Innovation and improvement are the lifeblood of business. If companies wish to outperform their competitors, they must offer customers newer and better products and services than those already on the market. But such innovation requires companies to invest in expensive research and development and assume the risk that such R&D may not even produce a marketable end product. The Research & Development Tax Credit is a dollar-for-dollar federal tax credit that incentivizes businesses to develop products and services by mitigating their liability for R&D costs come tax time.
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What Are Qualified Research Expenses (QREs)?
Research expenses claimed by companies under the R&D tax credit are called qualified research expenses (QREs). Any company that performs a “qualifying research activity” (QRA) within the US can claim the credit. However, many businesses fail to do so because they misunderstand qualified research expenses or do not believe the work they do counts as a qualifying research activity.
How To Know If Your Business Performs a Qualifying Research Activity
The IRS provides the following four-part test to determine if a research activity qualifies for the R&D tax credit:
- The purpose of the research must be to create a new product or process or improve upon an existing one, with an end goal to increase performance, function, reliability, or quality.
- You must be able to show that one of your goals was eliminating uncertainty regarding the development or improvement of a product or service. If you lacked information needed to improve your product or service and conducted your research to acquire that information, then you conducted a qualifying research activity.
- You must engage in experimentation, completing a trial-and-error process of testing theories to acquire the information you need to eliminate uncertainty regarding the development or improvement of your product or service.
- The development must be technological, and the process of experimentation must rely on hard sciences.
Are you still uncertain whether your company’s activities count as qualified research activities? Parachor Consulting can help you determine what R&D tax credit qualified expenses your company can claim for its research activities.
What research expenses qualify for the R&D tax credit?
The Internal Revenue Code (IRC) sorts QREs into two categories, “in-house research expenses” and “contract research expenses.” Activities within each of these categories must meet specific criteria to count toward the R&D tax credit.
Qualifying In-House Research Expenses
IRC section 41(b)(2) defines in-house research expenses as
- Any wages paid to an employee for “qualified services” performed by that employee.
- The cost of supplies used to conduct qualified research.
- Any amount paid to another person for using computers to conduct qualified research.
The third point is simple enough to understand, but the first two require more explanation to fully grasp.
Employee Compensation for Qualified Services
Employee wages may count towards the R&D credit, but only if that employee performs a “qualified service.” Business owners may be understandably confused about whether the work performed by one of their employees counts as such. To clarify, an employee performs a qualified service if:
- They engage in qualified research. This includes employees directly involved in conducting research, such as scientists performing lab experiments, developers coding new software, or engineers drawing up process plans.
- They directly supervise qualified research. This includes first-line managers or supervisors overseeing qualified research, such as scientists who supervise lab experiments. Higher-level managers to whom first-line supervisors report are not included here, even if they also work in research.
They directly support qualified research, meaning they support either the employees actively engaged in research or the direct supervisors of those employees. A CNC machinist who produces the parts for an experimental model or prototype counts as directly supporting qualified research. An employee performing administrative services does not count, even if that employee is also a member of the research department.
Supplies Used to Conduct Qualified Research
The IRC defines “supplies” as tangible property used to conduct qualified research. These supplies must be directly related to the research and must be used by employees performing one of the “qualified services” described in the section above. Several types of property, supplies, and expenses cannot be claimed under the R&D credit, and these include:
- Any property subject to the allowance for depreciation, such as the building inside which research occurs.
- Land or improvements to said land.
- Non-tangible expenses, such as rental or lease costs, license fees, professional dues, royalty expenses, entertainment, travel, or relocation.
- Supplies used for administrative activities.
Qualifying Contract Research Expenses
When companies lack the expertise or facilities needed to conduct their research activities, they may need to contract with a company better equipped to perform that research. In such cases, the R&D credit allows taxpayers to recoup 65% of the costs incurred to pay for qualifying contract research. If a “qualified research consortium” performs the contracted research work, then a taxpayer may recoup 75% of the costs of that research. The same standards for qualified research and services apply to contract research as do to in-house research, and prepaid research expenditures aren’t eligible for the credit until the completion of those services.
The taxpayer needs to make a formal agreement with the third-party contractor (typically in writing) to claim contract research expenses, and both parties must enter into this agreement before performing the qualified research. The taxpayer must retain rights to the results of this qualified research, and they must also bear the economic risk of conducting it.
This last point is critical. The taxpayer must be paying for the research itself and not just the successful completion of a product if they wish to claim contracted work under the R&D credit. After all, this credit exists to reward companies for assuming the risks and cost of developing new products and services or improving upon existing ones. Without taking on those risks and costs, you cannot claim the R&D credit for contracted research.
Payments to Qualified Research Consortia
When qualified contracted research is performed by a “qualified research consortia,” the taxpayer can claim 75% of the contract research costs instead of just 65%. This is yet another term in the tax code that may confound business owners, but the definition is simple enough. Qualified research consortia include organizations that are:
- Tax-exempt 501(c)(3) or 501(c)(6) organizations.
- Organized and operated primarily to conduct scientific research.
- Not a private foundation.
These organizations must also perform research on behalf of both the taxpayer and at least one other unrelated party, meaning a qualified research consortium must have at least two different taxpayers as employers.
Determining Your Companies R&D Tax Credit Eligibility
Determining your qualified research expenses under the R&D credit can be an intensive process, requiring careful analysis of every aspect of your research activities. At Parachor Consulting, we employ a team of CPAs, attorneys, engineers, and statisticians, who are experts in tax incentives. We work to help your business claim the maximum tax benefits legally possible, and there’s no risk to utilizing our services. If we can’t identify R&D tax credit incentives for your business, we won’t charge you for the consultation.
Do you want to get the most out of the R&D tax credit? Then contact Parachor Consulting today and let our tax incentive experts determine every R&D tax credit qualified expense your business can claim.