The R&D Tax Credit
Does your company provide services or products relating to manufacturing, technology, engineering, software, biological sciences? The U.S. Credit for Increasing Research Activities (R&D Tax Credit) incentivizes companies of all sizes to invest in innovation, product development and improvement, new technologies, improved processes, software, techniques and formulas. Additionally, there are approximately 35 states that also provide tax credit incentives for qualified research and development. Companies that are eligible for the R&D tax credit under IRC Section 41 must satisfy a four‐part test.
Eligibility: The 4-Part Test
1.Qualified Business Component: Any company/taxpayer (in a wide array of technological industries) will perform activities that qualify for the R&D Tax Credit under IRC Section 41 if they are developing a new or improved business component that is held for sale, lease, or license, or used by the taxpayer in its trade or business. These business components are defined as new or improved products, inventions, processes, techniques, formulas or software. For a research activity to qualify, the activity must provide new or improved functionality, capability, performance, reliability, or quality.
2. Technological In-Nature: The qualified activities must fundamentally rely on the principles of the physical or biological sciences, engineering, or computer science to satisfy this requirement. Activities related to market research and aesthetics are specifically non-qualified.
Most commonly, companies utilize chemistry, physical sciences, computer science or engineering principles in their process of experimentation.
3. Uncertainty: For an activity to qualify, the research must begin with some form of technological uncertainty at the outset of the development or improvement of the business component. Uncertainty defined by IRC Section 41 includes;
- Capability: Can we accomplish what is intended?
- Method: How do we accomplish what is intended? OR
- Design: What specific design allows us to achieve what is intended?
Uncertainty only has to be present in one of these three areas to satisfy this test element.
Typical uncertainties: How/Can we meet the product specifications or the process parameters (design, develop or improve)? What are some possible methods to achieve the product specifications or process parameters? What are some critical factors that may affect the design? Note: Most companies consider their work to be “routine”, but in fact are performing eligible research activities.
4. Process of Experimentation: The final element of the four-part test requires the taxpayer to utilize a process of experimentation to eliminate the aforementioned uncertainty. Qualified processes of experimentation include modeling, simulation or systematic trial and error experimentation.
Most frequently, companies begin by creating a conceptual design utilizing sketches, CAD or 3D drawings and/or associated simulation software to define basic design characteristics. The conceptual design is then further modeled by creating a prototype (modeling), that can be further analyzed and tested. Systematic trial and error experimentation to refine prototype alternatives is then performed to improve the product or process. When the approved product or process is found to meet the basic functional and economic needs of the taxpayer, the R&D is deemed complete.
Examples of the most common types of qualified activities include:
- Developing new product designs
- Improving functionality, performance or reliability
- Rapid prototyping
- Developing CAD or 3D drawings
- Performing experimental testing(s), materials testing, PPAP or FAI on new parts/design.
Qualified Research Expenditures
If the activity meets the four‐part test, the activity is considered qualified. There are four eligible categories of qualified research expenditures in calculating the R&D Credit:
1. Wages: Any wages/salaries paid to employees who are performing qualified activities, as well as managers/personnel in direct supervision of those employees.
2. Supply Costs: Supplies used/costs incurred during the performance of qualified activities. The supplies must be tangible and only used for performing qualified activities. Capital expenditures are not eligible for the R&D Credit.
NOTE: For most companies, the process development activities are similar to those of the Taxpayer in TG Missouri Corporation v. Commissioner, 133 T.C. No. 13. In this Tax Court case, the Taxpayer and the IRS submitted this case fully stipulated under Rule 122, meaning that both the Taxpayer and the IRS agreed the Taxpayer was engaging in qualified research in accordance with IRC §41 and the costs of the molds would otherwise qualify for a research credit if not for a disagreement as to the nature of the assets. That is, the IRS believed that the molds are assets of a character subject to depreciation, which is specifically excluded from the definition of eligible research expenditures for purposes of IRC §41.
In opining on the issue, the Tax Court differentiated between the molds that the Taxpayer sold to its customers and the molds that the customers retained ownership of, and therefore, depreciated over its useful life. This is an important aspect of the case as assets that are of a character that are subject to depreciation allowance are specifically excluded from the definition of qualified research.
