This article was originally published in the November 10, 2016 issue of the North Bay Business Journal.
The Research and Development Tax credit is a general business tax credit introduced in 1981 as a temporary credit to incentivize domestic research and job growth. At the end of 2015 the Protecting Americans from Tax Hikes (PATH) retroactively extended and made the popular R&D Tax Credit permanent.
Also included in the PATH Act were unexpected taxpayer-friendly incentives; beginning in 2016 eligible small businesses (i.e. those with $50 million or less in gross receipts) may claim the credit against alternative minimum tax (AMT) liability, and the credit can be used by certain even smaller start-up businesses against the employer’s Social Security portion of the payroll tax liability.
To determine whether or not your company qualifies for the R&D tax credit (IRS Revenue Code § 41) you need to evaluate your research activities and determine if the activities meet four-part test:
- Permitted Purpose: The purpose of the activity must create new or improve functionality, performance, reliability, or quality of the business component. The business component can consist of any product, technique, process, formula or invention.
- Elimination of Uncertainty: The activity must be intended to discover information to eliminate uncertainty concerning the capability, methodology,or appropriateness of design for developing or improving a product or process.
- Process of Experimentation: The taxpayer must engage in an evaluation process that is capable of identifying and evaluating one or more alternatives to achieve a result. This test may include modeling, simulation, or systematic trial and error methodology.
- Technological in Nature: The activity performed must fundamentally rely on the principles of physical, biological, engineering, or computer science. Examples of types of activities that may qualify include, but are not limited to product development, feasibility studies, design/engineering testing, trial runs, product specification development, design for serviceability or usability, prototype development, beta testing, manufacturing process/design development. Likewise examples of non-qualifying activities would include routine repairs & maintenance, adaptation, on-going or routine production, training, or administrative.
Once you’ve analyzed your activities and made a determination on the projects that qualify, the company needs to review the project expenditures to be sure they are eligible to be included in the calculation of the credit. Qualified Research Expenditures (“QRE”) are the sum of the in-house and contract research expenses paid or incurred by the taxpayer during the taxable year in carrying on any trade or business of the taxpayer.
Qualifying Research Expenditures include:
- Taxable Wages: Personnel who are performing qualified activities related to direct research, direct supervision, or direct support.
- Supplies: Tangible property other than land, land improvements, or other property subject to depreciation that is consumed in the conduct or support of research. Examples include, but are not limited to lab supplies, testing supplies, and prototypes.
- Contract Research: Sixty-five percent of payments made to outside vendors/contractors for performance of qualified research service on behalf of the taxpayer. The “on behalf of” is refined by I.R.C. §1.41-2(e) (3), which requires the taxpayer to have rights into the research results.
Once all of the projects and expenditures are identified it’s important to have and keep contemporaneous documentation for support of the calculation. The documentation is used to demonstrate that an activity meets the four part test for qualification of the business component. Examples of documentation may include, but are not limited to test results, research protocols, emails/reports regarding development or testing efforts, documentation describing research process, process flow charts, conceptual layouts, release comments to manufacturing for fabrication or build, material composition reports, and trial run logs.
Is your company eligible for the R&D Credit?
It depends on the stage of the company, but there are three different calculation methods in determining the tax benefit. In general the R&D Credit is an incremental credit that equals twenty percent of the taxpayer’s excess QRE’s for the taxable year over their base amount. For tax years beginning after Dec. 31, 1989, the base amount is computed by multiplying the taxpayer’s fixed base percentage by its annual gross receipts for the preceding four years. The maximum fixed base percentage is sixteen percent.
The taxpayer can elect to reduce the credit my making a 280c election on a timely filed return which allows the deduction of the qualified research expenditures claimed for the R&D Credit.
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