How to Determine Qualified Research Expenses
The IRS has established a four-part test that taxpayers must apply to each of their business activities (components). The four tests are described in Internal Revenue Code (IRC) §41(d)(1) and all four must be met to qualify for the credit. In addition to the four tests, the company carrying out the work must bear the financial risk of development and have rights to the research being performed.
Activities that meet the following four-part test defined by the IRS may qualify for the R&D Tax Credit:
- Was the research related to the development or improvement of the functionality, quality, reliability or performance of a business component (product, process, software, technique, formula or invention)?
- Was the development technological in nature?
- Was there technological uncertainty about either the capability or method of developing the business component or its appropriate design?
- Was the developmental process experimental in nature?
The activities that qualify for the R&D tax credit are the same ones driving growth in your business.
- Creating improved products, processes, formulas, software, and techniques
- Automating or improving internal manufacturing processes
- Designing tools, jigs, fixtures, and molds
- Integrating new equipment
- Development of data center, big data, and data mining tools
- Integration of APIs and other technologies
- Development of financial or pricing models
- Hiring outside consultants to perform any of the listed activities
- Manufacturing new or improved products
- Developing prototypes, first articles, models
- Evaluation of alternative materials
- Development of firmware
- Network hardware and software development and optimization
- Developing simulators
- Development of risk management systems
What Expenses Qualify for the R&D Credit?
Employee wages and contract expenses may be eligible for the R&D tax credit if the labor is performed in the United States. Supplies, defined as tangible raw materials used in the R&D process that were not capitalized or depreciated, may qualify, as well.
General and administrative costs, on the other hand, typically are not eligible. This is true for activities that were wholly or partially conducted in support of qualified research.
Qualified R&D Employee Wages
For wages to qualify for the R&D tax credit, employees must perform qualified research activities, such as:
- Conducting or executing the qualified research (e.g., testing a manufacturing prototype)
- Directly supervising the qualified research (e.g., managing a team of software developers)
- Directly supporting qualified research (e.g., organizing test results on formulation trials)
Only the time attributable to these specific activities may be claimed as part of the credit. In addition, employers must provide documentation that includes at least one of the following:
- Employee Form W-2s
- Payroll registers
- Time tracking data
- Time questionnaires
- Oral testimony
- Meeting minutes
Qualified R&D Supply Expenses
Qualified supply expenses are defined as tangible properties directly used in research activities that were not capitalized or depreciated. For example, raw materials used to fabricate and test prototypes would be eligible, but the research facility itself, depreciable equipment or general office materials would not.
Qualified Contract Research Expenses
Much like qualified wage expenses, qualified contract research expenses include time spent conducting or executing qualified research. The difference, however, is that these activities are performed by a third party, not the business entity itself.
According to IRS guidelines for contract research, businesses must:
Maintain substantial rights to the research performed by the contractor – and –Bear the economic risk of the contractor’s development
Ensuring that you understand the rules for qualification is an essential first step in claiming the R&D Tax Credit. This is normally done during a feasibility analysis, also referred to as Phase 1. R&D activities are explored and identified at a high level along with related qualified research expenses (QREs). This information is then used to estimate your federal and state R&D tax credits. Education is key and provides the ability to identify qualified activities and QREs so a more accurate benefit estimate can be determined.
The expenses that qualify for research activities within your company typically include employee compensation, materials, and contracted services. Various forms of documentation are sufficient to support your qualified expenses and may include payroll records, financial records showing supply or contract research expenses, and vendor invoices.
On average, companies are typically able to claim 7-10% of their qualified expenses as a federal R&D tax credit. For example, a single software developer, engineer, or lab technician who receives a W2 of $100,000 a year may generate a tax savings of up to $10,000.
Here's an example of a case study for a company specializing in Candy Manufacturing
This $30 million specialty-packaging manufacturer helps top food brands bring ideas to the market. They provide full service design, manufacturing, and co-packaging which has been key to their success.
The company performs hundreds of custom design packaging projects each year for a variety of customers.For this case study, the specific project that qualified for R&D Tax Credit was the design of a special container to hold gumballs. The product was targeted at children; so in addition to having appropriate functionality, the design also needed to have play value. R&D included identifying the right combination of materials that would allow for a design that could be easily manufactured, shipped, stored and withstand the rigors of child play. The container’s design required testing and experimentation to ensure product safety and functionality.
Source Advisors performs an initial feasibility analysis prior to engaging a customer to help set potential credit expectations and explain the process. After evaluating other providers, this packaging company chose to work with Source Advisors based on their phased approach and endorsement from their CPA. Source Advisors’ thorough analysis of the company’s specific R&D situation and tax position is critical to ensure they are maximizing tax credits for their innovative packaging designs.
The Results Speak for Themselves
Over a five-year period, the company was able to claim in excess of $750,000 of R&D Tax Credits . This was over $140,000 more than the estimate provided during the feasibility analysis. The tax savings generated from these credits were used to further conduct R&D to meet additional customer requests and expand product offerings into other markets.
Companies of all sizes and across many industries meet the federal government’s test for qualified innovation activities and can claim Research and Development (R&D) Tax Credits. However, many companies are not aware they qualify. There are thousands of companies that are leaving money on the table and not taking advantage of significant federal and state R&D tax credits.
Many people used to think R&D tax credits only applied to those that wear lab coats or create new best-in-class products. This is not the case – R&D credit is much more expansive and far-reaching than most people realize.
In addition, research and development tax credit guidelines for software development have relaxed. All of this opens the door for companies that have not taken advantage of or maximized their R&D tax credits in the past.
These research & development tax credit industries now include manufacturing, software, engineering, financial services, and many others.
If you’re improving or enhancing products and processes to remain relevant and profitable, you may be qualified for R&D tax credits.
