Did you know the R&D Tax Credit was originally for those experimenting in white lab coats? While many think that this still stands true today, the R&D Tax Credit has evolved throughout the years to include more than just nerdy laboratory scientists!
The most common industries that qualify for the R&D Tax Credit include manufacturing (OEMs and job shops), software development, engineering, and architecture design firms. Don’t worry though, those in white lab coats can still qualify.
To receive the R&D Tax Credit, you must complete Form 6765. However, there are important steps to follow beforehand to ensure that you accurately fill out the form. Not every job function can qualify for the credit!
Does the Work Qualify?
The first step to determining whether or not the work performed is deemed R&D worthy, is to identify if the work falls under the six R&D business components. I suggest reading that blog post for a deeper dive and a better foundational understanding. Once you’ve determined if the work does fall under one or more components, you must run it through the 4-Part Test, which is what this blog post is about. If the work passes all four parts, it is considered a Qualified Research Activity (QRA). To round it out, once you have determined your QRAs, then you can calculate your Qualified Research Expenses (QREs).
The 4-Part Test
There are four “mini” tests within the 4-Part Test. To complicate things even more, the work must pass each one of the tests listed below:
Step 1. The New or Improved Business Component Test — For this test, you have to show that you had a “Qualified Purpose” – also known as your Permitted Purpose. In other words, you have to be attempting to develop one (or more of the following):
- New or improved functionality
- New or improved performance
- New or improved reliability
- New or improved quality
Activities must seek to problem solve, create, innovate, evaluate, invent, or experiment. Making small adjustments, like changing the color of a product for aesthetic purposes, doesn’t count.
Step 2. The Technical Uncertainty Test — The law says you have to be “endeavoring to discover information that was uncertain at the outset.” In other words, there has to be a risk. However, not any kind of risk – not business, marketing, or financial risk. TECHNICAL risk. We’ll talk more about the word “technical” in the third test. For this test, though, case law has further defined that there are only three types of technical uncertainty:
- Uncertainty in your Capability – for instance, at the beginning of the Business Component (project), you weren’t sure you’d be successful in the objective.
- Uncertainty in your Research Method – how you’re going to go from the original concept to the final design. This is also called your “process of experimentation,” which we’ll look at further in the fourth test.
- Uncertainty in the Appropriate or Final Design – If you know you can get there (capability), and you know how you’re going to get there (research method), but at the beginning, you’re not exactly sure what the final design will look like, you have Technical Uncertainty. Activities must intend to eliminate the uncertainty of the development of a new or improved product, process, technique, software, formulation, or invention. In other words, this means you are trying to “push past” any barriers that might stop you from achieving your result.
Step 3. The Technological in Nature Test— The law says that to resolve that uncertainty, you fundamentally relied on the principles of either:
- Physical Science
- Biological Science, or
- Computer Science (our favorite). Activities must rely on hard science. Examples of sciences include engineering, environmental/life sciences, software, and manufacturing/design.
Step 4. The Process of Experimentation — activities include trial and error or evaluation of solutions while attempting to reach a result. Experiments don’t necessarily need to succeed. The IRS deems “failed” experiments as qualified.
It is important to keep in mind that there are statutory exclusions to certain activities that do not qualify for the R&D Tax Credit. According to Chapter 5 of the Audit Techniques Guide: Credit for Increasing Research Activities, the eight statutory exclusions are as follows:
- Exclusion for research after commercial production – any research conducted after the beginning of commercial production.
- Exclusion for adaptation – activities tailored to meet a specific customer’s requirement or need.
- Exclusion for duplication – reproducing an existing business component after the business component was developed.
- Exclusion for surveys, studies, research relating to management functions – surveys, data collection, quality control testing, managerial organizational plans, employee training, and changes in production processes.
- Exclusion for internal-use software – the regulations are a little fuzzy here, but this includes software developed to be sold outside of the company.
- Exclusion for foreign research – research cannot be done outside of the United States, including Puerto Rico or any land governed by the United States.
- Exclusion for research in the social sciences – research in economics, business management, behavioral sciences, arts, or humanities does not qualify.
- Exclusion for funded research – research funded by outside grants or money
If you have any questions or if your activities do qualify for the 4-Part Test, feel free to give us a quick call by scheduling time with one of our engineers: schedule a call.