New technologies and discoveries are being made at an increasingly fast rate nowadays. This rapid pace is due to the increased access to information leading to the proliferation of knowledge, ideas, discoveries, and new uses for technology.
As more and more businesses embrace technology and innovation to come up with new products and better processes and, at the same time, look for ways to reduce tax liability from income generated by innovation, they end up ignoring one of the most important tax opportunities available—R&D tax credits.
Before December 2001, there was a lot of debate on the requirements necessary to qualify for the R&D tax incentives. People argued that the requirements were rather difficult to meet and did not comply with congressional objectives. But in 2004, the IRS issued permanent regulations that reflected more of the congressional intent of creating this tax incentive.
Ever since that moment, more and more manufacturers, engineering firms, architecture firms, software developers, defense contractors, and other companies have claimed the tax credit. They were able to realize tax recoveries and eventually reduce tax payments in the future years.
There are two ways to determine eligibility for the R&D tax credits. First, companies must determine potentially qualifying activities. Next, if the activity meets the specified criteria, specific expenses related to the activity are included in calculating the tax credit.
To identify qualifying activities, companies must meet the criteria of the four-part test:
- Does the activity involve a new or improved product or process?
- Is the activity technological in nature?
- Did the company encounter any technical uncertainty for a given product design or development process?
- Was there an experimentation process involved in resolving the technical uncertainty?
You might think that this four-part test would limit the range of companies that qualify for this tax credit. But the qualifications are rather broad if these tests are approached correctly and effectively.
The main point, however, is whether your company’s research and development activities have resulted in something new or at least somehow changed something that it would be considered “new.”
Simply put, when you design and build a better food processor, for example, it should be able to address function performance, reliability, and quality issues.
Some types of activities simply do not qualify for the R&D tax credit for certain reasons. Some examples include:
- research after commercial production of a product starts
- adaptation of existing products and processes
- copying or duplicating existing products or processes
- cost of acquiring another’s patent
- market research and testing
- efficiency surveys
- advertising and promotions
- management functions
- routine testing, inspection and quality control
- routine data collection
The cost drivers for the R&D tax credits are wages of staff, supply costs involved in the R&D process, and expenses related with outside contractors (contract research) doing applicable projects.
As you can see, when it comes to companies that are resource and technology-intensive, these cost drivers translate to a significant amount of their business expenses. If a company cannot identify a cost as among the qualified expenditures, it will not qualify for the credit.
Supplies can include but are not limited to, computer supplies, laboratory supplies, shop floor supplies, compact discs, paper, and other incidentals used by support personnel, supervisory personnel, and researchers.
Supplies also include materials used in constructing prototypes or models or testing the same parts or sub-parts bought from third parties and included in prototypes as well as huge amounts of electricity or other utilities used in the research activity. Supplies, however, do not include depreciable land or property.
Sixty-five percent (65%) of costs (otherwise eligible for the tax credit) paid or incurred on behalf of the taxpayer by another person apart from the employee qualifies for the R&D tax credits as contract research.
If software development expenses meet the test of a qualified activity, it is considered a qualified cost. It is also considered a qualified cost if the software:
- is created and sold or given to a third party
- is part of or embedded in computer hardware
- is created to be used in qualified research activity or included in a production process
To qualify for the R&D tax credit, internal use software must meet these three additional criteria such as:
- the software must exhibit significant innovation
- the software must have huge economic risk with regard to the resources dedicated to the project
- the system must not be commercially available for purchase, rent/lease, license, or use without the need for modifications
Because applying for the R&D tax credits is a fact and circumstance-based activity, proper documentation is necessary to support and provide substantiation for IRS examination.
Among the most important documents to support this are those that show and illustrate the experimentation process, uncertainty, and level of innovation or novelty of the particular qualified activity.
The results of the experiment do not need to be recorded in any specific manner. The results of the experiments must be recorded in a manner that is relevant to the particular field of science in which the experiment is conducted and also for the type of experimentation involved.
For example, in some areas of discipline, experiments are recorded in lab books. But in manufacturing, for instance, the experiments can be recorded in testing and design verification evaluations.
The R&D tax credit continues to be a lucrative tax incentive for taxpayers for the designated extended period, and also to taxpayers with open tax return years, which could be significantly beneficial to business taxpayers by helping reduce their federal and state income tax liability.
Because companies can recover taxes for up to three prior tax years, thanks to the R&D tax credits, the recovered funds could be a great addition to the bottom line.
With the rapid growth of technological innovations in equipment and processes, the USA’s concentration of manufacturing complexes should greatly benefit from this grand opportunity. The American industry and professional associations have shown support for a permanent R&D tax credit.
R&D tax credits will continue to help US companies create and preserve quality jobs for Americans and at the same time develop innovative products and services that will help the country remain globally competitive.