In part 4 of this series, we shifted gears to focus on the project information rather than the expenses that are allowed for qualified activities. The bigger question and the one we will look at today is HOW we qualify projects as qualified research and development. Today, we will look at Project Qualification;
Many people are familiar with the four-part test that each activity or (as I suggest my clients think about it) development effort must undergo in order to be considered qualified research and development. As you will note, the answers to each test can be subjective and can vary depending upon the industry and activity. As a side note, I went through a discussion of these tests in Navigating the R&D tax credit minefield (Part 2) in our April, 2011 blog. Feel free to refer back to it for additional information.
Business Component Test
Under Section 41 (and supporting regulations) of the Internal Revenue Code (IRC), qualified research means research that is intended to be useful in the development of a new or improved business component of the taxpayer (IRC Section 41(d)(1)(B)(ii)). A business component is defined as a product, process, computer software, technique, formula or invention which is to be used in a taxpayer's trade or business (IRC 41(d)(2)(B)(ii)).
What constitutes an improvement?
Simply, an improvement is research conducted that relates to improved function, performance, reliability or quality. As you can imagine, the terms improved quality, performance, function or reliability are defined differently for different taxpayers.
Would the research devoted to evaluating new materials or food products that are incorporated into a new high protein food qualify? In most cases, yes, the efforts to evaluate and experiment with new materials will meet the tests for qualified research and development (assuming all four tests are met).
Elimination of Technical Uncertainty
We find the technical uncertainty requirements for qualified research incorporated into IRC Section 41 by reference to IRC Section 174 (Why make it simple, right?). Under IRC Section 174, expenses eligible for treatment as R&D expenses must be intended to discover information that is not available to the taxpayer AND to eliminate uncertainty either about the capability, or method of developing or improving the product or the appropriate design (IRC Section 174). Keep in mind that this requirement is a taxpayer-by-taxpayer test. Even though another company may have solved the same riddle your company is trying to solve, you can still qualify for the R&D tax credit for your efforts (as long as you are not reverse engineering another company’s work).
Process of Experimentation
Under the process of experimentation test, substantially all of the research efforts of the taxpayer must constitute a process of experimentation (I always appreciate a definition that incorporates the term you’re defining as part of the answer). What is a process of experimentation? For our purposes, a process of experimentation is a process that evaluates one or more alternatives designed to eliminate the technical uncertainties identified at the onset of the development effort.
From a documentation standpoint, it is important to document the uncertainties, alternatives and process conducted. I encourage my clients to also document the failures and reasons for multiple iterations of a particular development effort. This type of documentation helps substantiate the process of experimentation and demonstrates that the uncertainties existed.
The final test that each development activity must pass focuses on hard sciences. In short, the process of experimentation must rely on the principles of biological, engineering or computer science. In practice, this test is typically the easiest to pass given the principles of one of these sciences must be inherent in the process of experimentation.
In short, documenting the answers to these tests can seem a difficult task. In some companies where an R&D project might only last a few days but meet all the above requirements (and there may be thousands of R&D projects), a streamlined and consistent process should be developed. Some consultants suggest sampling major projects rather than documenting all projects. Unless a true statistical sample is taken, this approach can be risky and result in a difficult audit if questioned.
We recommend documenting all qualified activities against the above criteria in order to satisfy the expectations of both the IRS and state taxing authorities. Our team has developed a number of processes for various sizes of companies to help them develop efficient documentation standards for their research efforts without creating paperwork that inhibits their ability to drive their business.
Whatever process you choose, make sure your trusted business advisor agrees that it generates the documentation necessary.
Randy Eickhoff, CPA is President of Acena Consulting. With more than 20 years of tax and consulting experience, Randy focused on helping companies successfully document and secure tax incentives throughout the US. He has been a long-time speaker nationally as well as conducted numerous training sessions on R&D tax credits and other US tax incentives.
Click below for a free online documentation software demonstration