Who Qualifies for the Research & Development Tax Credit?
By: Warren Dazzio
What is the R&D Tax Credit?
The Research and Development Tax Credit is an incentive that is available to any company that attempts to design, develop, or improve upon any product, process, technique, invention, formula, or software. The legislation was enacted in 1981 under the Economic Recovery Tax Act and has since become a permanent fixture of the tax code with the passing of the PATH Act in 2016. With the passing of this legislation, the benefits for early-stage companies and small to midsize companies were expanded. To qualify for the incentive, the company must engage in research activities that meet a four-part test that is meant to be broadly construed. These activities must have a qualified purpose (i.e., business component), a process of experimentation, have some level of uncertainty, and be technological in nature. Companies that take advantage of the R&D tax credit can use it to reduce income tax owed, improve cash flow, reinvest into the company, hire additional employees, and continue to develop new and improved components to remain competitive.
Who can qualify?
The code that governs qualifying research activities can be broadly construed, so long as the four-part test is met. This allows companies spanning numerous industries to take advantage of the R&D tax credit. A non-exhaustive list of exemplar industries includes engineering, software and technology, pharmaceutical, aerospace, and manufacturing. Qualification in these industries is guided by IRC § 41 and essentially looks to tie the activities to the traditional scientific method. At a high level, the four-part test is a mechanism to determine whether the taxpayer asks the following questions when working on a qualified business component:
- Can we accomplish it?
- How can we accomplish it?
- What is this development process going to look like for our team?
In order to qualify for the credit, the qualifying research activities must be evaluated first prior to determining what expenditures could potentially qualify.
What expenses can be used to calculate the R&D credit?
Calculating the R&D credit requires identifying the “qualified research activities” and tying them to the “qualifying research expenditures”. These expenditures include:
- Wages paid to employees engaging in, supervising, or directly supporting the underlying development process;
- Expenditures for supplies used or consumed during the development process; and
- Contract research expenditures paid to a third-party for performing qualified research activities on behalf of the company.
Each of these expenditures are evaluated during an R&D study, and the research being performed does not have to ultimately be successful for the expenses to be claimed.
How Can I Claim the R&D Credit?
When it comes to claiming the R&D credit, it is important to work with someone who is familiar with the ins and outs of the tax code to ensure that the claimed credits can be substantiated. The most important factor in quantifying the research expenditures is to take an activities first approach and be sure that there is ample documentation to support the qualifying activities. Many CPA’s have preferred firms they work with to determine each client’s eligibility, and to help assess whether or not the R&D credit would be a good fit.
Many businesses in America have been negatively impacted by the global pandemic. R&D tax credits can be a remarkably effective way to offset those impacts and replenish valuable dollars spent on qualifying expenses many companies incur. If you are interested in learning more about R & D credits please contact us.