R&D Tax Credit Requirements

Feb 25, 2022

R&D Tax Credit Requirements

R&D Tax Credit: Section 41 of the tax code provides a tax credit for certain qualified research expenses (“QRE”). A QRE includes any in-house research expenses (i.e. wages, supply costs) and contract research expenses (i.e. third-party expenses) paid or incurred by the taxpayer during the taxable year in carrying on any trade or business of the taxpayer. The intent behind this tax provision is to give taxpayers credit for researching and developing new and innovative products and processes within their organization.

Tax Credit Firms: Some aggressive promoters are pitching this credit to dentists and offering to assist them with claiming the credit. For their services, the promoter will take a percentage of the potential tax savings. A client was recently approached by a firm who offered to assist him in claiming the credit for a fee equal to one-third of the claimed tax savings. The catch—if the client is audited, and the IRS disallows the credit, the client would be stuck repaying the full amount of the disallowed credit (plus any penalties assessed), and the promoter would not reimburse their fee. Below, we will discuss some of the things you should consider before engaging the services of a firm who offers to assist you with claiming the credit. If you think you may be eligible to claim the credit, be sure to consult with your accountant.

The Law: Under Section 41(d) of the tax code, research is qualified for the credit if:

  1. The research is undertaken to discover technological information;
  2. The application of that information is intended to be useful in the development of a new or improved business component of the taxpayer;
  3. Substantially all of the activities of the research constitute elements of a process of experimentation for a purpose related to a new or improved function, performance, or reliability or quality; and
  4. It is not covered by an exception listed under Section 41(d)(4)(listed below).

“Substantially All” Test: The third part of the test requires (and the taxpayer has the burden of proving) that “substantially all” (greater than 80%) of the taxpayer’s research must constitute elements of a process of experimentation. A process of experimentation is a process designed to evaluate one or more alternatives to achieve a result where the capability or method of achieving that result, or the appropriate design of that result, is uncertain at the beginning of the taxpayer’s research.

A process of experimentation must fundamentally rely on the principles of the physical or biological sciences, engineering, or computer science and involves the identification of uncertainty concerning the development or improvement of a business component, the identification of one or more alternatives intended to eliminate that uncertainty, and the identification and conduct of a process of evaluating the alternatives (through modeling, simulation, or a systematic trial-and-error methodology). A process of experimentation applies to activities, not physical components of the product being developed or improved. Further, research that is related to style, taste, cosmetic, or seasonal design factors, is not treated as conducted for a qualified purpose.

Importance of Documentation: Before beginning the research, the taxpayer should document the problem, identify the desired outcome, and list the potential alternatives that will be evaluated throughout the process. Examples of documentation include, concept development, project plans, design reviews, etc. It is critically important to document employees’ roles in the process of experimentation and the nexus between activities.

Note: the “substantially all” test is separately applied to each business component. This means, even if the entire process does not meet the test, one or more individual components (i.e., a sensor within a motor within a larger machine) may qualify even if the entire machine does not qualify. This underscores the importance of keeping detailed records of the process. If inadequate records are kept, there is no way for the examiners to determine if any sub-component meets the criteria and they may determine that the entire product is ineligible for the credit.

Exceptions in Section 41(d)(4): Qualified research shall not include any of the following:

  1. Research after commercial production;
  2. Adaptation of existing business components. For example, adaptation of an existing business product to a particular customer’s requirement or need;
  3. Duplication of existing product. Any research related to the reproduction of an existing product (in whole or in part) from a physical exam of the product itself, or from plans, blueprints, specs, or publicly available information with respect to the product;
  4. Surveys;
  5. Computer software;
  6. Foreign research;
  7. Social sciences;
  8. Funded research.

Penalty: If the IRS disallows a credit, it may assess a penalty if it finds that the credit was either claimed through negligence or the disregard of rules or regulations, or results in a substantial understatement of income tax. Generally, this penalty equals 20% of the credit disallowed, i.e., 20% of the tax the IRS believes was underpaid. The IRS may also assess interest due on that 20% from the date that the tax should have been paid.

Examples from past attempts to claim R&D Credit:

 

Disallowed Credits:

  1. X, a retail and distribution company, wants to upgrade its warehouse management software. X evaluates several of the alternative warehouse management software products available from vendors in the marketplace to determine which product will best serve X's technical requirements. X selects vendor V's software.

X's activities to select the software are not qualified research under the rules. X did not conduct a process of evaluating alternatives in order to eliminate uncertainty regarding the development of a business component. X's evaluation of products available from vendors is not a process of experimentation.

  1. X wants to develop a new web application to allow customers to purchase its products online. X, after reviewing commercial software offered by various vendors, purchases a commercial software package of objective-oriented functions from vendor Z that X can use in its web application (for example, a shopping cart). X evaluates the various objective-oriented functions included in vendor Z's software package to determine which functions it can use. X then incorporates the selected software functions in its new web application software.

X's activities related to selecting the commercial software vendor with the object-oriented functions it wanted, and then selecting which functions to use, are not qualified research under the rules. In addition, incorporating the selected object-oriented functions into the new web application software being developed by X did not involve conducting a process of evaluating alternatives in order to eliminate uncertainty regarding the development of software. X's evaluation of products available from vendors and selection of software functions are not a process of experimentation.

Allowed Credits:

  1. Corp X is engaged in the business of manufacturing food products and currently manufactures a large-shred version of a product. X seeks to modify its current production line to permit it to manufacture both a large-shred version and a fine-shred version of one of its food products. A smaller, thinner shredding blade capable of producing a fine-shred version of the food product, however, is not commercially available. Thus, X must develop a new shredding blade that can be fitted on to its current production line. X is uncertain concerning the design of the new shredding blade, because the material used in its existing blade breaks when machined into smaller, thinner blades. X engages in a systematic trial and error process of analyzing various blade designs and materials to determine whether the new shredding blade must be constructed of a different material from that of its existing shredding blade and, if so, what material will best meet X's functional requirements.

X's activities to modify its current production line by developing the new shredding blade meet the requirements of qualified research as set forth in Reg § 1.41-4(a)(5)(i). Substantially all of X's activities constitute elements of a process of experimentation, because X evaluated alternatives to achieve a result where the method of achieving that result, and the appropriate design of that result, were uncertain as of the beginning of the taxpayer's research activities. X identified uncertainties related to the development of a business component, and identified alternatives intended to eliminate these uncertainties. Further, X's process of evaluating identified alternatives was technological in nature, and was undertaken to eliminate the uncertainties.

  1. Costs of experiments undertaken by chemists or physicians in developing and testing a new drug are eligible for the credit, because the researchers are engaged in scientific experimentation.
  1. Engineers who design a new computer system, or who design improved or new integrated circuits for use in computer or other electronic products, are engaged in qualified research, because the design of those items is uncertain at the outset and can only be determined through a process of experimentation relating to specific design hypotheses and decisions.

 

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DISCLOSURE

Collier & Associates, Inc. provides this information as a service to clients and other friends for educational purposes only. It should not be construed or relied on as legal advice or to create a lawyer-client relationship. Readers should not act on this information without seeking advice from professional advisors.

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