The federal research and development (R&D) tax credit can prove lucrative, potentially worth up to 20 percent of your qualified research expenditures (QREs). And it’s probably easier to qualify than you think. You don’t have to meet any requirements as to industry or size; you don’t even need a formal R&D department. There’s no need to make a huge scientific breakthrough or conduct cutting-edge research, and you don’t even have to ultimately succeed in your quest.
Sound good? Read on to learn what you do need to do to qualify.
What is the R&D credit?
The credit was created to incentivize U.S. businesses to increase the amount of R&D work they perform in the United States.
It generally allows a business conducting “qualifying research” to apply a percentage
of its qualifying expenses to offset, on a dollar-for-dollar basis, its federal income tax liability (whether regular income tax or, for eligible small businesses, the alternative minimum tax). You also may be able to apply it to your payroll tax liability.
QREs include:
- Taxable wages for employees involved with the research,
- Supplies to conduct the research (for example, supplies used for prototypes),
- Amounts paid to rent or lease computers to conduct the research (including cloud services), and
- A portion of the amounts paid or incurred for contractors to work in the United States on the research (usually 65 percent).
There’s no limit on how large of a credit you can claim each year to offset income tax liability, although limits apply to how much you can use. But unused credits can be carried forward for 20 years or back one year to offset income tax liability.
Which research activities qualify for the credit?
The IRS has a four-part test for what it calls “qualifying research activities” (QRAs):
1. The research is performed to eliminate technical uncertainty about the development or improvement of a product or process, including computer software, techniques, formulas, and inventions (the Section 174 test),
2. The research activity undertaken must be technological in nature — that is, it relies on physical, biological, engineering, or computer science principles (the technological information test),
3. The research is intended for use in developing a new or improved business product or process (the business component test), and
4. Substantially all (generally, at least 80 percent) of the research activities are elements of a process of experimentation relating to a new or improved function, performance, reliability, or quality (the process of experimentation test).
You must satisfy each part for every QRA for which you claim the credit. We’ll dig into what’s required for each below.
What kinds of research activities are excluded from the credit?
The R&D credit isn’t allowed for expenses related to:
- General administration
- Research conducted after commercial production of the product or process has begun
- Research adapting an existing product or process to a particular customer’s need
- Duplication of an existing product or process (in whole or part)
- Surveys or studies, including:
- Efficiency studies
- Activities related to management functions or techniques
- Market research, testing, or development
- Routine data collection
- Routine quality control testing or inspection
- Research relating to certain internal-use computer software
- Research conducted outside the United States, Puerto Rico, or a U.S. possession
- Research in the social sciences, arts, or humanities
- Research funded by another person or governmental entity
How do I satisfy the Sec. 174 test?
Section 174 refers to the provision in the Internal Revenue Code that allows taxpayers to amortize a deduction for their research and experimentation costs. So a QRA expense must qualify for the Sec. 174 deduction to count toward your Sec. 41 R&D credit.
That means the expense:
- Is incurred in connection with your business, and
- Represents an R&D cost in the experimental or laboratory sense.
What does “in the experimental or laboratory sense” mean?
Expenses meet the second criteria above if they’re for activities intended to discover information that would eliminate uncertainty related to the development or improvement of a product. Uncertainty exists if the available information doesn’t establish the capability or method for developing or improving the product or its design.
What types of expenses don’t meet the Sec. 174 test?
The IRS has stated that expenses for land and depreciable property aren’t allowed under the provision (in certain cases, though, depreciation itself might be treated as a Sec. 174 expense).
Sec. 174 also doesn’t apply to expenses for:
- Exploration, or
- Determining the existence, location, extent, or quality of any ore, oil, gas, or other mineral deposit.
Note: It’s important to understand that Sec. 174, the research deduction, applies to a broader range of costs than Sec. 41, the R&D credit. Expenses that are eligible for the deduction aren’t necessarily also eligible for the tax credit. For example, the expenses related to the filing fees for obtaining a patent generally would qualify under Sec. 174, but they wouldn’t qualify under Sec. 41.
How do we satisfy the “technological information” test?
This test has two prongs: 1) the research must be done to “discover information,” and 2) that information must be “technological in nature.”
You conduct research to discover information if your goal is to eliminate uncertainty about the development or improvement of a business component. As under the Sec. 174 test, uncertainty exists if the available information doesn’t establish the capability or method for developing or improving the product or its design.
