The R&D Tax Credit is an incentive to protect American jobs by rewarding companies who are constantly striving for the “next best thing” here in the U.S. From startups to mid-sized businesses to Fortune 500s, this tax credit is for those who innovate, create, and problem solves with American ingenuity.
Form 6765 is often overlooked by CPAs and taxpayers for its complexity. It’s a shame because taking advantage of the R&D Tax Credit is worthwhile. If you can legally lower your tax bill, why wouldn’t you?!
Before filling out Form 6765, you must determine whether or not your employee’s (or your contractors) have spent time performing work which can be considered as “qualified research activities” (also known as QRAs). QRAs are determined by running the 4 Part Test. If their work passes the 4 Part Test then it is considered as a QRA. Additionally, the costs associated with these activities — also known as “qualified research expenses,” (QREs) are the building blocks of your R&D Credit calculation. For more details on how to calculate your QREs, check out our blog post, A Deeper Dive into Qualified Research Expenses.
The definition of qualified research (the foundation of the research credit) is found in IRC Section 41(d). Qualified research is defined as the development of a new or improved “business component.” A business component is just another fancy word for a project, initiative, agenda that your company may deem as research and development.
Internal Revenue Code section 41(d)(2) defines a “business component” as:
any product, process, computer software, technique, formula, or invention which is to be—
(i) held for sale, lease, or license, or
(ii) used by the taxpayer in a trade or business of the taxpayer.
To make things even more complicated, there are no regulations that define these business components. The good news is that we’ve simplified each component:
It’s what you make and sell for a profit. For instance, if you’re a widget manufacturer, and new widgets that you design and make, OR any improvements you make to your existing widgets would be your qualified product development. However, products don’t necessarily need to be tangible. For instance, if you’re an architect, your final design of a new building is your “product”, even though you didn’t actually build the building.
How you make your product and the expenses associated. For example, your investments in new equipment or improved production capabilities would be your qualified process improvements. Although the cost of the equipment itself is typically capitalized (and therefore is not counted towards your research credit), the cost of your employees figuring it out, as well as any materials you ran through it while you were optimizing it, and any third-party consultants you use to get it running, would all be your QREs.
Writing custom code? Buying someone else’s software doesn’t count. The qualified software development we see generally falls into four buckets:
- Writing code for sale, lease or license (like us – we’re a software development company)
- Writing code to embed in your tech products. Of course, you could call this software development or product improvements. Remember, it doesn’t matter what business component “type” you call it, as long as it qualifies under the definition of Qualified Research
- Writing code to run your production equipment. Examples would be coding your CNC machines to cut a new part, improving your PLC logic controls, or perhaps developing or improving your robotics capabilities.
- Writing code for your own internal use (known in the regulations as “internal use software”). This might include developing your own ERP platform, automating your inventory control capabilities, or developing advances ways to better communicate with your customers.
These are the “tools” you use for executing your processes. In a manufacturing plant, we’re talking about the guys and gals developing the tooling, fixturing, molds or dies. Of course, you could say that designing the mold to make a part is a new or improved Process. However, we like to think of the plastic injection molding machine as the process, and the effort to design the mold to make the part as the Technique – it’s how you execute the process (i.e. use the machine). Semantics, of course, since these terms aren’t formally defined, but it helps keep us all organized. The other area of Techniques we look for are any efforts you’re employing in an effort to drive out waste. Examples of this would be lean manufacturing kaizens, six sigma kanbans, quality initiatives, waste reduction initiatives, green initiatives.
There are two types. First is developing new recipes or raw materials. A good example of this is the food and beverage industry. They’re always coming up with new formulas or recipes. The second type of Formula business component is attempting to use new and alternative materials. For instance, if you’re a job shop, and you change suppliers of raw material, and that material doesn’t work the same, you have to figure out how to adjust. Likewise, if you’re an engineering design firm, and you specify a material that you’ve never used before, this would be a Formula business component for you.
The oldest and smallest of the six business components. This is the “old” definition of qualified research – all there was prior to 2001.
And that wraps up the six business components. Now you should have a better understanding if any of the activities your employees partake in are deemed R&D worthy.
Ready to calculate your R&D Tax Credit? The next step is to determine the qualified expenses associated with all of your business components. Check out this blog post for more details.
Once you have all your QREs, you’re ready to complete your Form 6765 to capture your credit. Click on the below button to for help in completing the form!
(don’t worry we won’t spam you).