Get the credit you deserve – The North Carolina Research and Development Tax Credit

Editor's Note: Deborah B. Andrews is a member of the Business Practice Group of Ward and Smith, P.A.

The North Carolina research and development tax credit is based on the percentage of qualified research expenses that a business pays or incurs during the year. Unlike a tax deduction that simply reduces taxable income, a tax credit is a dollar-for-dollar reduction in taxes. As a result of the tax credit, a business could experience an increase in its cash flow.

Over the years, North Carolina has been providing tax incentives in the form of tax credits to encourage research activities and increase technological advancements. In 2004, the General Assembly enacted a new research and development tax credit as an alternative to the credit which was set to expire on January 1, 2006. One of the most important aspects of the new tax credit was the availability of the credit to any type of business. Under the previous tax credit, only certain types of businesses were eligible for the credit.

North Carolina has remained consistent in its support of the research and development tax credit. In 2007, the General Assembly increased the percentages upon which the tax credit is based to provide a greater tax benefit for North Carolina businesses. In the just-concluded Session of the General Assembly, the tax credit, scheduled to expire on January 1, 2009, was extended for five years.

The following discussion provides just an overview of the credit, but it may help you determine if the credit is a viable option to reduce your tax bill.

Who Can Claim the Credit?

Any business that engages in "research and development activities" (as discussed more fully below), regardless of the business type or size, can take advantage of the credit if certain requirements are met. Therefore, corporations, partnerships, and limited liability companies are eligible. Many people may think that the credit is available only to so-called "high-tech" companies. However, the credit is available to any business that invests in a new or improved product or process and meets the following requirements:

 Wage Standard: The average wages paid to full-time employees at the location with respect to which the credit is claimed must meet or exceed the applicable wage standard. The North Carolina Department of Commerce publishes the applicable wage standard for each county.

• Health Insurance: The business must provide health insurance for the full-time employees at the location with respect to which the credit is claimed and must pay at least 50% of the premiums.

• Environmental Record: The business must not have been cited by the North Carolina Department of Environment and Natural Resources for any significant environmental violations within the prior five years.

• Occupational Safety and Health Act ("OSHA") Record: The business must not have been cited for any serious OSHA violations within the prior three years.

What is Research and Development?

One of the most common deterrents to a business's application for the tax credit is an unnecessarily narrow understanding of what qualifies as research and development. There is no simple definition of "research and development activities," but it expands beyond what is commonly thought of as traditional research. If a business spends money in an attempt to make something better or in an attempt to deliver a service more efficiently, it may be entitled to the credit. To qualify as research and development, the activity must meet the following criteria which are based on the federal tax rules:

• The purpose of the research must be to develop a new or improved product or process. The improvement does not have to be successful to qualify for the credit.

• The research must be technological in nature. This means that the process of experimentation relies on principles of physical or biological sciences, engineering, or computer science.

• Substantially all of the research activities must relate to a process of experimentation with no assurance of success. For this purpose, "substantially all" means at least 80% of the research activities.

• The research and development expenses must be expenses that would qualify as a business deduction. To qualify as a business deduction and, therefore, for the credit, the expenses must be related to the trade or business. The burden of proving the credit rests on the claimant. Therefore, detailed and well-documented records should be maintained to substantiate the amount of the credit in the event of a tax audit.

How Much is the Credit?

The credit applies to two different types of expenses: (1) expenses paid or owed to an institution within the University of North Carolina system for research performed in North Carolina ("University Research"), and (2) expenses paid or incurred for research performed in North Carolina other than University Research ("Other Research"). The credit provides the greatest benefits for businesses that partner with the University of North Carolina system. The credit for University Research is equal to 20% of the research and development expenses.

Other Research is divided further into three categories. If the expenses qualify for more than one category, the credit is based on the higher percentage.

• Small Business: For expenses associated with research performed by businesses with annual receipts of less than $1,000,000, the applicable percentage is 3.25%.

• Low Tier: For expenses associated with research performed in the most economically distressed areas, commonly referred to as "low tier areas," the applicable percentage is 3.25%.

• Other Expenses: For expenses associated with research other than Small Business and Low Tier, the applicable percentages are as follows:

1. 1.25% for the first $50 million
2. 2.25% for the amount over $50 million but less than $200 million
3. 3.25% for the amount over $200 million

How Does A Business Claim the Credit?

The credit is claimed for the year in which the expenses are paid or incurred. An election must be made to claim the credit against either the business's state income tax or its franchise tax, and is made when the business tax return is filed. The credit cannot exceed 50% of the amount of tax against which it is claimed, reduced by the total of all other credits that are allowed against that tax. The limit applies to the cumulative amount of the credit, including credits that have been carried forward from previous years. Any unused credit may be carried forward for the next fifteen years.

Conclusion

The North Carolina research and development tax credit is a valuable tax incentive and your business could be losing a substantial amount of money by not taking advantage of it. Smaller businesses definitely should take a closer look at the credit.

© 2008, Ward and Smith, P.A.

Ward and Smith, P.A. provides a multi-specialty approach to the representation of technology companies and their officers, directors, employees, and investors. Deborah Andrews practices in the Business Practice Group. She advises a wide range of businesses, individuals, and tax-exempt organizations on complex tax and compliance matters. Comments or questions may be sent to dba@wardandsmith.com.

This article is not intended to give, and should not be relied upon for, legal advice in any particular circumstance or fact situation. No action should be taken in reliance upon the information contained in this article without obtaining the advice of an attorney.