The R&D tax credit is a federal tax credit and may also entail an additional state benefit depending on which state you live in. This is a dollar for dollar tax credit primarily designed to stimulate research and development activity of US companies. Many of our clients engaging in innovative work or processes can take advantage of this tax credit, as its applications are expansive. The credit applies to many different industries. The credit calculation is fairly involved and contains several options/considerations, but primarily drives off of a 20 percent of qualified research expenditures calculation that is applied to a base amount.
The 1986 Tax Reform Act targeted the definition of qualified research with respect to which the credit is allowed. Initially, the term “qualified research” is defined as research with respect to which expenditures may be treated as expenses under section 174. In addition, section 41(d) sets forth three other requirements. Specifically, to constitute qualified research:
- The research must be undertaken for the purpose of discovering information that is technological in nature;
- Substantially all of the research activities must constitute a process of experimentation; and
- The experimentation must relate to a permitted
More specifically, the IRS typically utilizes a four part test detailed based on below:
Technical in Nature
The criterion must rely on the principals of, engineering, physical or biological science, or computer science. In other words, products or activities that are predicated upon literary, historical or social sciences do not qualify for the R&D Tax Credit.
The activity must result in a new or improved process, function, product, performance, reliability, quality, or significant reduction in cost. Updating of production‐line capabilities by a manufacturer that ultimately improved efficiency, increased production capacity, and eventually yielded an overall reduction in costs would be an example. For example if a manufacturere were to implement improvements in its manufacturing process, by way of automation or some other means that required investment then it is quite possible that the costs associated with the implementation of the new production process could be eligible for the R&D tax credit.
Elimination of Uncertainty
Specifically involves the identification of information that is uncertain at the onset of the project or activity. Such uncertainty can relate to the capability of the product, the method used to produce it, or the appropriate design of the product.
Process of Experimentation
Does the activity involve developing one or more hypotheses for specific design decisions, testing and analyzing those hypotheses, and refining and discarding the hypotheses?
This definition is relatively broad and encompasses such activities as:
- Developing new or improved products, processes or formulas;
- Developing prototypes or models;
- Developing or applying for patents;
- Certification testing;
- Developing new technology;
- Environmental testing;
- Developing or improving software technologies;
- Building or improving manufacturing facilities; and
- Streamlining internal
- Develop new, improved or more reliable products, processes or formulas
- Develop prototypes and models including computer generated models
- Design tools, jigs molds and dies
- Conduct testing of new concepts and technology
- Automate/streamline production process or manufacturing process
- Add new equipment (implies process improvement, not equipment cost)
The costs eligible for the research credit as QREs must meet the definition of IRC § 174, which permits taxpayers to elect either to deduct “research or experimental expenditures” or to amortize the costs over a period of not less than 60 months. Those expenses are limited to:
- In‐house wages and supplies attributable to qualified research;
- Certain time‐sharing costs for computer use in qualified research; and
- 65% of contract research expenses, that is, amounts paid to outside contractors in the U.S. for conducting qualified research on the taxpayer’s behalf.
RESEARCH CREDIT SUPPORTING DOCUMENTATION
To substantiate its qualified research, a taxpayer must prepare and retain documentation on paper or electronically. Numerous court cases over the years reflect difficulties by the IRS and taxpayers in administering the research tax credit. Some of the most recent court cases, such as U.S. v. McFerrin (docket no. H‐05‐3730, S.D. Texas, vacated and remanded, 5th Cir., 2009) and Union Carbide Corp. v. Commissioner (TC Memo 2009‐50), have addressed research credit substantiation and credible documentation, a key issue in IRS exams. In these cases, the courts ruled that the taxpayers, in the absence of certain contemporaneous records such as a time tracking or project accounting system, may still estimate research and experimentation expenses by looking to testimony of credible personnel and other available evidence.
Examples of research and development documentation:
- Email communications which show failures, problems, or concerns encountered during the development
- Product or project specifications, descriptions, or proposals
- Technical reports/test reports and results
- Documentation of alternative supplies/materials/technology evaluated
- Project diagrams/drawings/pictures including older versions and conceptual drawings which differ from the final product
- Issue logs/meeting minutes/flowcharts or time schedules/schedules of releases
- Patent applications or abstracts
- Contractual agreements with consultants and customers
January 4, 2016 Update:
As Part of the “Protecting Americans from Tax Hikes (PATH) Act of 2015” we were excited to see that the research and development (R&D) tax credit was permanently extended. This is a huge victory for U.S. businesses that were previously frustrated by the regular uncertainty around the R&D credit. Eligible small businesses ($50 million or less in gross receipts) may claim the R&D credit against the Alternative Minimum Tax (AMT), beginning in January 2016. This will benefit a significant number of closely‐held businesses and their shareholders who previously had to defer some or all use of their credit due to the AMT limitations. Additionally, certain small businesses ($5 million or less in gross receipts) will have the ability to offset the credit against payroll tax liability (capped at $250,000 for up to five years). There are many complexities to this law and how to apply it to your business.
Please contact us today and we can start planning on how to use this credit to help your business grow.