Many companies conduct research and development (R&D) activities as part of the ordinary course of business. These activities are essential because they help to create new products, improve existing ones, or implement efficiencies and enhancements to processes. However, the benefits do not end once the research is completed. A business can often claim the federal R&D tax credit, yielding significant tax savings. Unfortunately, many miss the savings opportunity because they are unfamiliar with the credit or do not think they are eligible. This results in many companies not claiming the credit and receiving significant tax savings. While not every project will be eligible, it is vital to become familiar with the criteria to evaluate your R&D activities. To help clients, prospects, and others, Tanner has summarized the key details below.
What is the R&D Tax Credit?
It is a federal incentive that allows companies to generate dollar for dollar tax savings for performing eligible activities. The potential savings can be significant (up to 13% of qualified research expenses) and provides needed funding to hire new employees, increase R&D activities, or to expand various facilities. To determine eligibility the IRS has published a four-part test that R&D projects must pass to qualify. Many states offer a similar incentive for R&D activities performed in their state that follow the federal rules.
Four Part Test
To qualify for the credit, a company must show that the project (or business component) meets all requirements necessary to constitute qualified research, which is determined through a four-part test. The components include:
- Section 174 Test – Eligible R&D credit expenses must be of the type that may be treated as specified research or experimental expenditures under Section 174. This means the expenditure must be incurred in connection with a company’s trade or business and represent a cost in the experimental or laboratory sense. Expenditures represent research and development costs in the experimental or laboratory sense if they are for activities intended to discover information that would eliminate uncertainty concerning the development or improvement of a product. Uncertainty exists if the information available to the taxpayer does not establish the capability or method for developing or improving the product or the appropriate design of the product. Whether expenditures qualify as research or experimental expenditures depends on the nature of the activity to which the expenditures relate, not the nature of the product or improvement being developed or the level of technological advancement the product or improvement represents. The ultimate success, failure, sale, or use of the product is irrelevant to determining eligibility under section 174.
- Technological Information Test – To pass this test, the R&D activity must fundamentally rely on the principles of the physical or biological sciences, engineering, or computer science.
- Business Component Test—The business must intend to apply the information discovered through the R&D activity to enhance an existing or develop a new business component. A business component is any product, process, technique, invention, or formula that is to be held for sale, lease, license, or used in the taxpayer’s business. A taxpayer must be able to tie the research to a relevant business component.
- Process of Experimentation Test – To pass this test, a company must demonstrate that substantially all of the research activities (at least 80%) constitute elements of a process of experimentation. A process of experimentation is defined as a process that evaluates one or more alternatives to achieve a result where the capability of achieving the result is uncertain as of the beginning of the project.
Contact Us
Federal and state R&D tax credits offer compelling incentives for those who perform R&D. Given the complexity of the eligibility criteria, it is essential to consult with a qualified tax advisor to determine whether you qualify. If you have questions about the information outlined above or need assistance claiming the R&D tax credit, Tanner can help. For additional information, call 801.532.7774 or click here to contact us. We look forward to speaking with you soon.