R&D Tax Credit: Qualifying and Non-Qualifying Research Activities
It’s tax time! Is your company and your CPA firm working vigorously to gather the financial data for 2017? Are you taking full advantage of the Research and Development (R&D) Tax Credit?
The R&D tax credit can provide huge tax savings regarding the expenses incurred for qualifying activities. So, what exactly are qualifying research activities?
Qualifying Research Activities
Qualifying Research Activities (QRAs) are efforts undertaken to develop new products, fabrication processes, or software, or improve existing ones, and the company carrying out the work must bear the financial risk. All companies regardless of industry, size, or revenue that perform these activities must satisfy the following criteria of the IRS Four-Part Test as outlined in IRC §41(d):
- Business Component Test
The activity must be related to the performance, quality, reliability, or new or improved function of a business component of the taxpaying company. A business component is defined to be “any product, process, software, technique, formula or invention used by the taxpaying company in trade or business.”
- Technological Uncertainty Test
The activity must involve the elimination of uncertainty. An activity entails uncertainty if the taxpayer did not know one or more of the following:
- Whether the desired results could be achieved
- The specific means of achieving the desired result
- The appropriate design of the business component being developed
- Process-of-Experimentation Test “Substantially all” of the activity must involve a “process of experimentation” involving more than one possible approach toward achieving the result, where the capability or method of achieving the result is uncertain at the outset of the activity.
- Technological‐in‐Nature Test
Activities undertaken to discover information must be technological in nature — for example, experiments used to eliminate uncertainty must rely on principles of physical or biological sciences, engineering or computer science.
Typical R&D activities include the following:
- Development of products, processes, or software using specific know‐how that is treated as a trade secret or is patentable
- Development of new or improved products in which the state of the art is advanced and that requires one or more design iterations to achieve
- Development or incorporation of a new technology to catch up to a competitor
- Implementation of a new process or improvements to an existing process involving manufacturing, testing, or quality control
- Development of new products in which technical uncertainties must be overcome to satisfy the requirements of a customer specification or performance requirement
- An attempt to develop a new or improved product, process, or software that was eventually abandoned
The following are not qualifying research activities:
- Market and consumer research
- Research relating to style, taste, cosmetic, or seasonal design
- Management studies and efficiency surveys
- Accounting tasks (e.g. bookkeeping, A/R, A/P, payroll)
- Customer service support
- Giving or receiving training
- Recruiting employees (e.g., hiring engineers, programmers, technicians, etc.)
- Attending industry or professional conferences
- Attending partnering and alliance activities and meetings
A question that often arises regarding attendance at trade shows and conferences is, “Does attending trade shows and conferences constitute a qualifying research activity?”
According to the IRS regulations, no. While it might seem that the time spent attending trade shows where innovative products and services can fuel ideas for new products or processes is a qualifying activity, the IRS considers these activities to be more or less market research and not laboratory research. Remember, the research must be “technological-in-nature.”
An exception, however, might be certain situations such as when a company takes a prototype product to a trade show to demonstrate and evaluate its performance and capabilities as a planned phase of its development process.
For example, a company that invented a magnetic floor sweeper attends a big machine show in Chicago where CNC milling machines are being demonstrated. At the show, company personnel walk the prototype sweeper around to the various machine booths to evaluate the device’s ability to pick up steel chips and shavings from the floor, its ability to release the magnetically-attracted materials, and to evaluate the durability of the device’s fabricated sheet aluminum base. As a result of the experiment, a number of modifications are subsequently made to the device.
Federal and state R&D tax credits can amount to as much as 20% of qualifying costs so it’s important to understand what those qualifying activities and costs are. The R&D Tax Credit is not a deduction — it is a dollar-for-dollar credit against taxes owed or taxes paid.
If you have any questions on these topics or if you would like to discuss your company’s unique situation, contact Intrepid Advisors.