The federal Research and Development Tax Credit (“R&D Credit”) was enacted in 1981 as an incentive to encourage domestic creation of new or improved products and processes, thereby increasing economic growth and U.S. competitiveness. Recent legislation has broadened the definition and hence the scope of the credit. In addition, new calculation methodologies have been added resulting in an increase to the number of taxpayers that are eligible for the credit. By taking advantage of the federal credit, and state and global credits where applicable, taxpayers can mitigate the cost and risk of research and development.
Currently the maximum federal tax incentive is equal to 13% of the qualifying expenditures that exceed a base amount. The credit is nonrefundable, but may be carried back one year and carried forward twenty years. Most states also allow a credit, which in some cases is larger than the federal credit. Globally, many other countries are now offering substantial incentives for research and development conducted within their borders.
The credit is allowed on the following categories of expenditures:
- Taxable Wages
- Contract Research
To qualify for the R&D Credit, activities must generally meet all the following four requirements:
- Permitted Purpose – Activities must relate to a new or improved function of a business component, or the business component’s performance, reliability, or quality.
- Development Uncertainty – This means that the development activities must be intended to discover information that would eliminate uncertainty concerning the development or improvement of a business component.
- Technological in Nature – The development must involve research in the physical or biological sciences, engineering, or computer science.
- Process of Experimentation – Includes the identification of uncertainty, identification of one or more alternatives to eliminate that uncertainty, and conducting an evaluation of the alternative(s). Acceptable evaluation methodologies include, but are not limited to, modeling, simulation, or systematic trial and error.
It is vitally important to properly document your research and development contemporaneously to the conduct of the activity. Although the IRS requirements for documentation are ambiguous at best, a system should be developed to capture relevant information. Unfortunately, the IRS has shown very little sympathy for taxpayers who suffer from the IRS’s own failure to provide guidance in this area. In addition, the research credit has been designated a “Tier One” issue under the IRS LMSB Strategic Initiative, subjecting claims for the credit to even greater scrutiny than credits claimed on originally filed tax returns. Premier Tax Consulting has extensive experience in working with clients to create and accumulate the needed documentation to substantiate research credits claimed.