Information is technological in nature if your process of experimentation (see below) to discover it “fundamentally” relies on principles of the biological or physical sciences, engineering, or computer science. You can use existing technologies and existing scientific principles.
Note: Research in the social sciences (for example, economics, business management, behavioral sciences, arts, or humanities) doesn’t qualify for the credit. But it’s the process, not the end result, that matters. For example, if you develop a new formula for artists’ paint, it could qualify for the credit if you relied on physical science to do so. On the other hand, research into the life of an artist wouldn’t qualify.
Will obtaining a patent help?
Yes. IRS regulations for the R&D credit include a patent safe harbor. It provides that a patent is conclusive evidence that a taxpayer has discovered information that’s technological in nature, and intended to eliminate uncertainty.
What is a “business component”?
The term means any product, process, computer software, technique, formula, or invention that is to be 1) held for sale, lease, or license or 2) used in the taxpayer’s business.
If you use a plant process, machinery, or technique for commercial production of a business component, it’s considered a separate business component — not part of the component being produced. You’ll have to satisfy the four-part test separately for each.
What is a “process of experimentation”?
It’s a process designed to evaluate one or more alternatives to achieve a result where there’s uncertainty about achieving that result when the research begins — evaluating alternatives to eliminate uncertainty that arises during a project doesn’t meet the definition. Simple trial and error to validate a process or product change also falls short.
You can fulfill this requirement even if there’s no uncertainty about your capability or method of achieving the desired result — if you’re uncertain about the appropriate design of that result when research starts.
How do I show that we’ve engaged in a process of experimentation?
In contrast to the Sec. 174 test, demonstrating uncertainty isn’t enough to satisfy the “process of experimentation” test. You’ll need to identify the following:
- The uncertainty about the development or improvement of a business component,
- One or more alternatives intended to eliminate this uncertainty, and
- A process of evaluating the alternatives (for example, through modeling, simulation, or a systematic trial-and-error methodology).
How does the “substantially all” test work?
The test requires that at least 80 percent of your research activities — generally measured based on cost — involve a process of experimentation for a qualified purpose (see below).
If they are, the remaining 20 percent (or less) of research activities also qualify for the credit — even though they don’t involve a process of experimentation. This assumes the balance of research activities 1) satisfy the Sec. 174 test, and 2) aren’t excluded activities (for example, as research after commercial production, adaptation, or duplication).
Does every process of experimentation qualify for the credit?
No. For purposes of the credit, a process of experimentation must be conducted for a qualified purpose — meaning it relates to a new or improved function, performance, reliability, or quality of the business component.
If it relates to aesthetic factors (for example, style, taste, cosmetic, or seasonal design factors), the process isn’t conducted for a qualified purpose.
Can I claim the R&D credit for research if we’ve already begun commercial production?
No. You can’t claim the credit for research on a business component already ready for use or meets your basic functional and economic needs. Activities deemed to occur after commercial production, and therefore aren’t eligible for the credit, include:
- Preproduction planning for a finished component,
- Tooling up for production,
- Trial production runs,
- Troubleshooting to detect faults in the production equipment or processes,
- Accumulating data on production processes, and
- Debugging flaws in a component.
What if a customer asks us to tailor an existing business component to its needs? Will that qualify?
It won’t. But the fact that a business component is intended for a specific customer doesn’t make the research ineligible. The exclusion is triggered only if the business component already exists.
Is any foreign research eligible for the credit?
Qualified research is strictly limited to research performed in the United States, Puerto Rico, and any U.S. possessions. The exclusion applies to both in-house and contract research, regardless of whether it’s done by U.S. researchers or for a U.S. taxpayer.
How do I know if my research is considered funded and therefore ineligible for the credit?
The question of whether research is funded depends on the answers to two questions:
- Is payment for your research activities contingent on the success of the research?
- Do you retain substantial rights in the results of the research?
If the answer to both questions is no, the research is funded. Conversely, if your payment is contingent on success and you retain substantial rights, the research generally isn’t funded, and you can claim the credit.
If you retain substantial rights and you’re paid for performing the research — regardless of success — the research is funded to the extent of the payments.
Note: You don’t retain substantial rights in research if you must pay for the rights to use the results.
What if I don’t yet know the extent to which research we’ve conducted is funded at tax filing time?
If you can’t determine the extent to which research may be funded, you should treat the research as wholly funded when completing your tax return. When you finally determine the amount, you can amend the return (and any interim returns) to reflect the proper funding
