R&D Tax Credit: The Four-Part Test
The research and development (R&D) federal tax credit provides an incentive for companies to increase their innovation and improvement activities. The credit is available to both public and private companies and is not industry specific. Per Internal Revenue Code Section 41, for research expenditures to qualify for the credit, they must meet four requirements.
Qualified Business Component
First, the code requires that the research activity tie directly to a new or improved business component that is held for sale, lease, or license by the taxpayer or used by the company in its trade or business. A business component could be any product, process, software, technique, formula, or invention, and the purpose of the research must be to increase the function, reliability, quality, or performance of that business component.
An improvement does not have to be significant; small incremental improvements can qualify if they meet the other requirements for qualified research. The tax code doesn’t define thresholds for research project size or scope.
Technological in Nature
Second, research expenditures must be technological in nature, i.e., they must fundamentally rely on the principles of hard science including, but not limited to, physical science, chemistry, biology, engineering, or computer science. It’s not necessary for the taxpayer to seek knowledge that “exceeds, expands, or refines the common knowledge of skilled professionals in the particular field of science or engineering.” In other words, the research does not have to involve the discovery of information that is new to the world or even to the industry; it only needs to be innovative or new to the taxpayer.
Third, qualified research activities must be undertaken for the purpose of eliminating technical uncertainties. Even if there is no doubt the objective of the research project can be achieved, expenditures could still qualify provided that at the onset of the project there is uncertainty regarding the capability, methodology, or appropriate design of the business component. It’s important to note that the research need not be successful to qualify for the credit.
Process of Experimentation
Finally, the code requires that a process of experimentation be used to eliminate the uncertainty in order to qualify for the credit. For purposes of the credit, experimentation means a process where one or more alternatives were identified as possibilities to eliminate uncertainty, and those alternatives were evaluated, discussed, designed, modeled, developed, and/or tested. The process of experimentation could involve a systematic method of trial and error and generally should be capable of evaluating more than one alternative.
The four-part test outlines what types of activities and expenses qualify for the R&D federal tax credit. Though there are some exclusions listed in the code, many activities that a company undertakes to improve and grow its business will qualify. It’s important to remember that the credit is available to U.S. companies across many industries, projects need not be successful to qualify, and many states also offer tax credits for research expenditures. Enlisting the services of a knowledgeable R&D tax advisor can help taxpayers understand the research credit, capture the qualifying expenses, and potentially reap significant tax savings.
For more information, contact your BKD Trusted Advisor™ or submit the Contact Us form below.