We finished our series on the four-part test that the Internal Revenue Service (IRS) uses to qualify research & development (R&D) activities for the federal R&D tax credit, formally called the Credit for Increasing Research Activities.
Businesses can claim this credit by documenting qualified R&D activities, capturing qualified research expenses (QREs) – including wages for qualified services and supply costs – and reporting the calculated credit amount via Form 6765 when filing annual tax returns.
We recently received a question from our readership, “How can I tell the difference between methods, processes, and techniques as I document my R&D projects?”
Let’s answer this question while reviewing the four-part test. We can immediately mitigate some complexity by considering each subtest individually.
The Permitted Purpose subtest asks, “What is the intended outcome of R&D activities?”
To qualify, R&D activities must innovate or improve a business component held for sale, lease, or license to taxpayers, or intended for taxpayers’ use during business or trade.
26 U.S. Code (USC) § 41(d)(2) lists the qualified types of business components. Among the possibilities are both processes and techniques. But what is the difference between them?
The answer is subjective – formally undefined among the tax codes and regulations – but here are the criteria we use in house.
Processes are ordered actions or steps to achieve an outcome. In other words, processes structure the overall strategy or workflow.
Example: A manufacturing company creates a new process for product assembly product that calls for a custom order of operations or steps, facilitated by robotic arms.
Techniques are specific methods or procedures to achieve an outcome.
Example: During the aforementioned manufacturing process, a new technique is developed to weld two components using a laser instead of traditional welding methods.
In summary, processes are broader in scope than techniques. A single process can encompass multiple techniques. Processes focus on the overall flow and sequence of activities, while techniques focus on the specific actions and methods used during one step.
But what about the difference between methods and techniques? This question can be confidently disregarded because both methods and techniques are not options for business components.
The four-part test mandates that qualified R&D seeks to eliminate Technical Uncertainty.
Technical Uncertainty exists if the available information to the taxpayer (e.g., your business) does not address specific unknowns, including the appropriate design or method for creating or improving the business component.
Let’s explore how these uncertainties may apply to the same theoretical project. A civil-engineering consultancy is tasked with restoring a coastal wetland, affected by an oil spill.
Appropriate design refers to a process' blueprint.
Example: The R&D team does not know what methodical permutation (i.e., set of ordered steps) would most effectively rehabilitate the biodiversity and the ecosystem's functionality.
Method refers to the means of completing a process.
Example: The R&D team does not know how to most effectively perform a step (e.g., controlled burning, invasive species removal, or reforestation) called for by the elected restoration design.
Do you still have lingering questions? Solicit a second opinion!
At Acena Consulting, R&D tax credits are our bread-and-butter business, 365 days a year. Our team of tax professionals includes CPAs who have partnered with startups and Fortune 500 companies, as well as engineers who understand the scientific questions underlying your operations.
Schedule a free consultation today to receive immediate assistance from Randy Eickhoff, CPA, Acena's Founder & Head Coach.
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Edited by Randy Eickhoff, CPA, Founder & Head Coach at Acena Consulting. Photo courtesy of ESO/M. Kornmesser (i.e., European Southern Observatory) on Flickr.