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The federal research and development (R&D) tax credit revolves around qualified research expenses (QREs). Businesses that can determine which fees fulfil the qualifying conditions may be eligible for a dollar-for-dollar tax reduction.
The Research and Development Tax Credit (R&D Tax Credit) is a tax credit granted by the United States government to stimulate and reward firms’ innovation activities. It is a tax credit that delivers substantial tax savings to many companies that work to develop.
If you’ve used your resources to develop your business, or even if you tried but failed, the R&D Tax Credit may be able to help you save money on your taxes.
The R&D Tax Credit can be used to cover the costs of performing research and provide a financial incentive for completing specified tasks. The Internal Revenue Service distinguishes between qualified research expenses (QREs) and qualified research activities.
It can be tough to negotiate the formalities and limitations of what R&D Tax Credit acceptable expenses and activities are, what expenses and activities do not qualify, and how to identify the difference unless you’re already familiar with the tax code.
Qualified research expenses1 are costs incurred during the development or improvement of items, processes, techniques, formulas, innovations, or software that fulfil particular IRS conditions. Employee salary, contract research fees, and supply costs are just a few examples.
The R&D tax credit may be available for activities that meet the IRS’s four-part criteria:
Was the study focused on developing or improving a business component’s functionality, quality, dependability, or performance (product, process, software, technique, formula, or invention)?
Was there any technological ambiguity concerning the business component’s capabilities or process of development, or proper design?
Qualified research must meet specific criteria to qualify for the credit under IRC section 41(d). Qualified research is research that is undertaken to discover technological information (also known as the discovering technological information test), and the application of which is intended to be useful in the development of a new or improved business component of the taxpayer (also known as the business component t) (also known as the process of experimentation test).
The IRC section 174 test requires that the expenditure be incurred in the taxpayer’s trade or business and that it be an R&D cost in the experimental or laboratory sense, which means that the expenditures are incurred for activities aimed at uncovering information that would eliminate uncertainty about the development or improvement of a product. It’s worth noting that the research doesn’t have to lead to a successful product or procedure. Uncertainty exists in the context of the section 174 test if the taxpayer’s information is insufficient to produce or improve a product competently.
Manufacturer X, for example, is a pharmaceutical company that produces LDL cholesterol medicine. Most contemporary cholesterol drugs are classified as “statins,” and their adverse effects include headaches, nausea, vomiting, and abdominal cramps. Manufacturer X is now working on a new drug that will control an individual’s LDL cholesterol level without these negative effects. They are hiring researchers to test novel chemical compounds. Because the salary expenses for the researchers are related to Manufacturer X’s business activities and were incurred to uncover new information to develop or improve a product, they pass the section 174 test.
The technical information discovery test necessitates a technological research effort. The experimentation technique utilized to uncover knowledge must be based on physical, biological, engineering, or computer science principles to meet this condition. This is a simple test that anyone can pass.
When people hear the phrase “technological in nature,” they often think of robotics. The employment of complex algorithms in robots would undoubtedly pass the finding of technological information; nevertheless, research does not have to be a huge technological achievement. It does not have to be prohibitively expensive. The activity must merely discover additional information or knowledge—even if the increased knowledge is minimal—and rely on the principles of one of the sciences listed above to pass the discovering technical information test.
Under the patent safe harbor rule [Treasury Regulations section 1.41-4(3)(iii)], the issue of a patent by the United States Patent and Trademark Office is irrefutable evidence that a taxpayer has discovered technological information. However, a patent only meets the discovery requirement. Qualified research must meet all four tests, including the business component test, which requires a taxpayer to apply the learned information to develop a new or better business component. Like the previous two, this test is widely applicable; it is not intended to remove many R&D operations, and it is quite simple to pass. To pass this test, the taxpayer must first uncover new information (i.e., learn something) that will improve the taxpayer’s business and then apply that new information to a specific aspect of the firm. As long as it is held for sale, lease, or license, or used in the taxpayer’s trade or business, the component of the business can be nearly any important piece of the business, such as a product, a method, a technique, a formula, an invention, or even software [IRC section 41(d)(2)(B)].
“Research doesn’t have to be a great technological breakthrough, and it doesn’t have to be prohibitively expensive.”
The experimentation test necessitates the inclusion of features of a process of experimentation for a specific purpose in nearly all of the activities. At least 80% of a taxpayer’s research activities, measured on a cost or other reasonable basis [and without respect to IRC section 41-2(d)(2)], must be aspects of a process of experimentation for a purpose to meet the “substantially all” requirement.
In essence, this test demands that most of the taxpayer’s research activities entail studying a solution or group of solutions to a research issue. Company Y, for example, is a defense contractor that produces military vehicles, with a focus on armored vehicles like tanks. With its hydraulic systems utilized to construct a tank’s turret, Company Y considers various potential options. Some options call for withdrawing the turret, while others call for pushing it. Company Y is engaging in the process of experimentation and satisfying the fourth and final test by evaluating all possibilities regarding the turret assembly.
Research after commercial production; adaptation; duplication; activities relating to surveys; studies; research relating to management functions; foreign research; research in the social sciences; funded research; and research performed outside of the United States are all specifically excluded from qualified research activities. These actions are discussed in sections 1.41-4(c) of the Treasury Regulations.
If the labor is performed in the United States, employee pay and contract expenses may be eligible for the R&D tax credit. Supplies, defined as non-capitalized or depreciated tangible raw materials utilized in the R&D process, may also qualify.
On the other hand, general and administrative expenses are usually not covered. This is true for activities carried out in whole or in part to support qualified research.
Employees must engage in eligible research activities to qualify for the R&D tax credit, such as:
Only the time spent on these specified activities can be used to claim the credit.
Employers must also produce paperwork that covers at least one of the following items:
Qualified supply expenses are tangible assets that were not capitalized or depreciated and were used directly in research operations. Raw materials used to construct and test prototypes, for example, would be eligible, but not the research facility, depreciable equipment, or ordinary office supplies.
Qualifying contract research expenses, like qualified wage expenses, comprise time spent conducting or executing qualified research. The distinction is that these activities are carried out by a third party rather than the company itself.
According to IRS contract research standards, businesses must: Maintain substantial rights to the contractor’s study and take on the financial risk of the contractor’s growth.