The federal research and development (R&D) tax credit provides businesses an opportunity to reduce their tax liability based on their research-related expenses. But which expenses can you include when you calculate the credit? Here’s what you need to know.
What is the R&D credit?
The R&D credit (also known as the Sec. 41 credit) was established to encourage domestic businesses to conduct R&D work in the United States. It generally allows a business doing “qualified research” to apply a percentage of its qualified expenses to offset, on a dollar-for-dollar basis, its federal income tax or payroll tax liability.
There’s no limit on the amount of credit you can claim each tax year to offset income tax liabilities and a limit of $250,000 each tax year to offset payroll tax (scheduled to increase to $500,000 under the Inflation Reduction Act). However, limitations on the amount of general business credits used each year do apply. You can carry unused credits forward for 20 years or back one year to offset tax liability in those years.
You also can apply some or all of the credit against your payroll tax liability. This allows businesses to benefit from the credit even if they haven’t yet incurred income tax liability.
Which expenses qualify?
R&D tax credit qualified expenses fall into two categories: basic research payments (BRPs) and qualified research expenses (QREs). Basic research is an original investigation to gain scientific knowledge, without a specific commercial objective, performed by a qualified organization. (For example, a university or scientific research organization.)
Most businesses base their R&D credits on QREs. QREs encompass in-house research expenses—generally, wages for qualified services, the cost of supplies, and rental costs for computers—and contract research expenses (see below for more information). In contrast to BRPs, QREs don’t need to be for original investigations but must be for specific commercial objectives.
Does my company’s research qualify for the credit?
The credit generally is available to any business that works to develop new products or processes—even if the research ultimately fails to produce the desired results. Many eligible taxpayers don’t claim the credit, though, likely due to misunderstandings about the kinds of research that qualify.
The IRS has a four-part test for qualified research activities. Your research may qualify if it satisfies all of the following criteria:
1. It’s performed to eliminate technical uncertainty about the development or improvement of a product or process, including computer software, techniques, formulas, and inventions. The research needs to be about more than making mere cosmetic changes.
2. It’s undertaken to discover information that’s “technological” in nature. This doesn’t mean it must be about technology, technological products or processes. It’s generally sufficient if the research employs physical, biological, engineering, or computer science principles.
3. It’s intended for use in developing a new or improved business product or process. That could translate to improvements in accuracy, quality, speed, or other performance measures.
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. “Experimentation” typically involves trial and error while determining the best route.
What types of activities don’t count as qualified research?
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 function or technique
- 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
Which compensation costs are included as wages?
For purposes of the credit, wages include all taxable wages paid to employees who perform “qualified services,” defined as:
- Engaging in qualified research (for example, a scientist conducting lab experiments),
- Directly supervising qualified research (for example, a first-line research scientist who directly supervises lab experiments but might not actually perform experiments), or
- Directly supporting qualified research (for example, a machinist who fabricates part of an experimental model).
Direct support doesn’t include general and administrative services that only indirectly benefit research activities.
Taxable wages include bonuses and stock option redemptions. They don’t include amounts not subject to withholding (for example, certain fringe benefits).
Note: If you benefited from the CARES Act’s COVID-19-related employee retention credits or 2020 qualified disaster employee retention credits, the wages used to claim those credits can’t also be used to claim the R&D credit. And you can’t include wages used to claim the Work Opportunity Tax Credit.
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How much of an employee’s wages can I include in my QREs?
Generally, you can include only wages for time attributable to qualified services performed by the employee. But there is an exception that allows you to include wages for time not clearly attributable to those activities.
If substantially all of an employee’s work consists of qualified services, you can include the wages for all of the services performed by that employee — qualified or not. In other words, if at least 80 percent of an employee’s hours are spent on qualified services, you can include 100 percent of their wages. If less than 80 percent of their hours are spent on qualified services, though, you can use only the actual hours spent on such services.
Note: You’ll need solid documentation of the wages you include as QREs. The IRS will look for information such as payroll records, job descriptions, performance evaluations, and calendars to determine the services performed and the time spent doing it. The focus is on the actual work performed, rather than a job description or title.
What counts as “supplies”?
The term generally refers to the cost of supplies used in qualified research. The IRS defines it as any tangible property (other than land and improvements) used in the R&D process that you haven’t depreciated. It includes, for example, component parts, tools, molds, dyes, reagents, chemicals, and other raw materials.
Supplies don’t include:
- Depreciable equipment
- General office supplies
- Travel, rental expenses, or meals
- License fees
- Asset rental costs
Supplies usually account for a relatively small portion of total QREs. If they represent a significant amount, it could be a red flag for the IRS that your QREs include ineligible expenses.
What are “contract research expenses”?
This refers to your expenses for time that third parties, who aren’t part of your business, spend conducting or executing qualified research.
Questions can sometimes arise about who can claim the credit: the business or the contractor. To get the credit, you must maintain substantial rights (not necessarily exclusive) to the research performed and bear the financial risk of failure.
The latter requirement means your business must be obligated to pay the contractor regardless of whether the research is successful. If payment is contingent on success, it’s deemed to be for the product or result, rather than research.
Note: You can’t include prepaid contract research expenses in your QREs until the research is actually performed.
Is there a limit on the amount of contract research expenses I can include in my QREs?
Yes. You can include 65 percent of any amount paid or incurred to a third party for qualified research.
If the research is performed by a qualified research consortium, you can claim 75 percent of the expenses. Research consortiums are generally tax-exempt and organized and operated to conduct scientific research.
Which computer costs are QREs?
You can include your rental costs for computers used in R&D tax credit qualified activities, including cloud computing used to perform research.
Do all of my Sec. 174 research and experimental (R&E) deduction expenses automatically count as QREs?
No. While QREs for the R&D credit must qualify for the Sec. 174 deduction, that’s only one part of the four-part test (the first part). Sec. 41 imposes additional requirements that needn’t be satisfied for purposes of the Sec. 174 deduction.
So while every QRE is necessarily a Sec. 174 expenditure, the opposite isn’t true. R&E expenses, for example, include certain indirect research expenses that aren’t QREs for the R&D credit, such as facilities and depreciation.