R&D Tax Credit: Failure vs. Success

7 Minute Read
Posted by Randy Eickhoff on Oct 19, 2017 4:25:00 AM

One of the things I tell my clients when we evaluate their development activities is that attempting to develop a new product and failing is a good thing for us when looking at the project for the R&D tax credit.

 

How can that be?

 

Failure costs time, money and resources. However, in the world of tax incentives, (and specifically, the R&D tax credit), failure is evidence that you have attempted to develop something, had uncertainties that needed to be eliminated and most likely went through some sort of process to achieve the desired outcome and were unsuccessful.

 

Let’s take a closer look at projects that fail and succeed as well as some changes in the tax law that are beneficial to you when spending money on research and development.

 

How do I qualify my project for the R&D tax credit?

 

The federal research tax credit has two components that must be evaluated and documented. The first is determining whether or not the development projects undertaken qualify. Under Section 41 of the Internal Revenue Code, each project (or development effort) must go through a four-part test to determine if it qualifies.

 

These four tests are:

 

The Business Component Test

Elimination of Technical Uncertainty

Process of Experimentation

Scientific Principles

Let’s take a quick look at each test:

 

The Business Component Test

Simply, the development effort must be to develop a new or improved business com

ponent for sale or use by a customer. We define a business component as a product, process, software, technique, formula or invention. In order for an improvement to qualify, the effort must 

related to new or improved functionality, performance, reliability or quality.
 

Example:

Acena Consulting R&D Tax Credit Blog

Surfware, LLC (a fictitious US based software company) embarks on the development of a new software to be used by surfers to predict wave height and

 speed through their smartwatch. The software would be considered the business component. Assuming they plan to sell this to customers, they would pass the initial test.

 

Elimination of Technical Uncertainty

In order to qualify, there must be uncertainty related to a taxpayer’s capability, process or appropriate design of the business component. Notice that I said the taxpayer’s rather than the industry’s uncertainty.

 

It is important to remember that these tests are applied at the taxpayer level. Even though another taxpayer may have solved the same uncertainty, if the current taxpayer encounters uncertainty related to capability, process or design, they can pass this test.

 

In our experience, taxpayers struggle with the appropriate design of the business component they are trying to develop more than capability or process.

 

Example:

Surfware recognizes at the beginning of the project that they do not know the appropriate design or coding for their software. They realize they can develop it but have significant uncertainty about the coding, interface, platform and connectivity with various types of smartwatches.

 

Process of Experimentation

The Internal Revenue Code defines this as:

 

“…a process designed to evaluate one or more alternatives to achieve a result where the capability or the method of achieving that result, or the appropriate design of that result, is uncertain as of the beginning of the taxpayer's research activities…”

 

The process can be computer modeling, simulation, systematic trial and error or iterative so long as it meets the definition above.

 

Example:

Surfware developers develop several iterations of computer code in an effort to generate the connectivity, results and speed needed for their software. The iterative development effort evaluates several methods of data collection, ways to connect to the smartwatch and display the results. This approach would satisfy the test.

 

Scientific Principles

The Process of Experimentation used to discover information (think technical uncertainty) must fundamentally rely on the principles of the physical or biological sciences, engineering or computer science. It is important to note that this test does not require a taxpayer to obtain information that exceeds, expands or refines the common knowledge of skilled professionals in a particular field.

 

Example:

Surfware’s development team utilizes the principles of computer science for their coding and development of the software.

 

OK, my project qualifies. How does that translate into a tax credit?

 

Once we have determined that the projects meet the 4-part test, we must now determine the expenses that are connected to the project AND fit into the category of qualified R&D expenses.

 

Under Internal Revenue Code Section 174, expenses incurred in connection with a taxpayer’s trade of business which represent research and development costs in the experimental or laboratory sense.

 

While these expenses may be deducted in the year incurred, the R&D tax credit only allows certain classes of expenses to be included in the calculation.

 

Under Section 41, only the wages, supplies and contract research expenses may be included in the calculation for the tax credit. This means that some expenses incurred for R&D may not be included.

 

In addition, the wages of employees completing, supervising or supporting the qualified R&D activities must be analyzed to include only the wages for time spent on the projects rather than their entire salary.

 

Supplies incurred on R&D projects typically include materials used in the testing or prototyping phase of the project as well as tooling costs.

 

Lastly, any outside costs incurred that are completed on the project as part of the development or R&D effort can also be included (65% of outside expenses rather than the full 100%). An example of a qualified outside costs would be a freelance software developer (based in the US) that was brought onboard for their special skills and experience.

 

Failure vs Success

 

As noted above, regardless of whether a project is successful and results in a new or improved business component, the time spent can qualify as a qualified R&D project and be included in the tax credit calculation.

 

In many cases, a taxpayer may not consider the time and effort expended on the improvement of a current product or software as qualified R&D. Likewise, they may consider a failed project as simply a sunk cost rather than an additional project that can generate a research tax credit.

 

Careful evaluation by a trained R&D tax credit expert will provide the correct filter and evaluation for including projects that may be difficult to otherwise qualify.

 

How do I secure my credit in the event of an audit?

Documentation and proper evaluation are the keys to successfully defending your tax credit. It is not only important to document the expenses but to do so at a project level. While recent court cases have softened the ability of the IRS to completely disallow an R&D tax credit where documentation is light, they can (and do) make adjustments that reduce the overall credit.

 

Proper review and knowing the types of documentation to develop and provide are critical to the overall success of your R&D credit under audit.

 

At Acena Consulting, we recognize that you have a lot more on your plate than worrying about another tax credit. Our role is to bring strong tax technical knowledge, ability to build efficient processes, and answer the questions you may not know to ask.

 

We take this concern off your list so you can focus on your core business. 

 

Want to learn more about the magic of our approach?

 

Let’s get started!