Originally introduced as part of the Economic Recovery Tax Act of 1981 and made permanent by the Protecting Americans from Tax Hikes (PATH) Act of 2015, the credit for increasing research activities (research credit) is a valuable, yet often-overlooked, tax break for qualifying businesses. This first article in a series on the research credit will take a look at what is considered “qualified research” for purposes of the credit. Future articles will focus on which expenses qualify for the credit, how to calculate the credit, and how to claim the credit.
Qualified Research
To qualify as research for purposes of the credit, the research must be conducted in the U.S. (including Puerto Rico and U.S. possession) and must be paid or incurred in carrying on your trade or business. As such, expenses paid or incurred before starting a trade or business are not eligible for the credit. Furthermore, it is not sufficient you be in a trade or business. Expenses incurred to develop new products that are of a different type than those you normally sell are considered to be expenses of a new trade or business and not expenses in carrying on your existing business. No credit is allowable in such cases.
A research expense only constitutes qualified research if:
- it meets the same tests that are required of expenses qualifying for the research and development deduction under IRC section 174,
- it is undertaken for the purpose of discovering information that is technological in nature (e.g. relies on the principles of the physical or biological sciences, engineering, or computer sciences), and the application of which is intended to be useful in the development of a new or improved business component of the taxpayer (e.g. a product, process, computer software, technique, formula or invention either held for sale or used in the taxpayer’s trade or business), and
- 80% or more of the research activities to which the expense relates constitute a process of experimentation (e.g. evaluation of one or more alternative methods of solving a problem or designing an item where the solution to the problem or the design of the item is uncertain at the outset).
The purpose of the research must be to achieve a new or improved function, performance, reliability, or quality as opposed to style, taste, cosmetic, or design changes. Obtaining a patent is considered conclusive evidence that you have discovered information that is technological in nature which is intended to eliminate uncertainty about the development or improvement of a business component. However, obtaining a patent is not a requirement for research to be considered qualified research.
Activities not eligible for the credit include:
- research after commercial production (e.g. trial production runs, trouble-shooting, de-bugging product flaws),
- adaptation of an existing business component to a particular customer’s requirement or need (the fact that an item is intended for a particular customer does not automatically disqualify otherwise qualifying research),
- duplication, or reverse engineering, of an existing business component (examination of a competitor’s product as part of a program to develop a new or improved product would be eligible for the credit),
- efficiency surveys, management functions and techniques (e.g. preparation of financial data and analysis, development of employee training programs, etc.), market research, testing, or development, routine data collection, or routine or ordinary testing or inspection for quality control,
- research with respect to computer software which is developed for your own internal use, unless the software is used in qualified research or in a production process that qualifies for the credit,
- any research in the social sciences, arts, or humanities, and
- any research to the extent funded by any grant, contract, or otherwise by another person (or governmental entity).
[add links for additional articles in the series as they’re released]
contact Edwards, Ellis & Associates to learn more about the research credit and how it can benefit your business.
