- Businesses can utilize the R&D tax credit carryforward to leverage past investments in research and development, boosting cash flow and innovation.
- Changes like the TCJA and CARES Act have impacted the utilization of R&D tax credits.
Tax credits and incentives are an excellent way to reduce your tax liability and operate your business more efficiently. Unfortunately, there are significant misconceptions regarding the R&D credit carryforward and how it works.
Many companies find themselves not claiming what they are entitled to and misunderstanding how a carry forward tax credit works.
What is a Credit Carryforward?
A carryforward credit applies a tax credit to a future tax year. It’s a provision within the tax code to allow businesses to take advantage of unused tax credits. There are many reasons why a tax credit could go unused, such as operating losses or that the IRS has a maximum limit on how much a business can claim per fiscal year.
Likewise, there’s also a carryback. An R&D credit carryback may be used if an organization has suffered considerable losses in one year and would rather deduct from a previous year’s profits.
Every carryforward and carryback credit has different rules that apply to it.
What is the R&D Credit Carryforward?
If you have Qualified Research Expenses (QRE), you can take any unused R&D tax credits and apply them to a future tax year. Companies may use these credits in bumper years to offset their tax liabilities.
A circumstance where someone may use an R&D tax credit carryforward is when there was a significant investment in research and development, but the company did not generate a profit during the tax year.
Another scenario where the R&D credit carryforward may be employed is if your business is eligible for a more significant tax credit than what you currently owed or paid through your taxes.
How Does the R&D Credit Carryforward Work?
Understanding the value of this tax credit is complicated because it varies based on the type of research activity, whether it was done in-house or contracted out to a third party. On average, this tax credit is worth anywhere from five to ten cents for every dollar spent on R&D activities, resulting in a significant carryforward if not utilized.
Businesses that cannot utilize their tax credits and must carry forward the benefit may find they can offset their tax liability in future years. The process begins with an R&D tax credit study followed by a formal claim.
If you decide to claim this tax credit, you will be filing IRS Form 6765, Credit for Increasing Research Activities with the full credit amount generated during the tax year. From the Form 6765, the R&D Tax Credit will flow through the Form 3800, where any carryforwards will be identified.
The way this research credit carryforward works has changed, however. The 2017 Tax Cuts and Jobs Act (TCJA) passed by the Trump Administration eliminated the Alternative Minimum Tax (AMT) for businesses structured as C-corporations.
The TCJA also allowed businesses to reduce their tax bills using R&D tax credits from the past, present, and future. Another change saw part of the tax code amended for tax years from 2018 onwards. This amendment stopped businesses from applying more than 80% of their net operating losses to their taxable income.
However, this limit set by the TCJA was suspended in 2020 by the CARES Act. It has been reinstated, as the suspension was only designed to last for a single fiscal year.
Additional Limitations on the R&D Credit Carryforward
The TCJA went further in changing the system of credit carryforwards for R&D activities. Known as the 25/25 limitation, any C-corporation with a tax liability exceeding $25,000 cannot offset more than 75% of its total tax liability using an R&D tax credit.
For this reason, using a carryforward or carryback may be a wise move for companies with volatile year-on-year tax liabilities.
Supporting Documentation for the R&D Tax Credit
The same rules apply to the R&D tax incentive as any other tax credit. You must maintain copious records to substantiate your expenses. If the IRS audits your business and doesn’t have enough supporting documentation, the tax credit may be rescinded, leaving you with a hefty tax bill.
Some of the types of documentation you should keep records of include:
- Financial records showing payments
- Business records demonstrating the payments were used for a qualifying expense
- Breakdown of qualified vs. non-qualified expenses
As a general rule, the more documentation you have, the better. Maintain an organized recordkeeping system to ensure you don’t get caught out. An intelligent accountant won’t allow you to claim an expense unless it can be firmly substantiated.
Refundable vs. Non-Refundable Tax Credits
Refundable tax credits enable you to claim the total value of a tax credit even if you don’t have a tax liability for the current fiscal year.
Unfortunately, the federal R&D tax credit is non-refundable, meaning if you don’t owe anything, your business isn’t going to get a check from the IRS. However, state credits may be refundable and generate a refund check in the year incurred instead of being carried forward.
Companies understand this, so opting for a carryforward allows them to maximize the value of the R&D credit in years where they have higher tax liabilities.
Some small businesses may also be eligible to apply the credit to their payroll taxes. Consult a professional from Eide Bailly to confirm your eligibility.
R&D Credit Carryforward FAQ
Understanding how this credit works and how to carry it forward can be challenging and complex. Recent changes to the tax code mean that how you were managing your R&D operations before may no longer apply.
While we always recommend consulting a professional on complicated matters, here are some of the most common questions people have about carrying forward the R&D tax credit.
How far back can you claim R&D tax credits?
You must carry the credit back one year before you can carry forward. Once you have applied the credit carry back, the only limitation on these credits is a 20-year R&D credit carryforward period. There is no maximum ceiling on how much you could claim via this tax credit. Some international enterprises may claim millions per year via this tax credit.
If you believe you were eligible for this tax credit and failed to claim it, you can amend your business’s tax returns for three years.
What do I need to know about claiming the R&D tax credit?
Claiming the R&D tax credit happens through filing IRS Form 6765. To prepare for claiming this credit, tell your CPA ahead of time.
Your accountant will go through your expenses to determine which ones qualify. Keeping supporting documentation throughout the year will streamline this process. It’s a complex process, so don’t wait until tax season arrives before deciding whether you will claim this credit.
Some business owners are worried that claiming this credit will increase their chances of getting audited. Note that this tax credit is not a loophole to avoid paying tax. It’s a legitimate credit designed to fuel innovation within the economy.
Your chances of getting audited remain the same as claiming any other credit or deduction. There’s a chance you might be audited, but you are at no greater risk than anyone else.
Startups have several special rules that apply to the R&D tax credit. If you’re a startup looking to opt for a credit carryforward, you’ll need to contact a specialist in this area.
What happens to credits in the carryback or carryover year?
The R&D tax credit is initially applied to offset taxable income in the year the credit is generated. If this is excess credit after the credit is applied in the tax year the credit was generated, the credit will first carry back once year to offset any available taxable income present. It will then forward for up to 20 years.
Credits can be constantly accumulated since there are no maximum limits, but you need to make sure you claim the credit every year. Remember, you can only amend your tax returns for up to three years, so if you were eligible for an R&D tax credit four years ago, you will more likely than not be able to use it now, depending on your tax situation.
Is there a limit on the R&D credit carryforward period?
The federal carryforward period is 20 years; however, state carryforward periods largely depends on where you are based. Many states simply mirror the 20-year period mandated by the Federal government. Other states may have shorter periods or unlimited periods.
The State of California, for example, is an outlier in that it allows businesses to carry forward their tax credits until they’re completely exhausted.
If you have any questions on carryforward regulations, talk to a professional with knowledge of how your state’s rules work regarding the R&D tax credit.
How to Utilize the R&D Credit Carryforward
The carryforward mechanism for tax credits is a valuable tool to maximize the tax credits available to your business.
Hiring a professional who understands the current rules is vital to ensuring you get the most from your tax credits.
