The R&D Tax Credit Four-Part Test
The R&D tax credit is surrounded by several myths. One of the most common is that qualifying is prohibitively hard. Remarkably, an estimated 5% of eligible companies never apply, when in fact many businesses of all sizes could use it for a substantial reduction in their tax burden.
In this installment of our R&D tax credit series, we’ll take a closer look at the four-part eligibility test that’s spelled out in Internal Revenue Code (IRC) Section 41. It turns out that the qualification bar is often lower than many business owners believe.
What is the four-part test for R&D tax credit eligibility?
When the R&D tax credit was introduced in 1981, it was originally a two-year limited incentive to spur investment in innovation. The thinking was that if businesses were rewarded for research and experimentation that led to long-term job growth, the economy as a whole would prosper. The credit has been extended and expanded many times over the years.
The ground rules for the credit set four basic eligibility criteria for qualifying activities:
- First, the activity must serve a qualifying purpose that’s fundamental to your business. Broadly, the purpose can be to develop a new or improved product or process. Your discovery does not have to be new to the world, or to your industry. It just has to be new and relevant to your core business.
- Second, the activity must address a specific technological uncertainty. In an industrial automation company, for example, you might be developing a new automation system for a unique customer application or implementing efficiency or quality improvements to an existing system.
- Third, the activity must be based on one of the established branches of hard science. This means that the product or process improvement you envision can be observed and explained in the accepted terms of chemistry, physics, earth science, microbiology or computer science.
- Fourth, the activity must follow a documented process of experimentation. You will need to capture and preserve detailed logs of things like your guiding assumptions, testing methods and timelines, and the iterative changes you make on the way to your desired outcome. These don’t have to be any more elaborate than the project plans and notes you may already use to run your business. IMPORTANT: To qualify for the credit, your attempts do not have to be successful. They just have to be properly recorded.
Are there other R&D tax credit qualifications I need to know about?
To bust another R&D tax credit myth, you do not need to have expensive laboratory facilities or a Fortune 500 research budget to qualify. Many small, medium and even startup businesses in a wide variety of industries are able to comfortably pass the four-part eligibility test. Contrary to popular belief, the credit is not limited to companies you’d normally associate with “big science” such as the pharmaceutical, microelectronics or life science giants.
Here are the primary items the IRS considers Qualified Research Expenses (QRE):
- Taxable wages paid to employees who directly contribute to qualified research activities
- Taxable wages paid to people who directly assist such employees
- Taxable wages paid to people who directly supervise such employees
- Payments to contractors who perform direct services in the U.S. in support of such work
- Payments to vendors who supply materials consumed in support of such work
Lists can be abstract, so let’s set up a quick illustration:
Imagine that you’re a systems integrator developing a new control system for a food and beverage manufacturer’s production line. A defined part of the taxable wages of the engineer who designs the control hardware and software, as well as the taxable wages of the engineer’s direct supervisor or assistant who supports the development would be considered QREs.
If your business creates new processes or products or enhances existing ones in a value-added way, there’s a good chance you can qualify for a federal and perhaps a corresponding state R&D credit. It’s best to seek advice from a qualified tax expert on the supporting documentation you’ll need such as payroll records, vendor receipts or contractor agreements.
Interested in learning more about R&D tax credits? Check out the rest of our R&D Roundup series:
- Your Guide to R&D Tax Credits
- What Expenses Qualify for R&D Tax Credits?
- How to Calculate R&D Tax Credits
- How to Claim R&D Tax Credits
If you’re thinking about claiming the R&D tax credit, or currently claim it but aren’t sure how IRS code changes might impact your tax return, we can help you explore your options, check for federal and possible state eligibility and devise a personalized strategy to get the maximum benefit from the credit, possibly for multiple tax years. Reach out for more information.