We continue unpacking 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.
Today, we’ll examine the third subtest, called the Process of Experimentation (PoE).
Keep in mind that activities need not succeed to qualify as R&D.
What is a Process of Experimentation?
The PoE refers to a systematic process of evaluating alternatives in pursuit of a permitted purpose until all Technical Uncertainty is resolved.
Let’s unpack the criteria in this summary by referencing the 26 Code of Federal Regulations (CFR) § 1.41-4.
- A systematic process means following a structured approach with clearly defined steps. This methodology discourages bias and inconsistency by ruling out haphazard approaches. In other words, qualified R&D is not randomly trying things without a clear plan or a way to measure results. Imagine combining ingredients without a recipe and hoping for a delicious cake!
- Alternatives mean specific solutions that are identified and evaluated to determine which option works best. Consider choosing among different routes to reach your destination; each route is an alternative.
- We recently published an explainer on Permitted Purpose. To have one, 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.
- Technical Uncertainty derives from questions related to appropriate design, capability, or method that must be answered to fulfill the permitted purpose. In simpler terms, they are questions that must be faced to answer: can we or how do we make something work?
- We will discuss this topic in greater detail during next week’s blog.
What Do Experimental Processes Look Like?
The PoE could look like anything, so long as it meets the above criteria.
The three classic types of PoE are called iterative, trial-and-error, and scientific method.
- Iterative experimentation means incrementally revising alternatives based on theoretical results.
- Example: A textile company creates an insulating, lightweight tote bag. The optimal insulation volume is unknown that maintains the bag’s internal temperature without becoming too heavy for the customer. Engineers use computer-assisted design (CAD) software to draw an initial design, then model how the bag behaves. Informed by these theoretical results, the engineers create an alternative design that better balances insulation volume and tote weight.
- Trial-and-error experimentation means incrementally revising alternatives based on empirical results.
- Example: A programmer designs a new user interface (UI) for a web application to minimize the number of clicks the customer must perform to place an order. The programmer launches the website, then tracks the average number of clicks made by customers to place orders. The programmer revises the UI design based on these real-life results to improve the application’s functionality.
- Following the scientific method means making observations, forming a hypothesis, conducting experiments to test the hypothesis, analyzing data, and drawing conclusions based on the results.
- Example: A scientist conducts a clinical trial to determine the effectiveness of a new drug.
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The Substantially All Requirement
The Substantially All requirement states that 80 percent of R&D activities must support the PoE.
The 80 percent must be calculated on cost or any other consistently applied basis (e.g., time spent), as further elaborated under 26 CFR § 1.45D-1.
Four-Part Test Recap (So Far)
Let’s review the four-part test criteria we’ve discussed for qualifying R&D activities.
- To have a Permitted Purpose, 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.
- To be considered Technological in Nature, R&D activities must support a PoE that fundamentally relies on the principles of physical or biological science, engineering, or computer science.
- At least 80 percent of R&D activities must support a PoE: a systematic process of evaluating alternatives in pursuit of a permitted purpose until all technical uncertainties are resolved.
Stay Informed
Happy holidays from all of us at Acena Consulting!
Next week, we’ll explore how qualified R&D must pass the four-part test’s final subtest: Technical Uncertainty.
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Interested in building your professional fluency in R&D tax incentives?
- Sign up for our free, interactive webinar on January 21: “Cracking the (Tax) Code for R&D.”
- This workshop provides one CPE credit for professionals who are keeping up with continuing education.
Reminders
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Arizona taxpayers applying for the state’s refundable R&D credit should immediately request a user name to file applications electronically via the ACA’s Electronic Application System (i.e., Easy Portal).
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The deadline for fourth-quarter 2024 estimated tax payments is January 15, 2025. Taxpayers may pay online via the IRS website.
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Edited by Randy Eickhoff, CPA, Founder & Head Coach at Acena Consulting. Photo courtesy of James Webb Space Telescope on Flickr.