We previously discussed how American companies conducting qualified research and development (R&D) may claim the Credit for Increasing Research Activities (i.e., the federal R&D tax credit) to increase their cash flow, reduce their tax liability, and maximize their time.
Businesses can claim the federal R&D tax 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 their annual tax returns.
But as a CFO, how do you know whether your business’ R&D activities qualify?
Last week, we introduced the four-part test, set forth under 26 U.S. Code § 41(d), that activities must pass to qualify as R&D.
Today, we'll unpack the first part or subtest: Permitted Purpose.
What is Permitted Purpose?
The Permitted Purpose subtest asks, “What is the intended outcome of R&D activities?”
Qualified 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.
Let’s define the diction in this answer while keeping in mind that activities need not succeed to qualify as R&D.
What Changes Constitute Improvement?
Improvements advance component functionality, performance, quality, or reliability.
Aesthetic changes do not qualify as R&D.
What Are Business Components?
26 U.S. Code § 41(d)(2) lists the qualified types of business components: products, processes, computer software, techniques, formulas, and inventions.
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Products: services or tangible goods manufactured or refined for sale.
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Processes: ordered steps of methods to achieve an outcome.
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Computer software: data or programs (e.g., applications) instructing the operation of hardware (i.e., the physical components of a computer system).
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There is a greater qualification standard for internal-use software (IUS) called the high threshold of innovation test, which must be passed in addition to the four-part test.
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Techniques: methods of performing tasks to achieve an outcome.
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Formulas: chemical compounds, mathematical expressions (e.g., algorithms), or recipes.
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Inventions: new, non-obvious, and useful actions (e.g., manufactures and processes) or things (e.g., machines and compositions of matter).
The R&D activities associated with each business component must pass the four-part test independently.
Next Steps
Consulting with your company’s internal teams may help you determine whether your R&D activities satisfy the Permitted Purpose subtest. For example:
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Product teams may know what types of business components are investigated during internal or contracted R&D.
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Engineering teams may speak to whether any activities are aimed at improving component functionality, performance, quality, or reliability.
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Legal teams may know whether any activities focus on designing inventions or developing proprietary processes.
We also recommend that you ask us!
At Acena Consulting, R&D tax credits are our bread-and-butter business, 365 days a year. Our team of tax professionals includes CPAs and engineers who have partnered with hundreds of businesses, from startups to Fortune 500 companies. We’ve seen it all.
Schedule a free consultation today to receive immediate assistance from Randy Eickhoff, CPA, Acena's Founder & Head Coach.
Stay Informed
Next week, we’ll explore how qualified R&D must pass the second subtest: Technological in Nature.
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Questions? Please email me at laura.whittenburg@acenaconsulting.com.
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Interested in building your professional fluency in R&D tax incentives?
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Sign up for our free, interactive webinar on December 17: “Cracking the (Tax) Code for R&D.”
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This workshop provides one CPE credit for professionals keeping up with continuing education.
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We can answer any questions you have about the four-part test.
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- Reminder: The deadline for fourth quarter 2023 estimated tax payments is January 15, 2024. Taxpayers may pay online via the IRS website.
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Edited by Erica Valdescaro, Human Resources Manager at Acena Consulting. Photo courtesy of NASA Goddard Space Flight Center on Flickr.