Misconceptions About the Research & Experimentation Tax Credit
Tim Finerty
As companies put more emphasis on Industry 4.0 and business processes become more automated and accessible, the opportunities for Research & Experimentation tax credits increase. The Research and Experimentation (R&E) tax credit, commonly known as the Research and Development (R&D) tax credit is a tax incentive that can provide tax benefits for companies investing in R&D. Many companies have qualified research activity; however, most businesses do not fully leverage this tax incentive. Learn what is considered a qualifying activity and discover what areas are most often overlooked when calculating the credit.
What Type of Activity Qualifies?
There are three prongs to the definition of the term qualified research. Qualified research includes:
- Research expenditures which may be treated as deductible expenses under the provisions of the tax code
- Research that is undertaken for the purpose of discovering information which is technological in nature and, the application of which, is intended to be useful in the development of new or improved business components
- Substantially all the activities that constitute elements of a process of experimentation for a functional purpose
What Does This Mean?
The most common misconception regarding the R&D credit is that companies must be inventing something entirely new or groundbreaking to qualify for the credit. However, back in 2003 the IRS loosened qualifications to include development efforts which only need to be evolutionary to you. In other words, if employees in your organization are spending time to discover technical information through research and experimentation, with the intention of developing or improving products or trade processes using the principals in Industry 4.0, those expenses will generally be qualified research and development costs for purposes of the credit.
Research expenditures generally include costs incidental to the development or improvement of a product, process, formula, invention, technique, patent or similar property.
The discovery requirement is satisfied if the research is “intended to eliminate uncertainty concerning the development or improvement of a business component.” The test is taxpayer-focused rather than industry-focused, which means it does not matter if another company has developed the product or process. If there is an element of uncertainty in the activity you are engaging, it may be a qualifying activity. Eligibility does not depend upon the ultimate success, failure, sale or use of the product. Typically, costs are eligible until the element of uncertainty is eliminated.
The process of experimentation test requires a facts and circumstances analysis; however, the IRS has provided three core elements needed to satisfy this test:
- Identifying uncertainties
- Identifying alternative solutions
- Evaluating the identified alternative
If your process includes all three steps, it is likely a qualifying activity.
Identifying Research Expenditures
Many companies aren’t aware that a product or process merely needs to be evolutionary to them in order to qualify. In addition, Clayton & McKervey has encountered many companies utilizing the credit, but not to the fullest extent.
Identifying qualifying expenditures is usually an area most taxpayers misunderstand. Costs incurred in the development or improvement of a plant process, a product and a technique are all qualifying expenditures. To put that into context, a system integrator often improves a product or technique for each automation cell produced. In that regard, the costs incurred to engineer and test a cell would be qualified expenses. If the cell is duplicated, only the costs incurred for the first cell would be qualified; however, most cells have a unique component.
If business owners drill down even further and question what type of costs are considered research costs for purposes of calculating the credit, they would find that many supply costs are also included in the definition of qualified expenditures. We have found supply costs are often an overlooked expenditure for purposes of the credit calculation, and often these are the largest costs incurred in the development of an automation cell.
How Much Is the Credit?
Typically the credit will be about 5 -10% of qualified research expenditures. The credit may be carried back one year and carried forward 20 years.
Contact Us
If you think you may qualify for the credit, or may not have utilized the credit to its fullest extent in prior years, there may an opportunity to amend returns and apply for a refund or credit carryover. For additional information call us at 248.208.8860 or click here to contact us. We look forward to speaking with you soon.