In 1981, the United States was one of the first countries in the world to enact a federal research and development (R&D) tax credit, which was a dollar-for-dollar reduction in tax owed (generally amounting to five to ten cents on every dollar of qualified research expenses). While this incentive delivered obvious benefits to help U.S. companies pursue innovative ideas, the credit was always temporary, which made it difficult for business leaders to rely on it for long-term planning and capital investment. That problem was finally solved in December 2015, when Congress finally made the R&D credit a permanent feature in the tax code.
While technology companies are among the largest users of the R&D credit, it’s worth noting that information services, scientific, manufacturing and professional services industries often have qualified research expenses enabling them to take advantage of this tax break. In general, these expenses include wage or salary expenses, certain supply or computing support costs related to research, or a portion of costs directly linked to contract research services conducted within the U.S.
To qualify for the credit, any claimed R&D expenses must pass a four-part test:
- The Elimination of Uncertainty test. In this test, a qualifying activity must show that it was intended to discover information to “eliminate uncertainty concerning the development of improvement of a product.” The expenditure must be incurred within the business, and it must represent R&D costs in an “experimental or laboratory sense.”
- The Discovering Technological Information test. In summary, to qualify for the R&D credit, research or investigative activity must rely of existing principles of physical science, biological science, computer science or engineering. While the Internal Revenue Service concedes that the receipt of a U.S. patent demonstrates that work was done to eliminate uncertainty, the patent alone is not sufficient to qualify a project for the R&D credit.
- The Business Component (or permitted purpose) test. The activity must demonstrate work toward a “new or improved” business component (such as a project, process, technique, formula or invention), which could be sold, leased or licensed for use in a commercial setting.
- The Process of Experimentation test. All qualifying R&D activities must demonstrate that they were applied to identify uncertainty, uncover alternatives to resolve uncertainty, and evaluate each of those alternatives using a systematic scientific method.
As a general rule, software developed for internal corporate use does not qualify for the R&D credit, unless the business can demonstrate that the work was innovative (i.e., reducing costs, improving speed), posed great economic risk due to the resources committed to its development, and could not be made commercially available without significant modifications.
Recent changes benefit smaller companies
When Congress made the R&D credit permanent under the Protecting Americans from Tax Hikes Act (PATH Act), lawmakers also added a pair of key provisions to make the tax break more useful to small and mid-market companies. These include:
- Offset for Alternative Minimum Tax. Prior to the PATH Act, the R&D credit could only be used to offset regular tax liabilities. This created a problem for many small pass-through, limited liability, S Corp and non-public C Corp businesses, which often had alternative minimum tax (AMT) liabilities that made the R&D credit essentially worthless. However, under the new rules, companies with $50 million or less in gross receipts over the past three years can use R&D credits on qualified research activities conducted after January 1, 2016 to offset their AMT liabilities.
- Payroll Tax Offset. In addition, the PATH ACT allows “qualified small businesses” (those with less than $5 million in gross receipts during the 2016 tax year, and gross receipts for 5 years or less) to use up to $250,000 in R&D tax credits as an offset against employer payroll tax liabilities per year for up to five years. Again, the qualified research activities used to calculate this credit must have occurred on or after January 1, 2016.
Consider an R&D credit study to improve documentation, odds of success
A major key to success in securing – and potentially defending – the R&D credit is documentation. One of the best ways to document R&D projects is as it happens, using records such as project timesheets, schedules, designs, test results and progress summaries as evidence, along with related budgets, customer contracts, purchasing invoices and other accounting records that specifically support one or more R&D initiatives. Remember, IRS rules require that the four-part test be applied to each specific R&D project for which a tax credit is filed.
In situations where a company has limited senior-level accounting staff, or has a complex research initiative that may be difficult to qualify, an R&D credit study may be a sound investment. Typically, this involves retaining a qualified third-party to do an initial feasibility assessment, followed by a detailed review to determine which R&D activities and expenses (if any) qualify for the tax credit. A sound R&D credit study should also include a final report of findings, as well as recommended actions business leaders can take to leverage future tax credit opportunities.
Please contact us for more information on R&D credit studies, or other business accounting issues.
October 12, 2017