The Federal R&D credit, also known as the Credit for Increasing Research Activities, is a credit to incentivize companies to increase their research activities. Most companies believe that if they aren’t running a full-fledged research lab, they don’t qualify. This common misconception leads to billions of dollars in government funds wasted. Funds that could be used to fund innovation in virtually every field.
The terms of R&D tax credits are fairly broad. At its core, the program is designed to reward companies that prioritize the creation and improvement of products and processes. While many Fortune 500 companies take advantage of this program, much of our most innovative work is done at the startup level. These smaller organizations are owed tens of thousands (if not more) to continue doing this groundbreaking work, yet most leave this money on the table.
To better understand the advantages of this program, especially for growing companies, let’s explore what this program is and how businesses like yours can qualify.
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What is the R&D Tax Credit?
The R&D tax credit program was introduced in 1981 as a two-year incentive to help businesses invest in advancing technology and has remained in place ever since. It’s available to any business that attempts to develop new, improved, or technologically advanced products or trade processes. Businesses that have improved upon the performance, functionality, reliability, or quality of existing products or processes may be eligible as well.
What most people don’t realize, is the credit is available to businesses of all sizes and designed to be used for common business activities. For this reason, many companies are missing out on money they could be saving each year. Simply put, if your company develops or designs new products, enhances existing products, or develops or improves upon existing prototypes and software, you’re likely eligible for R&D tax credits.
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Understanding the IRS’s Four-Part Test
Here’s where the qualification requirements come in. To help companies determine their eligibility status for the R&D tax credit, the IRS established a four-part test. If your company’s project(s) meet each of these four requirements, you will likely qualify:
1. Permitted Purpose
The purpose of your project must relate to creating a new business component or improving the function or performance of an existing one. This can mean improvements to accuracy, speed, or overall quality.
It’s also important to note that the advances you’re making don’t have to revolutionize the industry. Your company’s projects or processes should be in an effort to improve your business.
2. Elimination of Uncertainty
Research activities must have the intention of finding relevant information related to eliminating uncertainty concerning the capability, design, or methodology of the product or process. In other words, improvements can’t be purely cosmetic. Your research must prove that your improvements were or can be implemented.
3. Process of Experimentation
The research and development phase of the project must include different approaches to ensure you use the best option to reach your intended goal. This usually requires some record-keeping related to methods that failed or research that clarified which avenue would lead to success. This may include modeling, simulation, or records related to a systematic trial and error method.
In general, it’s good practice to keep a record of anything your company does that could be relevant to your tax credit claim. This ensures that you have proof of your work in the event of an IRS audit. We’ll touch on this more later.
4. Technological in Nature
This is the part that intimidates most. “Technological in Nature” doesn’t mean that your products, services, and research have to be about new technology. It actually means that your methods utilize hard sciences like physics, engineering, computer science, or chemistry.
Once you step back from the technical terms of the four-part test, it’s easy to see how your work could qualify. To further translate for the IRS:
- Your project’s goal must be to improve your company’s processes or products.
- Your research must prove that the activities will improve the capability of the product or process.
- Your research must explore multiple trials to reach the best method or improvement.
- Your research and development activities must apply scientific principles.
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Admittedly, the IRS four-part test still makes it sound like the credit is best suited for a scientific lab setting. That’s why it’s important to consider the activities in a business setting that fit under the umbrella of the four-part test.
Since the credit is designed to encourage companies to participate in research, the funds are allocated to offset the costs associated with conducting research. These costs can have a wide range from tools and materials used for research to payroll for individuals conducting research. Companies engaged in the following activities should consider looking into the R&D tax credit:
Activities that are technical in nature or that involve design, development, or improvement of new or existing:
- Processes: This may include investments in tools or research used to improve the way your company works or produces products or services.
- Products: Tools, researchers, and methodology used to create new products or improve upon existing products may be eligible for credit.
- Techniques: Improving techniques for design or production that improves the way your company works often requires considerable research and can also require new tools or equipment.
- Formulas: The development and evaluation of new or more reliable formulas often require testing and validation.
- Inventions: Practically any cost involved with the design and production of an entirely new product can be considered innovative development.
- Software: Developments can be related to software designed for public use that is not yet available on the market, or innovative software for internal use that fits certain criteria.
or Activities focused on making improvements in:
- Performance: These improvements can mean products work faster or more efficiently.
- Functionality: Usually functional improvements are those of products that are continually improving for new rollouts that keep up with technology changes and consumer demand.
- Reliability: Improvements that make products more durable or include more resilient components for improved performance or lifespan are considered innovative.
- Quality: Overall increases in quality mean that a product has improved year over year.
10 Examples of Qualifying Activities
- Testing of new concepts and technology using trial and error methodology or a similar scientific formula
- Development of prototypes and models whether the new product succeeds or fails
- Development of new, improved, or more reliable products, processes, or formulas
- Application for patents that require record-keeping to document the process
- Investment in equipment that improves a process
- Streamlined manufacturing process with new tools, equipment, or procedures
- Development of new software for commercial sale or internal use
- Design for LEED/green initiatives
- Environmental testing to improve existing products or produce new products
- HVAC concept and design
So, how do these research activities translate to everyday activities? The IRS defines certain activities as qualified research expenses. These expenses are typically related to activities like the ones above and include:
- Any wages paid to employees for performing qualified services
- The cost of supplies or materials used to conduct research or assist in development
- Costs related to securing tools like computers for research
- A percentage of the cost of contracted research professionals for the project
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There are many research expenses that qualify for credit. However, certain activities are specifically excluded to prevent organizations from taking advantage of government credits. These actions do not qualify for the R&D tax credit:
- Research after commercial production
- Adaptation for a particular customer
- Research for the duplication of an existing product
- Surveys and research related to company management function
- Research conducted outside the U.S.
- Funded research
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Claiming R&D Tax Credits
Claiming R&D tax credits doesn’t have to be intimidating or difficult. With the right documents, you may even be eligible to claim credits from current and prior tax years.
There are a few ways you can go about filing your claim. You can book a series of appointments with your accountant to evaluate your eligibility and get your documents in order. You can attempt to gather the right document and fill out the tax forms on your own. Or you can partner with MainStreet.
Every year, the government sets aside billions in tax credits that most accountants never think to claim. With MainStreet, you can plug your payroll and accounting software directly into our dashboard. We search through 200+ credits, finding the ones that best suit your business. Once you qualify, we do all the heavy-lifting to claim your credits and pass the savings onto you.