Research and Development Tax Credits

The federal R&D tax credit is a way for the United States government to reward business for investment in research. The PATH Act of 2015 permanently extended the R&D tax credit and expanded its provisions.

To qualify as research according to IRC section 41, the taxpayer must show that the activities—

are intended to resolve technological uncertainty that exists at the outset of the project or initiative, related to the capability or methodology for developing or improving the business component or the appropriate design of the business component;

rely on a hard science, such as engineering, computer science, biological science, or physical science;

relate to the development of a new or improved business component, defined as new or improved products, processes, internal use computer software, techniques, formulas, or inventions to be sold or used in the taxpayer’s trade or business;

Many thought that this tax credit was designed for the large fortune 500 companies, but as you read the requirements carefully you can see that any business who is investing money in itself, with the intent of improving its products, processes, or internal use of software, techniques, formulas, or inventions. This is meant to include a large percentage of companies.

The rules of the R&D tax credit can be found under Internal Revenue Code (IRC) section 41 and the related regulations. The R&D tax credit may apply to any taxpayer that incurs expenses for performing Qualified Research Activities (QRA) on U.S. soil.

The R&D credit includes the following types of Qualified Research Expenses (QRE):

  • Wages paid to employees for qualified services (including amounts considered to be wages for federal income tax withholding purposes)
  • Supplies (defined as any tangible property other than land or improvements to land, and property subject to depreciation) used and consumed in the R&D process
  • Contract research expenses paid to a third party for performing QRAs on behalf of the taxpayer, regardless of the success of the research, allowed at 65% of the actual cost incurred
  • Basic research payments made to qualified educational institutions and various scientific research organizations, allowed at 75% of the actual cost incurred.
  • substantially all constitute a process of experimentation involving testing and evaluation of alternatives to eliminate technological uncertainty.
  • If the development is related to internal use software (IUS), there are additional tests that must be satisfied:
    • The software must be innovative. It should result in a reduction of cost or an improvement in speed that is substantial and economically significant.
    • Developing the software involves significant economic risk, requiring the commitment of substantial resources and subject to substantial uncertainty of recovery in a reasonable time period.
    • The software is not commercially available. The taxpayer cannot purchase, lease, or license and use the software for the intended purpose without having to make significant modifications that satisfy the first two requirements.

There are numerous activities that are not within the definition of qualified R&D activities. The following are 10 primary types of activities that are specifically excluded from the definition of qualified research:

  1. Research conducted after the beginning of commercial production or implementation of the business component (with some exceptions)
  2. Adaptation or duplication of existing business components
  3. Surveys, studies, or activities related to management functions or techniques
  4. Market research, testing, or development (including advertising or promotions)
  5. Routine data collection
  6. Routine or ordinary testing or inspection for quality control
  7. Computer software, except where developed for internal use
  8. Any research conducted outside of the United States
  9. Any research in social sciences
  10. Funded research.

The cost of acquiring fixed assets used in a taxpayer’s trade or business is also excluded.

If you feel your business may qualify, you may have to go beyond your current CPA to get help. Applying for and reporting the ongoing year end work will require a specialist in this field.

SBO Advocates