Paying Tribute

If your company's research budget is growing, your federal tax refund could grow, too, with the help of a 25-year-old tax credit designed to encourage domestic innovation.

Many businesses don't realize they can use the research and experimentation credit, officially known as the Credit for Increasing Research Activities. The R&E credit can bring refunds of $100,000 or more to SMBs, says tax attorney Patricia Sweeney from the Washington, DC, law firm Miller & Chevalier.

To calculate the credit, establish a baseline year, noting your company's R&E costs. For each year thereafter, 20 percent of the increase can qualify as a tax credit, with each qualified dollar directly reducing your tax bill. To avoid losing out on some or all of your credit, be sure to document all research costs for each step of a project. In most cases, three previous years' tax forms can be refiled to add the credit if it has been overlooked.

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What qualifies: technical research that aims to improve a product or manufacturing process. Covered areas include building prototypes, adding new features to existing products, investigating new patents and introducing auto-mation to product manufacturing. Work can be done by employees or, under certain circumstances, by outside contractors, but it must be performed in the U.S.

What doesn't: research on organizational issues, such as marketing, management structure or departmental efficiency. Also, the IRS often looks askance at software research, Sweeney says.

The R&E credit is for businesses what the home-office credit is for individuals--a red-flag deduction that the IRS scrutinizes closely. So make sure your research qualifies.