Companies that invest in research and development (R&D) not only stay competitive, but drive progress and growth in their industries. When considering your R&D strategy, planning ahead can ensure you’re in an excellent position for tax season.
It’s estimated that less than 3 out of 10 qualifying businesses claim the R&D tax credit.
While taking advantage of government incentives can help take your business to the next level, the R&D tax credit requires careful planning to ensure you’re eligible and harnessing its full potential.
Are You Eligible for the R&D Tax Credit?
Business Eligibility
The R&D tax credit is designed to be inclusive and does not discriminate based on industry or sector, recognizing that innovation can emerge from any field. This means that your business may be eligible, regardless of size or industry.
However, the important step is determining if your activities themselves qualify for the R&D credit.
Activity Eligibility – The Four Tests
The definition of R&D is broader than many might think, but the work has to be considered “qualified research”, defined by the IRS as meeting all of the following four tests:
- Expenditures Treated as Expense or “The Section 174 Test”
The research activity must involve the systematic investigation or search for information aimed at discovering new knowledge or improving existing products, processes, or technologies. Section 174 allows businesses to deduct research and experimental expenditures as expenses, rather than capitalizing them.
- Discovering Technological Information Test
The research activity must be undertaken for the purpose of discovering information that is technological in nature. This refers to research that relies on principles of physical sciences, biological sciences, engineering, or computer science (rather than purely theoretical or social science research).
- Business Component Test:
This test requires that the research activity’s application is intended to be useful in the development of a new or improved business component. A business component refers to any product, process, computer software, technique, formula, or invention that is held for sale, lease, or used in the taxpayer’s trade or business.
- Process of Experimentation Test:
Substantially all of the activities of the research must constitute elements of a process of experimentation for a qualified purpose. Process of experimentation involves systematic trial and error methods, such as modeling, simulation, or systematic hypothesis testing, to evaluate alternatives and achieve a desired result.
Case Study – The Four Tests
Let’s take a practical example applying the four tests for qualified research. Remember that this can apply to even something such as software or digital products, but let’s use a concrete example of a small business that many people might find in their community.
Company: A small bakery invests in research to develop a new gluten-free baking technique to cater to customers with dietary restrictions. They decide to see if this work would be considered qualified research, and try the four tests.
- Section 174 Test:
- The bakery invests in research to create a new line of gluten-free bread. This includes purchasing special ingredients solely for developing gluten-free recipes.
- Explanation: The costs incurred in the development of the gluten-free bread line can be expensed under Section 174 as they are direct expenses related to the research and development of a new product.
- Discovering Technological Information Test:
- The bakery conducts experiments to understand the chemistry behind gluten-free flour alternatives and how they affect bread texture and flavor.
- Explanation: This exploration into the technological aspects of gluten-free baking ingredients and their impact on bread quality meets the criteria of seeking technological information that is applicable in developing new or improved products.
- Business Component Test:
- The objective of the bakery’s research is to create a new line of gluten-free bread that is not only healthy but also satisfies the taste and texture preferences of its customers.
- Explanation: The development of a new line of gluten-free bread represents a new or improved business component, as it introduces a novel product offering to the bakery’s existing lineup, targeting a specific customer need.
- Process of Experimentation Test:
- To finalize the recipe for the gluten-free bread, the bakery goes through multiple rounds of testing different flour blends, baking times, and temperatures.
- Explanation: This systematic process of trial and error to achieve the desired bread texture and flavor qualifies as a process of experimentation. The bakery is evaluating various alternatives to determine the most effective gluten-free bread recipe.
Common Questions
What Costs Are to Be Capitalized vs. Expensed?
The opportunity to deduct research and experimental expenditures as expenses, rather than capitalizing them, is a great opportunity. But how to make sure which expenses are eligible?
In the past, certain costs were supposed to be expensed while others were capitalized, however, since 2022, all R&D has to be capitalized.
There is currently a bill in Congress that may change things back to the old rules, but for current accounting purposes, all costs are to be capitalized.
Which Method Should be Used to Calculate the Credit?
The R&D tax credit can be calculated with two methods: the regular research credit (RRC) method and the alternative simplified credit (ASC) method. Deciding on the best approach depends on your circumstances. Consider the following:
1) Complexity: The regular research credit (RRC) method involves a more detailed calculation that considers various factors such as gross receipts, qualified research expenses (QREs), and base amounts. On the other hand, the alternative simplified credit (ASC) method offers a simpler calculation based on a fixed percentage of QREs. Businesses with straightforward R&D activities and expenses may find the ASC method more convenient and less time-consuming, while those with more complex operations may prefer the RRC method for its flexibility in capturing eligible expenses.
2) Potential Benefit: The ASC method provides a flat credit rate of 14% of qualified research expenses that exceed 50% of the average QREs for the three preceding tax years. In contrast, the RRC method allows for potentially higher credits by considering various factors and applying a credit rate of up to 20%.
3) Documentation: The documentation requirements may differ between the two methods. While both methods require businesses to maintain records of their R&D activities and expenses, the level of detail and documentation needed for the RRC method may be more extensive.
4) Compliance Costs: The RRC method may involve higher compliance costs due to its more intricate calculation process and documentation requirements. Businesses should consider the time and resources required to implement each method.
Are Any Activities Excluded?
Yes, excluded activities included:
- Adaptation or duplication of existing business components, such as through reverse engineering.
- Surveys and Studies: This includes market research, routine data collections, and studies for management purposes.
- Funded Research: If the research is funded by any grant, contract, or another party, and the taxpayer does not retain substantial rights in the research results.
- Foreign Research: Expenses related to research conducted outside the United States, Puerto Rico, or any U.S. possession.
- Certain Types of Software Development: The development of software that is for internal use often has stricter eligibility criteria. Although some internal-use software development may qualify under specific conditions, it is generally subject to higher scrutiny to ensure it includes significant innovation and is technically challenging.
Will Regulatory Changes Impact The Credit?
The R&D Tax Credit has changed several times since its implementation in 1981, and more changes are on the horizon. From alterations in reporting requirements, to potential amendments in tax laws affecting eligible expenses, it’s important to keep a close watch on regulatory developments to ensure your tax planning is optimized.
Pasquesi Partners Can Ensure a Smoother R&D Credit Experience
The R&D tax credit could bring your business to the next level by allowing you to innovate. However, with detailed criteria, choosing calculation methods, and changing regulations, the process may be intimidating for businesses.
Fortunately, Pasquesi Partners has years of experience helping businesses make the R&D tax credit process easier for clients. Let us help you grow your business. Get in touch today.