The R&D tax credit originally pertained to basic research expenses, such as those occurring in a laboratory setting. Subsequent modifications simplified the credit and made it available to a wider variety of businesses.
Eligibility: Meeting the Four-Part Test
The R&D tax credit incentivizes certain research activities by reducing a company’s liabilities for spending money on that research. The credit is equal to a certain percentage of a business’ qualified research expense (QRE) in excess of a base amount. Expenses that qualify are more comprehensive than you may think—QREs can include the salaries of employees and supervisors who are conducting research, supplies and even some of the research that is contracted out. A simple four-part test helps to determine qualified R&D activity. R&D tax credit eligibility largely depends on whether the work you are conducting meets the criteria established by the IRS in its four-part test:
1. Elimination of Uncertainty: You must demonstrate that you’ve attempted to eliminate uncertainty about the development or improvement of a product or process. In other words, something that has been changed solely for aesthetic purposes would not qualify.
2. Process of Experimentation: You must demonstrate – through modeling, simulation, systematic trial and error or other methods — that you’ve evaluated alternatives for achieving the desired result.
3. Technological in Nature (The Discovering Technological Information Test): The process of experimentation must rely on the hard sciences, such as engineering, physics, chemistry, biology or computer science.
4. Qualified Purpose (The Business Component Test): The purpose of the research must be to create a new or improved product or process, resulting in increased performance, function, reliability or quality.
What kinds of activities meet this 4-part test?
Here are 10 examples of qualifying research activities:
- Conduct testing of new concepts and technology
- Develop prototypes and models
- Develop new, improved or more reliable products, processes or formulas
- Develop or apply for patents
- Add equipment that improves a process
- Streamline your manufacturing process
- Develop new software
- Design for LEED/green initiatives
- Conduct environmental testing
- HVAC concept and design
By Matthew Shiebler, CPA