Business owners filing for a research and development tax credit often spend ample time identifying project eligibility and proper documentation required to pass an R&D tax credit audit. However, many entrepreneurs don't realize that mandated qualifications and legislated paperwork aren't the only considerations when preparing for an IRS inspection. To maximize cash flow opportunities and minimize risk (and stress) in the event of an audit, it's just as important to understand project types that are specifically excluded from research and development qualifications.
What Does Not Qualify For The R&D Tax Credit?
The IRS offers a section devoted to outlining types of initiatives that don’t qualify for the R&D tax credit. Here are eight items that won't pass a research and development tax credit audit.
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Research After Commercial Production
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Adaptation of Existing Business Components
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Duplication of an Existing Business Component
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Surveys, Studies, Etc.
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Funded Research
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Foreign Research
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Reverse Engineering
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Social Sciences
In this article we will get in depth one each of these disqualifying categories so you can better prepare for an R&D tax credit audit.
1. Research After Commercial Production
Once Technical Uncertainty has been eliminated, research and development (as defined in the Internal Revenue Code) is complete. Any expenses incurred after this point would not be able to be included in your qualified research expenses.
However…
As many people know, innovation often yields new developments and improvements to products, formulas, software, and other features that are functional in nature. These future development efforts may qualify as a new business component and should be broken out separately in your documentation to track and quantify costs, time, and tasks.
2. Adaptation of Existing Business Components
Slight changes or alterations for a specific customer that do not have technical uncertainties are excluded from qualified R&D.
But…
Improvements that require a new development effort where there is technical uncertainty and a process of experimentation may qualify the initiative as eligible R&D. A key point here is the need to have technical uncertainty (as well as demonstrate a process of experimentation) to be considered a new business component.
3. Duplication of an Existing Business Component
Unsurprisingly, the IRS doesn't reward efforts to reproduce a second (or several) product(s) from an existing business component.
4. Surveys, Studies, Etc.
This category includes efficiency surveys, management-related studies, market research, routine data collection, and ordinary or routine quality control.
Yet…
5. Funded Research
This includes development efforts funded by grants, contracts, or otherwise that are excluded explicitly from qualified research (IRC Regulation Section 1.41-4(c)(9)). Any contracts entered into between a taxpayer performing the research and other persons are considered in determining whether the research being conducted is funded. Payments under the contract that are contingent upon the success of the research are not considered funded; however, these initiatives would most likely not be considered qualified research and development if rights to the results transfer to the other party.
It should also be noted that partial payments to pay for separately stated engineering efforts can also be considered partial funding for research activities and revenue received and would need to offset internal R&D costs. Additionally, manufacturing contracts for the development and production of final deliverable products would be considered a manufacturing contract and may not be deemed an agreement to conduct qualified research. As a result, payments made would be for a manufactured product and not qualified research, unless the taxpayer is required to develop the process for manufacturing the product under contract. This exception provides a dynamic opportunity for contract manufacturers to take advantage of the R&D tax credit..
6. Foreign Research
Research conducted outside the U.S. is considered foreign development and is specifically excluded from qualified R&D tax credit claims. Some U.S. companies have begun using programmers located in foreign countries to save money on development costs. These expenses would not be considered in the innovation tax credit calculation.
7. Reverse Engineering
Reverse engineering of a product is specifically excluded under the legislation on duplication of an existing business component. While the term “reverse engineering” is not detailed, the section defines efforts related to a “physical examination of the business component...”
Still…
Efforts that begin with new research to improve new functionalities of a business component may qualify even if initial concept development must be excluded due to reverse engineering.
8. Social Sciences
The Internal Revenue Code specifically excludes this type of project. Research based in the social sciences, arts, or humanities does not qualify for Research & Development tax credits and would fail due to the lack of hard sciences missing from the process of experimentation. This includes physical, biological, engineering, or computer science.
Don't risk noncompliance during an R&D tax credit audit. Contact Acena Consulting today to discuss your project initiatives with our team of innovative and experienced research and development tax specialists.
