We conclude 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.
This article examines the fourth and final subtest: Technical Uncertainty.
What is Technical Uncertainty?
Qualified R&D must attempt to eliminate Technical Uncertainty. Technical Uncertainty exists if the available information to the taxpayer (e.g., your business) does not establish either the appropriate design of the business component, or the capability or method for creating or improving the business component.
The presence and resolution of Technical Uncertainty define the start and end of qualified R&D, respectively. Technical Uncertainty still exists if it is unknown, “Can we or how do we make something work?”
Recall from our explainer on Permitted Purpose that under 26 U.S. Code § 41(d)(2):
- Business components are held for sale, lease, or license to taxpayers (e.g., American customers), or intended for taxpayers’ use during business or trade.
- Qualified types of business components include products, processes, computer software, techniques, formulas, and inventions.
What are the Types of Technical Uncertainty?
The three types of Technical Uncertainty are set forth under the 26 Code of Federal Regulations (CFR) § 1.41-4.
- Appropriate design refers to the blueprint or specification of a business component. If this uncertainty is resolved, then it is known why the component should work as intended.
- Most R&D projects attempt to address uncertainties related to appropriate design.
- Example: A heating, ventilation, and air conditioning (HVAC) company is asked to create a custom system for a space storing musical instruments. The system needs to operate efficiently and maintain a constant temperature, and the humidity cannot exceed a threshold that would deform the instruments. It is unknown how the HVAC system should be designed to meet these criteria.
- Capability refers to the ability to create or improve a business component. If this uncertainty is resolved, then it is known whether the component could be created or improved using a defined set of resources.
- Example: A computer science company designed a chip to transmit the images of a client’s near-Earth telescope. While modeling results support that the chip should perform as intended, the company does not know whether it can be fabricated to the level of precision required for the chip to function in a vacuum.
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Method refers to the means of designing or developing a business component. If this uncertainty is resolved, then it is known how the component should be created or improved.
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Example: A consultancy for civil engineering is tasked with restoring a coastal wetland affected by an oil spill. However, the R&D team does not know what combination of approaches (e.g., controlled burns, invasive species removal, or reforestation) would most effectively and rapidly rehabilitate the biodiversity and the ecosystem's functionality.
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Four-Part Test Recap
Let’s review all criteria for qualifying R&D activities using the four-part test.
- 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 Process of Experimentation (PoE) that fundamentally relies on the principles of physical or biological science, engineering, or computer science.
- 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 Uncertainty is resolved.
- The PoE must attempt to eliminate Technical Uncertainty related to either the appropriate design of the business component, or the capability or method for creating or improving the business component.
Do you still have 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.
Stay Informed
Happy holidays from all of us at Acena Consulting!
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.
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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 Andrea Luck on Flickr.