The federal research and development (R&D) tax credit was created by Congress in 1981 as an incentive to increase R&D spending in the United States. Since then, the credit has been extended several times and made permanent by the Protecting Americans from Tax Hikes (PATH) Act of 2015. The R&D tax credit is applicable to all sizes of companies in a variety of industries. Manufacturers, software developers and technology companies commonly claim this incentive; however, it also can apply to contractors, engineering firms and financial institutions. Ultimately, the R&D tax credit is an incentive for any company to invest in the development of new or improved technology.
Research credits are driven by wage, supply and contract research expenses related to qualified research projects, which must meet these requirements:
- Research must have been conducted to discover information intended to be useful in the development of a new or improved business component, e.g., process, technique, formula, invention or software item
- Research must be technological in nature and rely on the principles of the hard sciences, i.e., engineering, computer science, biology, chemistry, physics, etc.
- Uncertainty regarding the development or improvement of a business component must exist at the outset of the project
- A process of experimentation must be used to eliminate the uncertainties. A process of experimentation includes the development of one or more alternatives and the use of a process to test and evaluate the alternatives
Below are some examples of qualified research activities:
- New product development
- Product improvement activities to increase functionality, quality, reliability or durability
- External and internal software development
- Internal use software development
- Design and engineering activities
- Process automation and robotics
- Tooling and mold design
- New equipment development
- Equipment modifications
- Development of manufacturing processes
- Scale-up activities for production
The value of the R&D tax credit is based on the increase in qualified research expenses (QRE) in a claim year over those in a base period. QREs include costs of labor to perform, support or direct technical research activities, supplies used in performing research and research activities performed by third parties at the taxpayer’s risk and expense. The federal U.S. R&D tax credit often amounts to 4.5 to 6.5 percent of the QREs in a claim year. In addition, several states offer R&D incentives, which can provide another 2.5 to 10 percent of the QREs in state-level tax savings.
In order for the taxpayer to claim expenses as QREs, the research must involve financial risk, since funded research is specifically excluded from the R&D tax credit calculation. It’s common for inbound companies to have an R&D cost-sharing agreement with a foreign parent. This doesn’t mean the U.S.-based research is funded. The R&D tax credit uses control group rules that often treat the foreign parent and the inbound company as a single taxpayer, thus disregarding the cost-sharing agreement for R&D tax credit purposes. Inbound companies should carefully examine agreements to determine if the funded research exclusion applies.
The IRS doesn’t offer specific record-keeping requirements or guidance on the R&D tax credit. U.S. Treasury Regulation 1.41-4(d)—qualified research for expenditures paid or incurred in taxable years ending on or after December 31, 2003—states that “a taxpayer claiming a credit under Section 41 must retain records in sufficiently usable form and detail to substantiate that the expenditures claimed are eligible for the credit.”
Taxpayers are expected to maintain documentation related to QREs, e.g., records of wages, supplies and contract research. Wage documentation commonly includes time surveys for qualified research activities and copies of W-2s. Supply and contract research documentation typically includes general ledger account information, purchase orders, invoices and contracts.
In addition, taxpayers are expected to maintain project documentation showing R&D projects meet the qualification requirements. Project narratives generally are used to describe the qualified nature of projects. Supporting documentation, such as product descriptions, project schedules, project status updates, revision histories, CAD drawings, lab books, test plans, test reports and technical email, is used to support the overall narrative and prove the existence of uncertainties and use of an experimentation process.
The R&D tax credit can provide lucrative tax savings at both federal and state levels. Taxpayers need to be aware of the qualification requirements and documentation expectations before claiming these tax credits. Opportunities exist for taxpayers to implement processes and procedures for routinely capturing applicable information on a go-forward basis.