Three generations of the R&D Tax Credit

The Three Generations of the R&D Tax Credit

The R&D Tax Credit has been around for almost 30 years. Although it has been continuously modified throughout this time, the intent of R&D Credit has evolved through three distinct generations. For more information on the history of the Credit, click here. Here is an overview:

First Generation: 1981 – 2001

The original R&D Tax Credit was intended to provide incentives to companies who were developing patent-worthy, new-to-the-world products and process. In order to claim the R&D Credit, a taxpayer had to prove that work passed the “Discovery Test” – an Internal Revenue Code requirement that verified the work was truly “innovative” by IRS standards.

Second Generation: 2001 – 2008

After the terrorist attacks of 9/11, and as part of the economic recovery effort, Congress modified the R&D Credit to expand its value to more manufacturers. In December of 2001, the Treasury Department and the IRS published Treasury Decision 8930, which made the Discovery Test optional, and effectively expanded what qualifies for R&D from “New to the World” to “New to the Taxpayer”. In other words, the R&D Credit was no longer just for “revolutionary” developments, but also provided incentives to companies for their internal, “evolutionary” developments.

Under these changes, R&D was redefined as the development of a new or improved “business component”. The IRS identified six types of business components: products, processes, software, techniques, formulas and inventions. To qualify for the R&D Tax Credit, the effort associated with developing the business component had to pass the “4-Part Test”. These tests are as follows (modified a bit for ease of explanation):

New/Improved Business Component Test: the taxpayer needs to be attempting to develop a business component with new or improved functionality, performance, reliability and/or quality (a qualified purpose).
Technological in Nature Test: the effort to develop the business component has to fundamentally rely on the principles of engineering, physical science, biological science and/or computer science.
Technical Uncertainty Test: the taxpayer needs to be endeavoring to discover technical information not know at the outset of the project. In other words, there needs to be technical risk, as defined in Section 174 of the IRC.
Process of Experimentation Test: the taxpayer needs to be evaluating one or more alternatives in the effort to discover that information not known at the outset of the project.

If your projects pass this 4-Part Test, than the costs associated in developing the projects (i.e. your in-house labor costs, supplies consumed in the development process, or any 3rd-party contractors utilized to complete the project) can be captured as Qualified Research Expenses (QREs) for purposes of calculating your R&D Tax Credit.

Third Generation: 2008 – today

As early as 2007, Congress pushed the Treasury Department to address the “Tax Gap” – the difference between what the Treasury Department expected to collect in federal revenue, and what was actually collected. Through this process, the Treasury Department identified 25 areas of the tax code that constituted the major contributors to the Tax Gap. The R&D Tax Credit was one of these areas.

To close the gap on the R&D Credit, the IRS elevated the R&D Credit to a “Tier I Issue“.  Under the Tier I Issue, the IRS has published two Industry Directives to date:

4/4/07: R&D Tax Credit Industry Directive #1
1/15/09: R&D Tax Credit Industry Directive #2

Today, the IRS requires documentation to verify that your innovative activities and their associated expenses meet the congressional guidelines. In addition, the IRS expects you to maintain this documentation WHILE YOU’RE EXECUTING THE WORK. Simple, right? If you’re not careful, you can easily spend a significant amount of these federal incentives on the administrative labor cost associated with the documentation efforts. This is why we built Titan Armor.