Qualifying for R&D Tax Credits: The Four-Part Test

By March 19, 2020Uncategorized

In 1981, the federal government introduced the Research and Experimentation tax program. The purpose of this program was to increase the amount of new technology coming out of the U.S. And create jobs. The program had initially been intended to be a temporary one but was extended by acts of Congress over 12 times. In December of 2015, the Protecting Americans from Tax Hikes, or PATH Act, established the R&D tax credit as a permanent program.

While this tax credit was initially drafted to cover research expenses, typically those in a laboratory or similar setting, modifications to the program widened the potential pool of recipients.

The Purpose of the Four-Part Test

The idea behind the R&D tax credit is relatively simple: if you limit a company’s liabilities as they pertain to research spending, you incentivize them to conduct further research. The tax credit is given as a certain percentage of a business’ qualified research expense that exceeds a given base amount.

There are many things that qualify as QREs – more than most people realize. These can include contracted research, salaries of employees and supervisors, and supplies used in the research. In order to determine whether or not a given expense qualifies as a QRE, a simple four-part test was created. Tax credit eligibility for R&D mainly comes down to whether the research being conducted meets the IRS’s criteria in four areas:

  1. Establishment of Uncertainty- The IRS requires that the company seeking R&D tax credits establishes that there is some aspect of uncertainty at the onset of the research. There needs to be uncertainty in one of the following three areas:
    1. Can this be done? In other words, is the business taking a risk in making this endeavor?
    2. How can this be done? Put another way, is there uncertainty in how the business will go from the original concept to a finished product?
    3. What would the appropriate design of the desired outcome be? Uncertainty in this area would mean knowing that the process can be done or the product can be made, and that the business knows how they will get to the final product, but are unsure of what the final product will actually look like.
  2. Technological in Nature- The IRS also requires companies to prove that their research and development is occurring in one of the high sciences. These include engineering, chemistry, computer science, and biology.
  3. Process of Experimentation- The third requirement for R&D tax credits dictates that a company must show, through some sort of method of experimentation such as trial and error or modeling, that there are no reasonable alternative paths to the intended final result.
  4. Qualified Purpose- Finally, the IRS requires that the company shows that they are attempting to develop some new or improved product, technique, process, formula, software, or other invention. This eliminates such adjustments as changing some aesthetic aspect of the product.

Examples of Qualifying Research Activities

While the four-part test may seem a bit stringent, there are many examples of qualifying research activities. Such activities include:

  • Designing LEED eligible components,
  • Conceptualizing and designing HVAC systems,
  • Developing new software,
  • Prototyping and modeling,
  • Streamlining an existing manufacturing process,
  • Adding equipment to an existing manufacturing process,
  • Applying for or developing patents.

A qualified R&D tax credit expert can help any company figure out whether they qualify for R&D tax credits through the use of a tax credit study.

Do Your Activities Qualify?

At Incentax, we specialize in identifying and maximizing the tax credits that your business is eligible for. Our entire team is made up of industry experts, many of whom have previous experience with the Big 4. We provide audit support as a means of guaranteeing our work and work on contingent fees. That means that we only get paid if we can find savings for you. If you’d like to find out if your business activities qualify for R&D tax credits, contact us today.