Any company that develops new or improved products, processes, or software could qualify and be eligible to claim the R&D tax credit under the US tax code – whether developed successfully or not.
R&D Tax Credit Four-Part Test
The R&D tax credit incentivizes certain research activities by reducing a company’s liabilities for spending money on that research. Expenses that qualify are more comprehensive than you may think.
Qualified research expenses (QREs) can include the salaries of employees and supervisors who are conducting research, supplies, and even some contractors.
Congress created the “Four-Part Test” that determines eligibility for the credit.
- Qualified Purpose
- Technological in Nature
- Elimination of Uncertainty
- Process of Experimentation
Qualified Purpose
The activity must create or improve a product, process, formula, or software with respect to its functionality, performance, reliability, or quality. You must intend to use it in your business or retain intellectual ownership.
Even if the activity was not successful, you may still qualify for the R&D tax credit.
Technological in Nature
Your innovation must rely on hard sciences such as:
- physical sciences,
- biological sciences,
- computer science, or
- engineering.
Elimination of Uncertainty
You must demonstrate that you’ve attempted to eliminate uncertainty. Your innovation must go beyond cosmetic design and seek to improve functionality by gaining information and reducing ambiguity associated with its development. When work on a qualifying project began there would have been uncertainty related to your capability to create the product or improvement, the methodology you would use, or the correct product design.
Process of Experimentation
You must be able to show that you have explored alternatives to achieve proof of concept. Through modeling, simulation, systematic trial and error, or other methods, you must have evaluated alternatives for achieving the desired result. the project must involve a process by which you tested alternatives and resolved the uncertainty above.
Exclusions
Your work may pass the four-part test but there are still a few exclusions to the R&D tax credit. The following may appear in the four-part test but they will still not qualify for the incentive:
- The activity must take place in the U.S. and cannot include routine data collection or market research
- The activity cannot receive funding from an unrelated third party because your company might not retain ownership of the resulting intellectual property
Regardless of industry, size, or revenue, any business that performs activities meeting the Four-Part Test qualifies for the R&D tax credit.
Monetizing the claimed R&D tax credit
The R&D tax credits can be used to offset:
- Income taxes, if you are in a taxable position.
- Alternative Minimum Tax (AMT) if you have average annual gross receipts for the prior three years of $50 million or less, and you owe AMT in the current year.
- Employer portion of Social Security taxes up to $250,000 for each fiscal year if you are a qualified small business. This payroll tax offset allows qualified small businesses to receive a benefit for their research activities regardless of profitability.