The Research and Development Tax Credit (R&D tax credit) is a dollar-for-dollar cash incentive for US-based businesses that experiment and create more efficient processes and products, but a large amount of businesses are missing out because of some confusion surrounding the credit. What was initially created as a temporary credit in the Economic Recovery Act of 1981 is now a permanent and more wide-reaching incentive meant to reward innovative businesses that invest in research in the US.
When enacted as part of the tax code, Congress neglected to define the term “research and development” and instead left it to the IRS and Treasury to define the term through treasury regulations. Without a concrete definition, accountants and their clients may not realize that the IRS definition of “R&D” is much broader than scientists in white lab coats.
Without the necessary background, accountants may assume their clients will not qualify, and only an experienced R&D tax credit specialist would have the expertise needed to unlock the maximum cash flow a client may receive. These specialists understand that the nature of the R&D activity is what’s relevant, not the product being developed and that alone provides a huge value.
How can this help businesses?
Eligible start-ups can qualify for up to $250k in reduced payroll offsets per year so long as they qualify as a start-up, (a business with fewer than five years of gross receipts and less than $5 million in the year the credit is elected) with no cap on companies utilizing these credits against actual tax liability. The difference can result in increased overall cash flow, and it’s not uncommon for companies who have previously owed at the end of the year to receive a refund when the R&D credit is properly utilized. For start-ups that are not yet generating revenue, this can extend the growth period, and for small businesses like partnerships and sole proprietorships, the credit can reduce the taxes owed by owners or shareholders. The common barrier to utilization is understanding the definition of “qualified research”.
Defining qualified research
The IRS uses a formula to determine whether a business’ research activities are eligible for the R&D tax credit, known as the four-part test, which examines these four criteria:
Permitted purpose: Research expenses must pertain to a new or improved product, process or design. In order to qualify, a company should focus on developing a new or improved use or functionality of their process or product.
Technological in nature: The activities performed must relate to “hard” sciences and principles, specifically computer science, mathematics, chemistry, physics and other natural sciences. Innovation that relies on “soft” sciences is not sufficient.
Elimination of uncertainty: Businesses must demonstrate that the activity was used to determine whether the company would be able to solve a problem, how to solve that problem and the most appropriate way to solve said problem.
Process of experimentation: The activity must be related to experimenting with possible solutions, testing and/or trial and error. Directly related to elimination of uncertainty, this component refers to a company coming up with a handful of ideas, testing those ideas to determine which is the best, and why it is better than the others. A common question asked is “Does my company offer a new and improved product?” If the answer to that question is yes, there is a good chance the company has qualified R&D expenses.
Seek counsel from a qualified R&D tax credit specialist
Only an experienced R&D tax credit specialist will be able to ensure your business has qualified R&D expenses AND that your business will receive the maximum financial benefit from utilizing the credit. These professionals often know the right questions to ask, where to look and how to be certain activities are meeting the IRS definition of R&D in order to maximize your credit. Would you rather employ a general contractor to reroute the pipes in your newly renovated home over a plumber with 30 years of experience?
While our understanding of the term “research and development” may limit what we believe would be eligible for the R&D tax credit, the IRS and Treasury have a much more practical and applicable standard of the definition.