R&D tax credits are an excellent way for companies to reduce their tax liability. Still, many small businesses may miss out on potential savings by overlooking activities that could qualify for tax credits. Discovering new qualifying R&D activities in their organizations can help companies increase the amount of credit they receive. Here are actions you can take to raise savings.
About the R&D tax credit
The federal government created R&D tax credits in 1981 to encourage companies to innovate their lineup and as a response to declining research and development in the 1970s. In the following decades, Congress passed legislation to make the R&D tax credit more accessible, including the Discovery Rule that made it easier for companies to qualify by allowing existing research to be part of a claim as long as it was new to the company. To make a successful R&D tax credit claim, organizations must thoroughly document research activities and track expenditures to verify their R&D activities.
Determine if activities pass the four-part test
To determine a qualifying research activity (QRA), the IRS issues a four-part test, a set of criteria companies must meet to receive R&D tax credits. The test requires that actions:
- Relate to technology: Research and development activities must involve methods that utilize the hard sciences, including physics, computer science, mathematics, biology, and chemistry.
- Attempt to eliminate uncertainty: The IRS defines uncertainty as companies not knowing the outcome of R&D activities at the beginning of development. QRAs must attempt to eliminate uncertainty, and businesses can do so by including the process outline, technical document, timelines, and prototypes in their R&D tax credit claim.
- Utilize an experimental process: When performing research and development; organizations must demonstrate that they are evaluating alternatives to improve their business component’s functionality, reliability, design, or performance.
- Improve business components: Companies must improve business components such as a product, processes, techniques, software, or formula. Improvements can be minute changes or complete overhauls of the component.
After a company determines its activities meet the criteria, it must document QRAs and qualifying research expenses (QREs) for the IRS to verify. Businesses must include W-2s, activity logs, and contract research expenses in their claim to substantiate their research and development and maximize the chance of the IRS approving their claim.
Look beyond traditional lab research
While traditional lab research is often eligible for R&D tax credits, some companies may have additional unaccounted-for QRAs. Businesses in non-science sectors are likelier to have overlooked activities that may qualify as research. While QRAs vary between each organization, any activity that utilizes a scientific process to improve a business component is likely a good candidate for an R&D tax credit claim.
Some activities outside traditional laboratories that can qualify include improving food taste, implementing user-friendly ecommerce store features, and streamlining manufacturing processes. Further, it is crucial to note that activities need not be groundbreaking or successful in qualifying; QRAs only need to be new to an organization. For instance, an organization can qualify for R&D tax credits by streamlining its manufacturing processes with the latest technology available to the mass market.
What does not count as qualifying research?
Although the IRS broadly defines QRAs, certain activities do not count for an R&D tax credit claim. For example, changing an administrative assistant’s workflow to include fewer tasks or conducting quality control for machinery are not qualifying research activities.
Non-qualifying activities also include routine technology maintenance, social-science-based studies, purely aesthetic changes, and improvements to administrative tasks. Moreover, activities not involving hard sciences are unlikely to count as QRAs.
There are many activities businesses can use as part of their R&D tax credit claims, but reporting and claiming them can be challenging for small businesses. MainStreet helps companies claim each R&D tax credit they are eligible for, saving them time and money. If your startup or small business needs help to claim R&D tax credits, contact us to get started today.