Tax Credits and Incentives: R&D Credit, ERC, LIHTC, and How Credits Differ From Deductions

Deduction vs Credit: Why Credits Are More Valuable

The distinction between a tax deduction and a tax credit is fundamental. A deduction reduces taxable income; its tax saving equals the deduction amount multiplied by the applicable tax rate. A credit reduces the actual tax liability dollar-for-dollar, regardless of tax rate.

Credits are also distinct based on their refundability: a non-refundable credit can reduce tax liability to zero but cannot generate a cash refund (though it may be carried back or forward). A refundable credit can result in a cash payment from the government even if the taxpayer owes no tax — making it valuable even for loss companies. For broader tax context, see the introduction to tax accounting.

The Research and Development (R&D) Tax Credit

The R&D credit (formally the Credit for Increasing Research Activities under IRC Section 41) provides a tax credit for qualified research expenditures (QREs) — spending on activities designed to discover information that is technological in nature and intended to develop or improve a business component. The credit rate is 20% of QREs above a base amount (using the regular credit method) or 14% of QREs above 50% of the average QREs for the preceding three years (the alternative simplified credit — the more commonly used method).

Qualifying activities: developing or improving products, processes, software, formulas, or techniques; trial and error experimentation; activities where outcomes are uncertain at the start. Non-qualifying activities: market research, social science research, funded research (where another party bears the risk), and research after commercial production begins.

The R&D credit is non-refundable but carries back 1 year and forward 20 years. Qualified small businesses (QSBs) — those with less than $5 million of gross receipts — may elect to apply up to $250,000 of the R&D credit against payroll taxes instead of income tax, making the credit valuable even in loss years. The software development accounting guide covers the related question of when software development costs qualify as QREs.

Employee Retention Credit (ERC)

The Employee Retention Credit (ERC) was created under the CARES Act (2020) to incentivise employers to retain employees during COVID-19 disruptions and subsequently expanded multiple times. The ERC was a refundable payroll tax credit available for eligible wages paid between March 2020 and September 2021 (with some eligible periods extending to December 2021 for recovery startup businesses). The credit rate reached 70% of up to $10,000 of qualified wages per employee per quarter in 2021, for a maximum of $21,000 per employee for the full 2021 period.

The IRS has been scrutinising aggressive ERC claims and many promoters encouraged questionable claims. ERC claims are subject to audit for up to five years from the filing date. Businesses that received ERC payments must reduce their deductible wage expense by the credit amount — the "no double benefit" rule. For GAAP purposes, ERC proceeds received by for-profit entities are typically classified as a government grant or reduction of payroll expense under ASC 958-605 or analogous guidance.

Low-Income Housing Tax Credit (LIHTC)

The Low-Income Housing Tax Credit (LIHTC, pronounced "lie-tech") is the primary federal subsidy for affordable housing construction and rehabilitation. Investors who provide equity capital for qualifying low-income housing projects receive a credit equal to approximately 9% per year (for new construction) or 4% per year (for acquisition/rehabilitation using tax-exempt bond financing) of the qualified basis over 10 years.

The mechanics: state housing finance agencies allocate LIHTC credits to qualifying projects. Developers sell these credits to corporate investors (typically large banks and insurance companies seeking community reinvestment obligations) through limited partnerships. The investor receives the annual credit stream in exchange for upfront equity capital, producing a below-market expected return that is compensated by the tax credits. A typical 9% LIHTC project might generate $1 million of credits over 10 years in exchange for $800,000 of equity investment — a positive NPV for the tax-credit investor.

For investors, LIHTC partnerships are accounted for using either the proportional amortisation method (preferred for qualifying investments) or the equity method. Under proportional amortisation, the investment is amortised in proportion to the tax benefits received, and the net amortisation and tax benefit appear together as income tax expense — simplifying the accounting.

Other Major Federal Tax Credits

Work Opportunity Tax Credit (WOTC): Credit for hiring individuals from certain target groups (veterans, ex-felons, long-term unemployment recipients). Generally 25–40% of first-year wages up to a maximum of $2,400–$9,600 per qualifying hire depending on the target group.

Investment Tax Credit (ITC): Credit for investment in qualifying clean energy property (solar, fuel cells, energy storage). The Inflation Reduction Act (2022) restored and expanded the ITC to 30% for most qualifying solar and wind installations, with additional bonus credits for projects in energy communities or meeting domestic content requirements.

New Markets Tax Credit (NMTC): Credit for investments in Community Development Entities (CDEs) that deploy capital in low-income communities. The credit is 39% of the qualified equity investment, claimed over 7 years.

Accounting for Tax Credits Under ASC 740

Under ASC 740, the accounting for tax credits depends on their nature. The most common approach for general business credits (R&D, WOTC, ITC): the credit directly reduces income tax expense in the year earned (the "flow-through" method). The credit's impact on the effective tax rate is disclosed in the rate reconciliation footnote. If the credit creates a deferred tax benefit (e.g., because the credit reduces the tax basis of an asset), a deferred tax liability is recognised for the basis difference. See the full framework in the deferred tax accounting guide.

Tax Credit Planning Considerations

Effective tax credit planning requires: identifying qualifying activities before they occur (retrofitting documentation for activities already completed is more difficult); maintaining contemporaneous records of QREs (particularly for R&D credit — employee time tracking, project cost logs, technical uncertainty documentation); understanding the interaction between credits and deductions (the R&D credit reduces deductible R&D expense by the credit amount — the "reduced deduction" rule); and assessing passive activity limitations (LIHTC credits from passive activities are limited for individuals with AGI above $100,000).