The Tax Court held that the production molds the Taxpayer sold to its customers are not assets of a character subject to the allowance for depreciation purposes of IRC §41 and IRC §174. The Taxpayer properly included the costs of the production molds it purchased from third party toolmaker that it sold to its customers as supplies used in the conduct of research.
Further the Taxpayer was able to take a project accounting approach, thus allowing Taxpayer to define the qualified mold expenditures with specific qualified projects.
The Taxpayer seldom retains ownership of the production mold. When the final production mold was retained by the Taxpayer, the Taxpayer depreciated all accumulated costs connected with developing and constructing the mold. For purposes of the Research and Experimentation tax credit, all depreciated costs were not included in the amount of qualified research supplies expenditures.
Therefore, the Taxpayer is including the mold costs of those molds used in the conduct of research that were not of a character subject to the allowance for depreciation.
3. Contract Research: Any amount paid for outsourced/subcontracted research, design, and/or testing.
4. Computer Leasing/Rental: Any amount paid for the lease of computers in the conduct of qualified research.
Calculating the Credit
The IRS Code allows for two methods of calculating the R&D Credit: The Regular Method (RRC) or the Alternative Simplified Method (ASC).
The Regular Method consists of 20% of the taxpayer’s qualified research expenditures in excess of the base amount. This base amount consists of the greater of 50% of the current year‐end research expenditures, or the product of the average gross receipts from the prior four tax years and the fixed based percentage. The fixed-base percentage consists of the aggregate qualified research expenditures over the aggregate gross receipts during the base period. The base period is determined by when the taxpayer first began incurring qualified research expenditures. This method tends to be very complicated and less practical.
The Alternative Simplified Method is a much more practical solution, especially when it is difficult to obtain the required historical information necessary to calculate the credit using the RRC. The ASC method is equal to 14% of the taxpayers qualified research expenditures in excess of its base amount. The base amount is equal to 50% of the average qualified research expenditures paid or incurred in the prior three tax years.
New Legislation-Offsetting Tax Liability
Originally, companies were required to have taxable income to be eligible for the R&D Credit. Recent changes to the law allow businesses in a loss position to take advantage of the credit and monetize their research credit. This is done by applying it against their payroll tax liability. Note that a business must be a ‘qualified small business’ (QSB) to be eligible to offset its payroll tax liability with the research credit. For a business to be considered a QSB, it must be defined as a tax partnership, corporation, or person with no gross receipts for any of the preceding five tax years, and gross receipts of less than $5 million in the current tax year.
Another recent change to the tax law favors companies in an alternative minimum tax (AMT) position. These companies can now offset their tax liability with the research credit under a new ‘specified credit’ category under the tax law. A business must be an ‘eligible small business’ (ESB) to be eligible to offset its AMT tax liability using the research credit. For a business to be considered an ESB, it must be defined as a sole proprietorship, partnership, or non‐public corporation with average annual gross receipts of $50 million or less for the three preceding tax years.
Claiming the Credit & Supporting Documentation
Claiming the R&D Tax Credit involves a study that includes both quantitative and qualitative analyses. While it is obviously important to provide the quantifiable data, the taxpayer must also provide qualitative information necessary to support and prove that that qualified activities are being performed. This is necessary because if a company’s R&D tax credit comes under IRS examination, the qualitative supporting documentation will be used to demonstrate that research was taking place. This qualitative supporting documentation can consist of several items. Commonly, business documents pertaining to the qualified activities that are already prepared as part of the company’s routine engineering and/or reporting systems are adequate to support the qualified activities. Examples of these documents include, but are not limited to, conceptual sketches, CAD/3D design drawings with iterations and/or revisions, photographs, test data/reports, research notes, meeting/collaboration notes, e‐mails and purchase orders. This R&E supporting documentation can usually be obtained with little to no interruption of the company’s daily routine and procedures.
The R&D Tax Credit can be extremely beneficial and also provides a competitive edge to companies investing in the development or improvement of its products and/or processes. The recent changes to the tax law make it even more versatile by permitting start‐ups and taxpayers in the AMT position to benefit from taking advantage of the R&D credit, and allow eligible taxpayers to reduce their tax liability.