Research & Development (R&D) Tax Credits

Research Credit Claiming Criteria: The "Four-Part Test"

The R&D Credit has been part of the Internal Revenue Code since 1981; however, a large number of companies have not taken advantage of this provision. In the past, the rules were very confusing. It was hard to determine who qualified, let alone which products or processes might qualify. While the rules are still complex, a company may be able to claim the credit providing that they are conducting research in the US, and if they meet the four following criteria:

Costs that Qualify for the R&D Credit

Generally, the credit will be 20% (13% net) of qualifying expenditures that exceed a base amount. So, as you can ascertain, the potential for R&D Credits to be large amounts is very reasonable. In fact, it is not uncommon for R&D Credits to be in excess of $100,000 per year. The base-amount calculation is probably one of the more challenging calculations of the entire project. You must be aware that if the company was conducting qualified research, and had qualified expenses and gross receipts from the period 1984 through 1988, then the more complicated calculation in developing a base period amount will result in significantly more R&D Credits than the short-cut technique, Alternative Incremental Research Credit Method. Conversely, if the company did not conduct qualified research until after 1989, then they are deemed to be a startup company, and must calculate their base period amount using the Start-Up Method.

The first step is to determine whether the expenditures fall under the R&D Credit definitions. This determination needs to be made by a qualified, experienced team of accountants and tax experts. If the initial assessment shows potential savings, a complete assessment is conducted. This assessment process normally involves site visits and interviews with financial personnel, product developers, engineers, and IT staff. The process ultimately results in the production of an encompassing R&D Credit Study Report that’s delivered to the company. It captures the information connected to the various qualifying projects.

• All W-2 wages for employees engaged in qualified research activities. This number includes the wages of personnel directly involved in, supervising or supporting research and development efforts. If an individual spends 80% or more of their time working in the R&D area, then 100% of their wages are counted when calculating the R&D credit. If the percentage of time spent is less than 80%, then the actual percentage of time the individual spends in the R&D area is multiplied by his or her salary and allocated.
  
  
• Non-capitalizable materials and supplies. Things that don't qualify for the R&D tax credit are things such as capitalizable assets. If a company purchases equipment and depreciates the equipment (which is done almost 100% of the time), then the cost of the equipment does not qualify for the credit computation.
  
  
• Fully 65% of costs of contracted research,
  (or 75% of contract research performed by a qualified research group; i.e., a University or consortium).

The rules for software development are still somewhat complicated, but one recent clarification states that if customized software is developed for sale or lease (not for internal purposes), then it is not subject to the extra hurdles of the High Threshold of Innovation Test. If a company develops internal use software, however, it may still qualify for the R&D Credit, providing that:

• The software is innovative;
• The development involved significant economic risk, and
• A similar product is not commercially available.

If the above three criteria are met, then the cost of developing software for internal use may qualify for the R&D Credit. If any R&D Credits are discovered involving expenditures during the previous three years, you may amend the tax returns of the company or individuals in the case of flow-through entities.

R&D Case Study #1: Elimination of Uncertainty

R&D Case Study #2: Improving Manufacturing Processes

It’s important to note that if your company is considering a R&D tax credit study, one of the previous items in the Treasury Regulations has been changed. Previous law stated that contemporaneous documentation had to be taken at the time the R&D work was performed. Finalization of the regulations has cleared up this issue, however, by eliminating the contemporaneous documentation requirement.

Listen to our R&D Tax Credit Radio Commercial:  as heard on the Buffalo Bills Radio Network!

R&D Tax Credit Contacts:

Rich Wright, Jr., CPA		Joe Burwick, CPA
Director		Manager