The 4-Part Test to Qualify for the R&D Tax Credit

The Research and Development (R&D) Tax Credit, recently made permanent, can be a financial boon as you work to improve cash flow in your business. As we've discussed in previous posts, if you rely on the hard sciences or use technology in your business to create or improve products or processes, you might be able to reduce your federal taxes by a portion of the qualified costs incurred.

A four-part test can help you determine if your company’s activities qualify for the R&D credit.

#1: Permitted Purposes

To qualify for the R&D credit, the activity must relate to a new or improved business component’s function, performance, reliability, quality, or composition. You don’t necessarily have to discover an innovation or advancement that’s new to your industry, only what may be innovative or new to you and your company’s processes or products.

#2: Technological in Nature

The activity performed must fundamentally rely on principles of physical sciences, biological sciences, computer science, or engineering. For example, if you’re in food production, simply adding more salt to your product won’t necessarily qualify—but a method based in hard sciences to enhance your product’s flavor might, as would similar methods designed to keep food fresher longer.

#3: Elimination of Uncertainty

The activity must be intended to discover information to eliminate uncertainty concerning the capability or method for developing or improving a product or process, or the appropriateness of the product design.

#4: Process of Experimentation

The qualifying activities must constitute the process of experimentation involving: simulation; evaluation of alternatives; confirmation of hypotheses through trial and error; testing and/or modeling; or refining or discarding of hypotheses.

Beyond definitions stipulated by the four-part test, examples of activities that might qualify for the credit include those to advance the design of an existing product or process, or those to correct significant design defects or obtain significant cost reductions or enhanced function. Costs of design, construction, and testing of pre-production prototypes and models can also qualify.

For example...

Let’s say you’re a manufacturing firm developing eyewear and you want to increase productivity 10% to 15%. Your costs for doing an evaluation of the raw materials, considering new molds, and determining such factors as the proper heating and cooling temperatures for that raw material and/or molds may qualify for the R&D credit.

Similarly, if you have a product run by software, costs of developing new software to make that product more reliable and more efficient might quality for the credit. If you’re an architectural or engineering firm, costs of researching and incorporating green technology might qualify.

Other activities potentially qualifying for the credit: conceptual formulation, design, and testing of possible product or process alternatives; launch activities involving a new component or process; or design time, tool design and testing, prototype building, and similar activities. Also:

• Engineering efforts to develop new plant processes or technical redesign of an existing plant layout that result in substantial production gains;
• Efforts to solve production problems where there was uncertainty as to the best solution; and
• Design and testing involved in improving the configuration or altering the composition of an existing product or process to increase efficiency or decrease cost.

Some activities do not qualify for the R&D credit, including funded research (for example, funded by a government grant), ordinary testing and inspection, research done outside the U.S., reverse engineering (unless such engineering involves an enhancement, in which case a percentage of your R&D costs may qualify for the credit), adaptation of an existing business component to a particular customer’s requirement or need (for example, adapting a computer program you sell to a particular customer’s requirement), or research with a non-functional focus such as improving or changing style, taste, or cosmetic changes.

Also not qualifying: research after commercial production; management studies or activities; and efficiency or consumer surveys.

Qualified costs include wages paid to employees directly involved with, in direct supervision of, and in direct support of the R&D; materials and supplies used and consumed in the process; and work performed by outside contractors in any of the four parts of the test qualify as long as you retain substantial rights in what the contractors do.

The R&D credit can apply to companies in many industries. We can help you explore the potential of the R&D credit for current and prior open tax years and talk about how your efforts to grow your business could generate cash savings on your federal (and state) tax returns. Contact us to learn more.

For more insight, observations and guidance on the R&D Tax Credit, visit our Freed Maxick Guide to the Federal Research and Development Tax Credit webpage.