“Research and development:” the words tend to evoke images of microscopes, test tubes, and laboratories abuzz with scientists who spend their days unearthing groundbreaking discoveries or inventing world-changing products.  With these images in mind, many businesses wrongly assume that they do not qualify for the Research and Development Tax Credit, a federal tax incentive that saves individual businesses hundreds of thousands of dollars each year for performing some of their routine functions.  The R&D Tax Credit is not limited to any one type of activity or category or size of business.  Businesses that benefit from the credit represent a wide array of specializations, including engineering, architecture, technology, and manufacturing.

Although the steps required to claim the R&D Tax Credit might be confusing, taxpayers may refer to four basic requirements to help determine if their activities constitute qualified research:

  • Create or improve – the purpose of the activity must be to create new or improve existing functionality of a business component.  Have you pursued state, federal, or industry certification?  Researched and filed for a patent?  Is your business an architecture firm that has developed designs for clients?  A manufacturing company that has streamlined a process or improved a facility?  Are you a tech company that has developed or improved software for use somewhere else than within your own company?  Activities such as these may be considered permissible purposes under the R&D Tax Credit.  However, activities like adapting an existing business component to a customer’s specifications or reproducing an existing business component do not qualify. (Sources: AIArchitect This Week – Architecture Firms Can Get R&D Tax Credits; http://www.huffingtonpost.com/deborah-sweeney/how-tech-startups-can-cla_b_4956075.html; “The Research and Development Tax Credit,” http://www.ipc.org/3.0_Industry/3.3_Gov_Relations/2008/tax_credit_whitepaper08.pdf; http://www.businessweek.com/small-business/the-rampd-tax-credit-explained-for-small-business-08162011.html).
  • Eliminate uncertainty – the taxpayer must intend to eliminate uncertainty about the project.  As your business embarks on any project, you most likely face questions that can only be answered by conducting some sort of experimentation or testing: what is the best way to achieve the objective of this project?  Will it turn out as expected?  If you seek to answer such questions over the course of the project, you intend to eliminate uncertainty.
  • Process of experimentation – the taxpayer must engage in some sort of systematic process of experimentation designed to evaluate one or more alternatives.  This process may range from informal trial and error to more precise modeling or computational analysis.
  • Technological in nature – the process must be technological in nature and must fundamentally rely upon principles of the physical or biological sciences, engineering, or computer science.  Research in the social sciences, behavioral sciences, or humanities does not qualify. (Source: http://www.irs.gov/Businesses/Audit-Techniques-Guide:–Credit-for-Increasing-Research-Activities-(i.e.-Research-Tax-Credit)-IRC-%C2%A7-41*—Qualified-Research-Activities).

Over the years, this test has grown increasingly complicated as case law and Treasury Regulations have been issued to interpret its elements.  As a result, claims must be examined on a case-by-case basis to determine whether the taxpayer qualifies for the R&D Tax Credit.  Thorough documentation of R&D activities is essential to support a claim.

After determining whether a particular activity constitutes qualified research, a business must figure out which expenses count as qualified research expenses, or QREs.  QREs include wages paid to employees and amounts paid for supplies used in the conduct of qualified activities, certain time-sharing costs for the use of computers in the conduct of qualified research, and 65 percent of amounts paid to others within the U.S. for contract research.  The cost of QREs provides the basis for determining the amount of the R&D Tax Credit. (Source: http://www.journalofaccountancy.com/issues/2010/mar/20092122).

In addition to the federal credit, nearly all states now offer some form of tax incentive for R&D.  The rates of state credits vary dramatically, and businesses sometimes find that their state credits are even more generous than their federal credits.

Although applying for the R&D Tax Credit can be daunting, taking the time to determine whether your business qualifies may save hundreds of thousands of dollars.  Capital Review Group (CRG) provides the expertise to help businesses determine eligibility and capture the lucrative benefits of state and federal R&D Tax Credits.  For additional information, contact CRG.