Today, innovative discoveries are being made at an increasingly amazing pace. This rapid pace is due to faster access to information, resulting in a proliferation of ideas, discoveries and new applications of innovation-driven technology. As companies continue to embrace technology and innovation to develop new products and processes and seek leverage to reduce the tax liability due to innovation-generated revenues, they often overlook one of the biggest tax options – the low-risk, high-study return Development (R&D) tax credit.
The tax credit for research and development (R&D) was introduced in 1981 as an incentive to reverse a decline in US research activities and to encourage companies engaged in research activities to step up their efforts. With a rate of up to 20 percent, this tax credit lowers a taxpayer’s dollar for taxpayers. For example, a $ 100 tax credit reduces a tax liability by $ 100. Studies have shown that the R&D driving this incentive has had an impact over time. Since spill-over effects of new inventions multiply their benefits to society many times, it has been shown that the benefits to society resulting from R&D far exceed the gains private companies can make on their R&D investments.
Before December 2001, people were strongly convinced that the requirements necessary to qualify for the R&D tax credit were rather difficult to meet and did not meet Congress’s intentions. However, in 2004, the IRS issued permanent regulations to better reflect congressional intent.
Since then, an increasing number of architectural firms, engineering firms, manufacturers, software developers, defense contractors and other companies have been able to make tax refunds and ultimately reduce tax payments in the coming years through the careful application of this tax credit.
Determining whether you qualify for the tax credit is actually a two-step process. First, companies must identify potentially qualifying activities. When the activity subsequently meets the specified criteria, certain expenses related to the activity are included in the calculation of the tax credit.
To identify qualifying activities, companies must meet each of the following four-part test criteria:
1. Is their work a new or improved product or process?
2. Is their work technological in nature?
3. Was there technical uncertainty in a particular product design or process development?
4. Was there an experimentation process to solve the technical uncertainty?
It could be thought that this four-part test would greatly limit the number of companies eligible for this credit. However, the qualifications are quite broad if these tests are addressed correctly and effectively. The real pivot is whether your company’s efforts and intellectual capital have created something new or at least gradually changed something that would be considered new. In other words, when you design and build a better mousetrap, that new or improved mousetrap would address the issues related to function, performance, reliability, or quality.
Certain types of activities are specifically not eligible for the R&D credit; research after, for example, commercial production of a product begins; adaptation of existing products or processes; duplication of existing products or processes; costs for acquiring another patent; efficiency studies, management functions or techniques; market research and testing; advertising and promotions; routine data collection; and routine testing, inspection and quality control.
The cost factors for this credit are salaries and wages of selected staff, delivery costs involved in the R&D process and costs related to external contractors (contract research) working on applicable projects. As you can imagine, these cost factors for companies that are resource and technology intensive can account for a lion’s share of their business expenses. If a cost cannot be classified as one of these three types of expenditure, it will not be eligible for the credit.
Supplies may include, but are not limited to, paper, compact discs, computer supplies, laboratory supplies, workplace supplies, and other incidental items used by investigators, supervisors, and support personnel. In addition, the scope of supply also includes materials used in the construction or testing of prototypes or models, components or subassemblies purchased from third parties and incorporated into prototypes, and extraordinary amounts of electricity or other utilities consumed in the research activity. However, inventories do not include depreciable property or land.
Sixty-five percent of the cost (otherwise eligible for the credit) paid or incurred on behalf of the taxpayer by a person other than an employee is eligible for the R&D credit as a contract study.
Software development costs are treated as qualified costs if such costs pass the test of a qualified activity and if the software:
• Has been developed and sold or given to a third party.
• Become part of or embedded in computer hardware.
• Has been developed for use in qualified research activities or as part of a production process.
In order to qualify for the R&D credit, software for internal use must meet three additional criteria:
• The software must show significant innovation.
• The software must present a significant economic risk in terms of the resources allocated to the project.
• The system may not be commercially available for purchase, lease, license or use without requiring modifications.
Since pursuing the R&D tax credit is an evidence-driven business, it must be sufficiently documented and supported to provide evidence for the IRS investigation. One of the main supporting documents are documents demonstrating the process of experimentation, uncertainty and level of innovation or novelty of the specific qualified activity. This does not require that the results of the experiments are recorded in a specific manner. The results of the experiments should be documented in a way that is appropriate for the specific field of science in which the experiment is being conducted and for the type of experiment involved. For example, in some areas, experiments are recorded in laboratory books. In production, on the other hand, the experiments can be documented in tests and design verification analyzes.
Although set on a “temporary” basis and renewable, the R&D credit remains a viable tax incentive for taxpayers for the designated extended period and for taxpayers with open tax return years, which could potentially represent a significant financial benefit for business taxpayers to reduce their federal and state income taxes. In addition, as companies can collect taxes for up to three previous tax years using the R&D credit, the recovered assets could be a great addition to profit.
With the rapid increase in technological innovations in equipment and processes, the concentration of production complexes in the country should take advantage of this great opportunity. US industry and professional associations have demonstrated support for a permanent R&D tax credit. It is believed that the credit will continue to engage the U.S. companies to create and maintain high-quality jobs for the U.S. worker, develop innovative products and services, and ultimately remain competitive in global markets. Such activation will continue to fulfill Congress’s original intent.